1. UK government ‘IR35’ rules around off-payroll working by contractors in the private sector changed in April 2021
2. IR35 rules are designed to combat PAYE tax avoidance through ‘disguised employment’, a practice whereby employees are incorrectly classified as contractors, allowing clients and contractors to pay less tax and National Insurance Contributions.
3. Medium to large end-clients are now responsible for correctly classifying contracts according to IR35 criteria. Workers and any agencies involved in the employment chain must also ensure that the IR35 status is correct for each contract. Small businesses are exempt.
4. Her Majesty’s Revenue and Customs (HMRC) apply specific criteria to distinguish self-employed contractors from regular employees. There are also some legal grey areas. Contractors and the companies who hire them may benefit from taking expert advice before agreeing assignments in order to maintain legal compliance and tax efficient operation.
The IR35 legal and tax rules around off-payroll working in the private sector have changed in the UK. Since April 2021 end-users have responsibility for evaluating the IR35 status of assignments given to contractors. If assessment shows that contractors are ‘deemed employees’ for HMRC purposes, the end-client must pay relevant tax, National Insurance, and Health and Social Care contributions.
Whether you’re a contractor with your own limited company or a business leader wondering how IR35 rule changes might affect your contingent workforce and bottom line, our article explains the key facts and context you need around off-payroll working in the UK today.
What is IR35?
IR35 is the common term used to describe application of rules around UK off-payroll working under legislation designed to combat tax avoidance. The term came from the Inland Revenue press release announcing a government clamp down on disguised employment in 2000 (this is similar to the notion of ‘employee misclassification‘ in other countries such as the US). IR35 rules target contractors who are considered to be ‘disguised employees’ according to HMRC criteria.
IR35 is governed by two relevant areas of law:
- Section 8 of the Income Tax (Earnings and Pensions) Act 2000
- The Social Security Contributions (Intermediaries) Regulations 2000.
How are contractors taxed in the UK?
Employees and contractors are treated differently under UK employment law and tax laws.
If a contractor provides services through their own limited company without receiving employee benefits (pension contributions, sick pay, annual leave allowance etc..), they will generally be taxed in a different way to employees.
Contractors may take some of their pay in dividends from their company instead of taxable salary. They can also offset many business expenses against tax, and will pay less in National Insurance Contributions.
The lower tax requirements are intended to reflect the greater financial risk entailed by being self-employed.
Aside from limited companies, the self-employed might also choose to operate as a sole proprietor or sole trader, though, in that case, they will pay taxes on their income at full personal income tax rates (not corporate rates).
It should also be observed that contractors in the UK are often eligible for the tax-free trading allowance that does not apply to employee income.
How has IR35 changed recently?
New off-payroll rules were introduced in the UK in April 2021. These changes brought those working for medium to large private sector firms into line with amendments already implemented across the public sector in April 2017.
Under updated IR35 rules, contractors operating through limited companies in the private sector can no longer independently set the IR35 status of their own assignment. Responsibility for setting correct IR35 status lies with the end-client (except for small businesses, who are exempt). Contractor, client and any intermediary parties involved, must all ensure that they remain IR35 compliant.
After making an IR35 status assessment on a contract, the end-client must pass a record of this evaluation – including the decision, reasoning and evidence of “reasonable care” – to all relevant parties. This document is known as a Status Determination Statement (SDS). If the contract is amended, the client must create a new SDS, assessing whether changes have altered the IR35 status of the relationship with the contractor.
If the contractor disagrees with an SDS decision, they can appeal within 45 days, and their client will have an additional 45 days to consider and respond to their appeal. If a client company doesn’t meet the 45 day limit for response they become liable for taxes and NICs incurred by the contractor due to changed IR35 status.
Who does IR35 apply to?
IR35 rules must be checked by:
- Workers who provide services through an intermediary entity (limited company, partnership etc..)
- Clients who receive services from a worker via a limited company or other intermediaries
- Recruitment and other agencies providing workers’ services.
Contractors will be ‘caught’ by IR35 rules when they provide services to their clients via an intermediary legal entity, and if they would be classified as employee without use of the intermediary entity.
HMRC uses specific criteria to determine whether contractors lie ‘inside’ or ‘outside’ IR35. Some criteria are common sense and will show quickly and clearly that certain workers are contractors or employees. If you’re unsure, an HMRC online tool allows you make an unofficial employment status check.
Stricter IR35 rules have nudged some limited company contractors into moving to an ‘umbrella’ working model where they are become temporary employees of an umbrella company. Umbrella company workers pay the same tax as ‘inside’ IR35 contractors, but also receive benefits including holiday and sick pay entitlements. Umbrella working is typically a temporary arrangement and does not provide the same long-term employment solutions as a Global PEO service.
There are a number of legal grey areas where contractors and client companies might benefit from professional advice before agreeing or renewing a contract in order to ensure they remain both compliant and tax efficient.
