What is IR35 and When Does it Apply?
If you’re self-employed, you’ve probably been hearing a lot about IR35 over the past few months. In fact, the mere sight of that specific sequence of letters and numbers on this page may even make your stomach flip. And not in a good way.
IR35 rules have been part of UK law since April 2000. But HMRC has recently proposed extending their scope. And this move is expected to affect an additional 2 million self-employed contractors.
With this in mind, here’s a rundown of what IR35 is, when it applies and how you can avoid it.
What is IR35?
IR35 is a tax law whose full name is Intermediaries Legislation. It’s not so affectionately known as IR35 after press release number 35 — the press release in which the government announced it. It aims to prevent tax avoidance through what the government calls ‘disguised employment’.
What is ‘disguised employment’?
‘Disguised employment’ happens when businesses hire self-employed workers when they really should be hiring employees. This is because the workers fulfil one or more tests of employment (more on this in a minute).
There are several perfectly legal and, more importantly, ethical reasons for hiring self-employed workers. The business might not have enough regular work to justify hiring someone full-time (or even part-time). Or maybe they just need someone for a specific project or to cover during an employee’s leave of absence.
But hiring a contractor can also save a lot of money. It avoids having to pay employers’ national insurance or making pension contributions. And it avoids having to pay sick pay, holiday pay and other benefits.
And here lies the rub.
In disguised employment, the business gets the benefits of an employee without any of the duties. And the worker gets all the responsibilities of employment without any of the benefits.
More to the point, some self-employed workers tend to pay less tax, because they work through a limited liability company or umbrella company. HMRC expect they’ll lose £1.2 billion in revenue to ‘disguised employment’ by 2023. So, it’s not surprising that they want to crack down.
What are the IR35 rules?
IR35 forces businesses to treat self-employed workers as employees if they meet the tests of employment. Or, as contractor insurance providers Qdos Contractor’s Seb Maley puts it, it “looks to differentiate between genuine businesses and workers, who are for all intents and purposes, a temporary employee.”
The upshot is that, if an HMRC inspector finds that a contractor is actually an employee:
- The independent contractor agreement is disregarded
- The worker is treated as if they’d been hired on an employment contract, with all its rights and responsibilities. And, of course, with its tax implications.
What are the tests of employment?
The UK courts have developed the tests of employment for IR35 over 15 years. As a result, they’re complex, nuanced and sometimes contradictory. For this reason, you should seek professional advice.
That said, very broadly, the main tests of employment include:
- Supervision and control, also known as the ‘How, What, When and Where’ test
- Mutuality of obligation
- The nature of the relationship.
Let’s have a more in-depth look at each of these tests.
Test 1: Supervision and control
Do you get to decide:
- How you do your work?
- Where to do it?
- When to do it?
- Whether you’d like to take on a particular job or not?
If you’ve answered ‘yes’ to most of these questions, you’re probably self-employed. If, on the other hand, you’ve answered ‘no’ to one or more of them, you might be an employee.
Telltale signs that you’re probably an employee and, so, within IR35’s scope, include:
- A contract clause specifying the times you start and finish work
- You’re expected to work on specific days
- A contract clause specifying lunch break times
- A contract clause that states your ‘client’ has supervision and control over you during working hours.
Test 2: Substitution
Can you send a replacement if you can’t do the job? Or do you have to do it personally?
If your client expects you to do the job personally, HMRC will likely consider you an employee.
Test 3: Mutuality of obligation
When you’re self-employed, your clients aren’t obliged to guarantee that they’ll give you work. By the same token, you’re free to turn down any projects you don’t want to do. And, you can take on other clients.
This means HMRC will probably consider you an employee if:
- Your contract guarantees a certain amount of work every week or month
- Your contract guarantees the client will regularly pay you a certain amount of money
- You have to ask for the client’s permission to take on other clients
- You’re obliged to take on any work your client sends your way, even if you don’t want to.
Test 4: The nature of your relationship
Are you part and parcel of your client’s business?
This would be the case if, for instance, you’re listed on your client’s website as part of the team. Or you’ve been given duties that would normally belong to an employee, such as being appointed the office First Aider.
HMRC can also look at you and your client’s broader intentions when you made the contract.
When does IR35 apply?
IR35 applies if:
- The services you provide to clients goes through an intermediary
- You hire people who provide services to clients in the public sector through an intermediary
- You or the people you hire would be the client’s employees if they didn’t work through the intermediary
- You or the people you hire hold an office for the client. An example would be if you act as the client’s company secretary.
HMRC calls this working ‘off-payroll’. This is because, while employees get their salary through the pay as you earn system (PAYE), independent contractors submit invoices or timesheets and take care of their own tax and national insurance contributions.
