Most business owners will have heard of the IR35 rules and will be aware that there can be some heavy penalties if a business is found to be in breach of the rules. In this blog we explain IR35, provide an introduction to the rules, the forthcoming changes and how they will affect your business.
What is IR35?
IR35 refers to legislation introduced in 2000 which aimed to tackle the misuse of personal service companies (PSCs) for tax avoidance purposes.
The Finance Act 2000 contained the first set of rules dealing with this issue.
The measures were announced by a government press release entitled ‘Countering Avoidance in the Provision of Personal Services’, which had the reference number IR35 (which is the origin of the term). It described the purpose of the new rules:
“There has for some time been general concern about the hiring of individuals through their own service companies so that they can exploit the fiscal advantages offered by a corporate structure. It is possible for someone to leave work as an employee on a Friday, only to return the following Monday to do exactly the same job as an indirectly engaged ‘consultant’ paying substantially reduced tax and national insurance.
The Government is going to bring forward legislation to tackle this sort of avoidance. The Inland Revenue will be discussing the practical application of new legislation with interested parties and will work with representative bodies on the production of guidance.The new rules will take effect from April 2000.”
Also known as the ‘off-payroll working rules’, IR35 can apply if a contractor provides their services through their own limited company to the client.
The effect of the rules is to ensure that any such contractors, who would otherwise have been employees if they were providing their services directly to the client, pay the equivalent rates of tax and National Insurance Contributions (NICs), as if they were employees.
Any of the following parties need to be aware of their responsibilities under the IR35 rules:
- contractors who provide their services through a PSC or another intermediary
- clients who receive services from a contractor through their PSC or another intermediary
- agencies which provide workers’ services through a PSC or another intermediary
If the rules apply, tax and NICs must be deducted from fees and paid to HMRC.
Changes to IR35
Changes to the off-payroll working rules were due to come into effect on 6 April 2020. However, as a result of the COVID-19 pandemic, these changes were delayed until 6 April 2021 – the start of the new tax year.
The changes mean that all public authorities, and medium and large sized clients will be responsible for deciding the employment status of workers. In effect, they need to decide whether a contractor falls under the IR35 rules.
The new rules apply to all public sector clients, and private sector companies that meet at least two of the following conditions:
- an annual turnover of more than £10.2 million
- a balance sheet total of more than £5.1 million
- more than 50 employees
There is also a simplified test where the only criteria is an annual turnover of more than £10.2 million. This simplified test applies to clients who are not any of the following:
- a company
- a limited liability partnership
- an unregistered company
- an overseas company
Furthermore, if the parent of a group is considered ‘medium’ or ‘large’, their subsidiaries will also have to apply the off-payroll working rules.
What do clients need to do under the new rules?
Clients covered by the new rules are required to determine the employment status of any of their contractors. In this case, the employment status refers to whether a worker is employed or self-employed (i.e. for tax purposes).
A decision on employment status should be made in respect of each and every contract agreed with either the contractor or agency or worker, and this should be communicated using a Status Determination Statement (SDS). This SDS must be passed to the contractor (and agency if applicable) and should contain the reasons for coming to a decision. Other duties include:
- Keeping detailed records of any employment status determinations, along with the reasons for the decisions and any fees paid
- Putting processes in place to deal with any disagreements that arise from employment status determinations
Small-sized clients in the private sector are not required to determine the employment status of their workers or contractors.
Whether or not the IR35 rules apply is determined by the terms and conditions and working practices of each contract. When making a determination, the ‘Check Employment Status for Tax’ service can be used to help clients decide if the IR35 rules apply.
What if a contractor disagrees with a determination?
If a worker disagrees with the employment status determination of a client, the client must:
- consider the reasons for disagreement
- decide whether to maintain the determination if they think it is correct (and provide reasons why) or provide a new determination
- keep a record of any determinations and the reasons for them, as well as records of any disagreements
- confirm which date a determination is valid from
Please note: A disagreement can be raised by a contractor until the last payment is made for their services.
Clients must provide a response within 45 days of receiving a notification of disagreement regarding employment status determination. They should continue to apply the rules in line with their original determination during this period.
Does IR35 apply to my business?
The IR35 rules apply if a worker provides their services to a client through their PSC or another intermediary, under circumstances where they would be classed as an employee if they were contracted directly.
The IR35 rules apply on a contract-by-contract basis. A contractor may have some contracts which fall within the rules and others which do not, depending on the terms and conditions, etc. A contract for the purpose of IR35 is a written, verbal or implied agreement between parties.
What about contractors working through umbrella companies?
Contractors who work through an umbrella company generally will not be affected by IR35.
Although there is no statutory definition of an umbrella company, according to HMRC “it is generally accepted that an umbrella company is a company that employs temporary workers who work at different end clients’ premises.”
Umbrella companies do not act as recruitment agencies. They neither source work for contractors, nor do they find employees for companies. Instead they facilitate the overall contract, acting as an intermediary between the contractors, the end client and occasionally a recruitment agency.
The main purpose of an umbrella company is to manage the employment and payroll of contractors whilst helping to protect end clients or recruitment agencies from being caught by IR35 liabilities.
Penalties for non-compliance with IR35
HMRC have the power to investigate the employment status of off-payroll workers in an organisation in the UK.
If HMRC find that an individual has been incorrectly categorised by the end hirer, they will issue a determination which will require the unpaid PAYE tax and National Insurance contributions. Any late payment fines and interest, will also require to be paid by the end hirer.
HMRC can issue a penalty ranging from 0% to 100% of the initial outstanding liability. This is based on the co-operation of the end hirer during the investigation, and what care was taken in coming to the categorisation for IR35 purposes.
Does IR35 apply to sole traders?
IR35 does not directly apply to sole traders. However, any clients who use a sole trader will still be required to follow the rules for determining the employment status of the sole trader.
As such, many clients will be wary of taking on regular contractors who are sole traders if there is any potential ambiguity regarding their employment status. The client could be penalised for failing to make a correct determination.
Therefore, sole traders may be asked to use an umbrella company to avoid any potential issues regarding IR35.
Other tax considerations
Many sole traders who had used PSCs prior to the introduction of IR35 started using Managed Service Companies (MSCs) instead.
MSCs essentially provided more distance between the contractor and company through which they traded and collected dividends, to try and avoid IR35. However, the government introduced MSC legislation in 2007, which deemed all payments received by a contractor working through a MSC to be employment income.
These days, contractors are often asked by clients to work under umbrella companies which makes it less likely to be caught out by IR35 legislation. But there are no tax benefits for contractors providing their services under an umbrella company, since they are paid via PAYE.
In terms of taxes, sole traders need to pay the following every year:
- Income tax
- National insurance contributions
- VAT payments (if registered for VAT)
Subject to the IR35 rules, converting from a sole trader to a limited company can provide various tax efficiency benefits. Find out more about setting up a limited company here.