What happens if a non-employee worker meets IR35 criteria?
Tax and National Insurance payments
HMRC classifies workers falling inside IR35 as ‘deemed employees’. On this basis, the end client (or recruitment agency, if involved) must pay income tax and employers and employees National Insurance Contributions (NICs) for these contractors, just as for any other ordinary employees in the same tax bracket. This can potentially reduce a contractor’s net income by 25%.
Employment rights and benefits
If contractors are caught inside IR35, and liable to pay taxes as an employee, this does not automatically confer full employment status beyond tax obligations. IR35 employees are not entitled to employment rights and benefits such as pension contributions or annual leave.
Penalties may be given by HMRC if a contractor now caught by updated IR35 rules was found to have been previously classified outside IR35 and therefore paying less tax than they should have done in earlier tax years. These contractors, and their end-clients, are obliged to back pay missing taxes plus interest and penalties. HMRC has powers to investigate up to six previous tax years.
While the UK government has stated that it does not plan to enforce penalties for accidental rule-breaking by those who have taken “reasonable care”, they have also been clear in plans to punish and publicly identify companies who deliberately break the rules.
Evidence of “reasonable care might include gathering and recording information on whether the contractor has other clients, whether their work entails financial risk, and working patterns and practices which are not identical to those of employees.
When does HMRC consider a contractor as a ‘deemed employee’?
HMRC is able to conduct IR35 compliance checks on contractors, investigating both the wording of contracts and working practices in the course of delivering contracts. The outcome of an HMRC checks would determine whether a contractor should be considered as employed or self-employed for tax purposes.
Factors considered as part of HMRC’s decision-making on whether a contractor lies inside or outside IR35 include:
- Mutuality of obligation
- If a contract contains clauses obligating a client to give further work, or for a contractor to accept further work, this implies ‘mutuality of obligation’, a key characteristic of an employment relationship, rather than self-employment. Contracts which set to roll over, or are continuously renewed, could also imply mutuality of obligation and place the contract within IR35 rules.
- Right of substitution
- Another key characteristic of an employment relationship is having one individual assigned to carry out a particular role. Where this constraint is built into a contract, the worker is more likely to be considered within IR35. If a contractor is free to carry out contracted duties themselves or to hire someone else appropriate to complete them, they are more likely to be considered self-employed and outside IR35.
- Right of control
- Generally, the more control exerted over a contractor by a client, the more likely the assignment is to fall within IR35 rules. Contracts that specify work in detail, including when, where and how it needs to be completed, strongly imply an employment relationship and are likely to fall within IR35.
- Shifting contractors to meet client business priorities, or controlling contractor workstreams and performance through a corporate line-management system are also examples of context which is likely to be found in employment situations.
- If contractors have autonomy in how they deliver their contractual obligations, this is more indicative of self-employment falling outside IR35.
What other factors contribute to HMRC’s decision?
IR35 regulations are complex and HMRC may consider and balance a wide range of information on individual cases, including contract wording, context and working practices. Contracts which resemble those of comparable full-time employees are likely to be caught inside IR35. Relevant considerations can include:
- Employee benefits
- Workers receiving learning and development courses, annual leave, sick pay and pensions contributions are likely to be considered as employees. These benefits are not normally given to contractors.
- Financial outlay for work
- Contractors may have to pay for their own equipment, training, software etc.. while employees would normally have everything they need to work provided by their employer.
- Termination of contract
- Employees normally have a set notice period agreed in their contract. Clients are able to terminate the assignment of a contractor immediately and without notice.
Horizons and IR35
Despite IR35 changes and ongoing challenges and risks around Brexit, the UK offers growth opportunities and an impressive talent pool for many businesses. Companies operating in the UK must ensure they understand and are able to comply with the updated IR35 regime. Horizons offer Global PEO solutions in the UK as part of their international work across 150+ countries. Get in touch today for tailored guidance on IR35 and wider UK business needs.
Frequently Asked Questions
IR35 rules are intended to combat tax avoidance by contractors who are effectively operating as employees while benefiting from the self-employed tax regime. Contractors who fall clearly outside IR35 are deemed self-employed by HMRC and are able to pay lower overall levels of tax and National Insurance Contributions. IR35 contractors who fall within the HMRC off-payroll rules must pay tax and national insurance on the same basis as any other employee performing their role.
Contractors who are fully and clearly self-employed according to HMRC criteria will be considered outside IR35.
In terms of end-clients, small businesses (as defined in the Companies Act 2006) are exempt from IR35. Companies are always considered as ‘small businesses” in their first financial year of trading. After that, they will be considered small if two of the following criteria are met over two consecutive financial years:
– Annual turnover £10.2 million or less
– Balance sheet total of £5.1 million or less
– No more than 50 employees for the company’s financial year.