Contractors in IT and other industries used to operate as self employed individuals and were responsible for taking care of their own tax and National Insurance payments. HMRC, however, were always rather wary of this arrangement and in the 1980s, the Government legislated to make recruitment companies handling self-employed contractors deduct PAYE from their payments.
The law of unintended consequences kicked in at this point and most recruitment companies pulled out of managing contractors, leaving them to set up their own limited companies. This saw HMRC’s tax take reduce so it went back to the legislative drawing board.
In 2000 the Intermediaries Legislation – IR35 to its followers – was introduced in order to establish the true status of self-employed contractors. What this meant in practice was that contractors who were deemed to be employed now needed to be paid all of their income under PAYE rules with just a five percent allowance paid gross to cover limited company expenses. This is known as ‘disguised employment’ and occurs when a contractor is primarily working for just one business rather than multiple different ones.
This acted as something as a disincentive to setting up as a self-employed contractor because if you were deemed to be employed you ended up paying tax like an employee but without any of the benefits such as holiday and sick pay.
Since its introduction, IR35 has been subject to numerous challenges in the courts concerning the assessment of employment status. For HMRC the legislation has proved hard to enforce.
Why this matters
All of this is important because a contractor working through their own limited company can pay tax at the corporation tax rate on their profits and offset some business costs against their tax liability, as well as avoid making full national insurance contributions. They can then pay themselves a lower salary augmented with dividends to mitigate their income tax liability. Note that this only applies to those who set up limited companies – or personal services companies (PSCs) – those operating as sole traders are not affected.
It cuts tax for employers too as they can avoid paying NI contributions as well as mandatory employment benefits for contractors such as holiday pay, sick pay and pensions.
It’s easy to see why HMRC wants to close this loophole and regularise the status of people who work for just one company but do so on a self-employed basis. It sees them as effectively avoiding tax while taking few if any entrepreneurial risks.
All change in 2020
From April 2020, changes to the way IR35 is applied are coming into force as HMRC seeks to make a further crackdown on disguised employment. In the past, the contractor themselves has been responsible for determining their employment status. From 2020 this responsibility will move to the employing company who will be responsible for deciding what a freelancer’s or contractor’s employment status is.
Many contractors are thought to be unaware of the upcoming changes to IR35 even though it’s estimated that in some cases they could end up paying more than £9,000 extra in tax. Many businesses employing contractors are also uncertain and worried about their responsibilities under the legislation. They could face additional pressures and costs from handling the necessary paperwork when employing and recruiting.
The good news for smaller companies – defined by the Companies Act as having less than £10.2million in turnover, a balance sheet total of no more than £5.1million and hiring no more than 50 employees – is that they have an IR35 exemption.
Will you be caught by the rules?
The IR35 rules are aimed at anyone who puts an intermediary between themselves and an employer in order to gain a tax advantage. The most common form of this is the PSC where an individual contracts their services though a one-person company. If, ignoring the existence of the company, the individual would be classified as employed, then this falls under IR35. On the other hand, if the individual is working for multiple clients, then they would still be classed as self-employed.
If you operate a PSC IR35 apples if:
- You and your family own more than five percent of the company’s share capital.
- You and your family receive more than five percent of the company dividends.
- You can get non-salary payments or benefits from the company.
Partnerships may also fall under the IR35 rules if a member of the partnership is contracted to a client under terms which would otherwise amount to employment. This only applies, however, if the services of one particular partner are involved. If the partnership as a whole is under contract to provide services then IR35 won’t apply.
If you are working in the public sector you may also not be subject to IR35. This applies to local and national government, the NHS, armed forces, the BBC and other publicly owned organisations. This is further complicated as the public end user body may be receiving the services of the contractor but the payments may be coming from an agency. It’s up to the public body to decide whether the employment falls under IR35. More detailed guidance on this can be found on the HMRC site.
The building and construction industry has its own special rules when it comes to subcontractors and again details can be found on the HMRC site.
Contractor tips
When operating as a contractor or freelancer, it’s obviously important that you properly understand your IR35 status. This can affect whether or not you choose to take an assignment for example, because a job that falls outside IR35 will be more profitable for you.
It will also influence whether you choose to work through a limited company or in some other way. And further if you do use a limited company, how you choose to take income from it.
It’s important to get this right as failure to do so could result in a time consuming and costly HMRC investigation. If you are found to be abusing the rules, then fines can be 100 percent of any additional taxes assessed following an investigation.
Note that determining your IR35 status is not a one-off exercise; it needs to be kept under constant review. At each new assignment or contract you need to assess your status again to make sure that you are still operating within the rules.
With the changes coming into force for the 2020/21 tax year, it is important that freelancers and contractors, as well as the businesses that employ them, take the time to understand their status under IR35 and ensure that they don’t fall foul of the rules. If you are unsure then it’s worth taking the time to consult with your accountant or financial advisor rather than take the risk of incurring a penalty.
