If you’re working as a freelancer or a contractor through your own limited company you’ve probably heard people talking about IR35 legislation.
They’ve probably spoken about it in hushed tones, like IR35 is this big scary thing to be feared.
IR35 is a piece of legislation that you need to know about, but it’s not actually as complicated as a lot of people think it is.
In this article:
What is IR35?
Introduced in 1999, IR35 is a tax law. It is properly known as the Intermediaries Legislation and came into force in April 2000 as part of the Finance Act. IR35 takes its name from the original press released published by the then Inland Revenue (now HMRC) announcing its creation.
The income tax element of the Intermediaries Legislation has subsequently been integrated into the Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003), and the NICs element into the Social Security Contributions (Intermediaries) Regulations 2000.
IR35 is tax legislation that is designed to combat tax avoidance by freelancers supplying their services to clients via an intermediary, such as a limited company, but who would be an employee if the intermediary was not used.
Such freelancers are called ‘disguised employees’ by Her Majesty’s Revenue and Customs (HMRC).
If caught by IR35, they have to pay income tax and National Insurance Contributions (NICs) as if they were employed.
Why was IR35 introduced?
IR35 was introduced to tackle the problem of ‘disguised employment’.
This is where organisations engage freelancers on a self-employed basis and usually through an intermediary, rather than on an employment contract, so they become disguised employees.
This can save the engaging organisation a significant amount of cash as they no longer have to pay employers’ NICs, and it also means they do not have to offer any employment rights or benefits.
What is IR35 designed to stop?
The IR35 rules were put in place to stop people leaving work as an employee on Friday, and then turning up on Monday and saying "I’m a limited company contractor now!" and potentially paying a lot less tax revenue to HMRC.
HMRC view this as tax avoidance.
So the overall aim of IR35 is to determine whether you are legitimately self-employed, whether you’re an independent freelancer, or whether you’re what’s known as a ‘disguised employee’ and you should be on the payroll of the company you’re working for.
IR35: Full-Time Employees vs Freelancers
The crux of IR35 is the difference in the way full-time employees are taxed and the way limited company directors are taxed.
If you’re a full-time employee, the way you are taxed is quite rigid and it’s handled by your employer.
If you’re the director of a limited company or a freelancer, you have more flexibility in the way you take on freelance jobs or extract profits out of your company.
So to give you an idea of why this important to HMRC, an employee earning £120,000 a year will pay about £5,000 more tax to HMRC than a limited company contractor.
Key IR35 terms explained
You’ll also find that there’s a lot of jargon around IR35.
- Inside IR35: If you are caught by the rules you can be referred to as ‘inside IR35’.
- Outside IR35: If you are not caught by the rules, you are ‘outside IR35’.
If HMRC decides that you are inside IR35, they can launch an investigation into your business which can run on for many years and be very costly, and could result in you paying back all the tax that you would have paid if you were a full-time employee.
What is the impact of IR35?
The financial impact of IR35 is significant.
It can reduce the freelancer’s net income by up to 25%, costing the typical limited company freelancer thousands of pounds in additional income tax and NICs.
Despite having been in force since 1999, IR35 has been heavily criticised by tax experts and the business community as being poorly conceived, badly implemented by HMRC and causing unnecessary costs and hardships for genuine freelancers and small businesses.
Should you worry about IR35?
If you are a genuine freelancer, sole trader, interim or consultant who is in business on your own account, you should have nothing to fear from IR35.
This is so long as you take the time to understand how the legislation works and apply best practice to ensure it does not apply to you, and have a defence prepared if investigated by HMRC.
What is an example of an IR35 issue?
A common example is the ‘Friday to Monday’ phenomenon.
That is when an employee leaves employment with their employer on a Friday only to return to the same role in the same office on the Monday, only engaged as a freelancer or consultant trading through a personal services company and paying much less tax.
IR35 should have a genuine role to play in defending both freelancers’ rights from unscrupulous employers and the Exchequer from lost tax yield. Unfortunately, the legislation in its current form falls well short of that aims.
How does IR35 work?