The intermediary can be:
- Your own limited liability company. Also known as a personal service company, or PSC
- An umbrella company, that is a third party limited liability company that employs and pays you and other independent contractors
- A partnership
- Another individual
What are your responsibilities under IR35?
This depends on whether you work in the public or private sector.
Working in the public sector
If you work in the public sector, it’s up to the public authority you work with to decide whether IR35 applies. Public authorities include:
- The UK Parliament, the National Assembly for Wales Commission and the Northern Ireland Assembly Commission
- Government departments, their executive agencies and local authorities
- Companies that the government either owns or controls
- Schools and universities
- The National Health Service.
You won’t be able to start work before the public authority confirms your status. That said, it’s your responsibility to provide the information the authority needs to do this.
Working in the private sector
If you work in the private sector, it’s your responsibility to check whether IR35 applies. This means it’s up to you to make sure your relationship with a client isn’t ‘disguised employment’.
What happens if you’re in breach of IR35?
Two things will happen: you’ll pay more tax and you’ll get hit with stiff penalties.
Paying more tax
Your tax bill as an employee will likely be much higher than it is as a self-employed contractor working through a limited liability company.
Example 1: Your tax bill as a limited liability company
Let’s say you work under your own limited liability company. In 2018/19, you earn £40,000 after expenses.
In this scenario, you’d pay tax as follows:
- You’d probably take £8,424 as a salary. This is lower than the personal allowance of £11,850, so it’s tax-free. It’s also lower than the National Insurance minimum threshold but over the lower earnings limit. Which means you don’t have to pay National Insurance but qualify for National Insurance credits
- This would bring your company’s profits down to £31,576. Your company would pay corporation tax on this amount at a rate of 19 percent, that is £5,999.44. This would leave your company with a profit after tax of £25,576.56
- You’d take that £25,576.56 as a dividend. In 2018/19, a dividend £2,000 is tax-free. The rest, that is £23,576.56, is within the basic tax band rate. This means you pay dividend tax at 7.5%, that is £1,768.24
- So, your total tax bill would be £7,767.68.
Example 2: Paying tax as an employee
Now, let’s say you earned £40,000 as an employee.
The first £11,850 is within the personal allowance, which means it’s tax-free. You’d pay tax on the remaining £28,150 at the basic rate of 20 percent.
This means you’d owe HMRC £5,630 in income tax.
You’d also have to pay Class 1 National Insurance. £40,000 is equivalent to £3,333.33 a month. So, you’d have to pay National Insurance at the basic rate of 12 percent, which would add up to £4,800.
This means that, in total, you’d pay £10,430 as an employee — £2,662.32 more than you’d pay as a self-employed contractor working through a limited liability company.
And that’s just for one year.
Extra taxes aside, it’s not surprising to hear that HMRC will also fine you. The penalties are incredibly stiff:
- 30 percent of your unpaid taxes if HMRC finds you were negligent or careless about your IR35 status
- 70 percent of your unpaid taxes if HMRC finds you knew you were within IR35 but ignored it
- 100 percent of your unpaid taxes if you try to hide your IR35 status.
This means your tax bill could double if you’re not careful. And, of course, you may also get hit with interest on back taxes.
How do you avoid IR35?
HMRC can open an investigation to check you’re not a disguised employee at any time. This means that the only way to avoid IR35 is to make sure you’re legitimately self-employed.
Here are some tips on doing this:
- Always make it clear in your contract that you’re an independent contractor. You can get template clauses from websites such as LawDepot and tweak them as needed
- Make sure you’re in control. At a minimum, you should get to decide how, when and where you do your work. You should also specifically reserve the right to turn down jobs you don’t want to work on. More importantly, keep proof that you have this freedom, such as email trails
- If possible, exercise your right to send a replacement. This shows the HMRC that the obligation to fulfil the work doesn’t entirely fall on you.
- Don’t put all your eggs in one basket. HMRC is more likely to believe you’re a legitimate business if you serve more than one client. In any case, it’s never a good idea to rely on just one client for all your income
- Avoid getting sucked in. Don’t let clients include you on their organisational chart, website or give you company business cards. It’s probably also a good idea to turn down benefits your client gives their employees.
IR35 can be tricky. But if you’re legitimately self-employed and can prove it, you should have nothing to worry about.
As HMRC themselves put it: “We estimate that two-thirds of people working through a company are genuinely self-employed and not affected by these rules.”
So if you’re self-employed, don’t be afraid to flaunt it. Do good work. Be reliable and pleasant to work with.
But embrace your freedom and flexibility too.