Because IR35 essentially seeks to turn a legitimate one person small business into being an employee, it is underpinned by employment legislation and IR35 case law.
As a result, the tests of employment evolved over decades by the UK legal system are applied,
The key IR35 case law dates back to a seminal employment law case tribunal, Ready Mixed Concrete (South East) Ltd v Minister of Pensions from 1968. More recent cases, particularly those ruled on since IR35 was introduced, can also apply. For example, this case involving the BBC.
Essentially, an HMRC inspector will disregard the written contract in force between the freelancer and their client, and use the actual nature of the working relationship to create a ‘notional contract’.
An inspector, or a tribunal judge, will use this notional/hypothetical contract to determine whether the contract is one of employment, when IR35 applies, or one for business to business services where IR35 does not apply.
Not surprisingly, an expert knowledge of employment law is required to fully interpret these tests.
Neither those independent professionals being investigated nor HMRC’s tax inspectors can possibly be expected to become experts.
As a result, IR35 has been incorrectly applied in numerous high profile tax cases, and freelancers are left without certainty about their tax status.
Determining whether you are caught by IR35 is complex, and ideally you should seek expert IR35 advice.
What are the principles of IR35?
IR35 involves applying three principles to determine employment status from the Ready Mixed Concrete case.
These are known as the principal ‘tests of employment’:
- Control: what degree of control does the client have over what, how, when and where the freelancer completes the work
- Substitution: is personal service by the freelancer required, or can the freelancer send a substitute in their place?
- Mutuality of obligation: mutuality of obligation is a concept where the employer is obliged to offer work, and the freelancer is obligated to accept it.
Other factors taken into account to determine whether you are caught by IR35 include:
- the contract type
- whether you are taking a financial risk
- If you are ‘part and parcel’ of the engager’s organisation
- being in business on your own account
- provision of equipment
All of this evidence is taken into account, and if the balance of probabilities is that the freelancer is an employee, then IR35 applies.
So, for example, if a freelancer has an unfettered right to send a substitute in their place, personal service is not required and IR35 cannot possibly apply.
What is a hypothetical contract?
An important concept to get your head around when trying to work out your IR35 status is something called a hypothetical contract.
This is trying to determine whether the contract should be between your client and your limited company or your client and you as an employee.
There will be a contract between the limited company and the client.
However, IR35 looks at the hypothetical contract that would be in place between the freelancer and the client.
This hypothetical contract is very important for IR35.
This is because if it is one of an employee relationship, you are inside of IR35.
A few of the key points that we’ll look around this contract, is both the working practices and the contractual terms between the limited company and the client.
Additionally with this type of structure there could also be an agent in place.
However, IR35 always looks at the hypothetical contract between the freelancer and the client.
What to do if IR35 applies to you?
If IR35 does apply to you, then the legislation makes provision for paying that extra income tax and NICs.
Another frightening aspect of IR35 is that HMRC can go back at least six years and evaluate past contracts to see if the legislation applies.
That means HMRC can demand income tax and NICs, plus penalties and interest, going back several years, resulting in tax demands reaching six figures
When IR35 has been found to apply to an IR35 contract, then you need to calculate what is known as the deemed payment on your limited company income.
This means that you deduct your Pay As You Earn (PAYE) salary, a 5% expenses allowance, plus any pension contributions.
What is left must be treated as if it were a salary from an employer, so you calculate the additional tax due.
In practice, if you are certain your contract is caught by IR35, then the simplest solution is to pay out all of your limited company’s fees less legitimate expenses and pension contributions as a PAYE salary.
Because you are paying yourself like an employee, then IR35 won’t apply.
How can IR35 issues be avoided by freelancers?
If you are a legitimate small business, then IR35 will not apply.
However, that does not prevent HMRC from launching an investigation into whether it does. And that can be time consuming, costly and highly stressful.
There are some other factors you can think about that could influence your status such as when you have to complete the work personally, whether you can leave the contract at any time, and whether you have control over how the freelance work is completed.
Hopefully that clears up a bit of the confusion around IR35, it’s a very complicated subject. If you have any concerns, we recommend you contact an accountant or contract specialist.