What is IR35? One of the first questions a contractor or freelancer usually asks us is ‘what is IR35?’ – our guide below explains this complicated topic in plan English! Note : there is a really important update for the 17/18 tax year with relation to new IR35 rules if you work in the Public Sector, this is covered further on in this guide. HMRC introduced IR35 many years ago as a measure to tackle the situation where an individual would be treated as an employee were it not for the fact they were providing their services through a limited company, known as a ‘Personal Service Company’. IR35 is also known as the ‘intermediaries legislation’. This is an area that particularly affects contractors and freelancers providing their services through a limited company, although all limited companies need to be aware of this. Trading through a limited company can lead to significant tax and national insurance savings but if HMRC investigate a contract and decide that it is caught by IR35 they will seek the lost tax and national insurance and can potentially go back several years. This is because if you are caught by IR35 you aren’t allowed to pay dividends – essentially everything has to be treated as taxable salary and if you have paid dividends when you shouldn’t have then an adjustment will need to be made. The optimum way to save tax for freelancers and contractors, which we cover in our article here, is usually by taking a low level of salary with the rest of your income being taken as dividends. This avoids unnecessary national insurance payments (there is an optimum level of salary which protects your national insurance position). However, if HMRC investigate your contract with a client and assess that actually the relationship is one of employer and employee, rather than being true self-employment, then it means you are caught by IR35 (known as inside IR35) and HMRC will assess the lost tax and national insurance on you. ** ** UPDATE for 17/18 – unless you are in the Public Sector which has new rules, covered shortly. IR35 is a specialist area with little that is 100% certain – we would encourage you to read our guide but to seek specialist advice from an IR35 advisor if you are not sure of your position. Our IR35 advice is meant as an introductory guide only. If HMRC were to investigate a contract and decide that it is ‘caught’ by IR35 they will calculate a deemed payment, treating all income received as salary and demanding all tax and national insurance contributions on payments originally paid out as dividends. There are many factors that have to be considered when trying to determine employment status. When HMRC perform an IR35 investigation they will look at both the actual contract in place between the contractor and engager as well as what the real day to day working practices are. HMRC will speak to the engager and the contractor during their investigation, therefore it is important to assess your position in relation to both of these areas. Ensuring you have an ‘outside IR35’ contract in place is an important step, but it’s just as important to make sure that the working arrangements actually do reflect the contractual terms. There are a number of key areas to consider when determining IR35 status, but three of them are particularly important – Personal Service / Substitution, Mutuality of Obligation and Control. Personal service / substitution It is important to understand that a self-employed contractor / freelancer should be providing a service rather than their own personal skills and if required they should be allowed to provide someone else to do their work. This is known as ‘substitution’. If you were an employee of a client then you would be providing your services personally with no ability for you to bring in someone else to do the work. The tricky thing is that for many contractors and freelancers, in reality, they will never bring anyone else in to do their work, so substitution is often a theoretical situation, however as long as their contract with the client provides a right to substitute someone else to undertake the work (and this is genuine) then this is a very important step towards not being caught by IR35. It is often the case that the client / engager retains a right to say no to a substitution on reasonable grounds but this should be limited to factors such as the experience or qualifications of the potential substitute. It is very important that the client can only reject a substitution on reasonable grounds. Key point: make sure your contract has a substitution clause, and ideally exercise this right. Without a strong substitution clause you are at a higher risk of failing an employment status assessment. Mutuality of obligation This means that there is no obligation on either the client or the contractor to offer or be offered continuing work. A self-employed contractor will work on the specific project that they are being contracted to do and once finished there should be no expectation of any further work by either side. An issue can arise in a situation where work is continued to be performed over a longer period of time – purely on the basis of this ‘habit’ HMRC could try and argue that the contractor has become an employee. Your contract should let you leave a contract early if you wish, and equally the client should be able to terminate early. It is also good habit for a notice period to not be longer than one month. Key point: make sure your contract has a short notice period, no more than one month if possible, and also make sure there is a clause to cover mutuality of obligation. The contract should also state an end date. Control The more direction and control that a contractor has over the services they are providing, the better. A true subcontractor is being engaged to provide their expert services, not to come into a business and be told what to do. The more specialist skills and expertise that a contractor has, the more control they are likely to have over their services. For example, if a manager tells a contractor to move from one job to another, it tends to be an indicator of employment. Other important IR35 factors Although the above three areas are very important, there are many other factors to consider, including: Financial risk – if a contractor does something wrong they should have to correct the mistake at their own cost and should not be paid for the additional work. Own equipment – the more of their own equipment that a contractor uses to perform their services, the better. Ideally they should provide their own computers and phones. Other work – it is important that a contractor has the right to take on other work / work for other clients – if a contract states that they are not allowed to work for anyone else this is an indicator of employment rather than self-employment. Part and parcel – HMRC will look at whether a contractor is in effect a ‘part and parcel’ of the organisation they are working for – examples of this would include having a client email address, being on internal employee contact lists or receiving any employment benefits. Being in business – general proof that a contractor is a real business is good, for example do they have a website, business insurances and other typical things that businesses would have but employees would not. As you can see there are many factors to consider with IR35 and employment status – it is important to ensure that your contract covers these factors and also that your day to day working practices are in line with the contract. The NEW IR35 rules for the Public Sector, from April 2017 From April 2017 freelancers and contractors operating through a limited company in the public sector will lose their say on whether they are caught by IR35. Traditionally under IR35 it is down to the freelancer / contractor to decide if they believe they are caught within IR35 or not, however from April 2017 this will no longer be the case. These new rules only apply to those working in the public sector. The responsibility to assess whether IR35 applies will move from the worker to the end-user client, staffing agency or the third-party who pays them. However, the absolute responsibility for deciding if IR35 applies is down to the end-user client, even if an agency is present. If the public sector client decides that IR35 applies to the engagement (i.e. that the engagement is inside IR35) then the payment to the contractor’s limited company gets taxed at source – much like an employee, without actually being a proper employee, so they will not receive the usual rights of employees such as sick pay, holiday pay and unfair dismissal rights. It is important to understand that the underlying determining factors of IR35 are not actually changing – it is the responsibility of which party has to decide if an engagement is caught by IR35 or not that is changing, as is the treatment of how tax is deducted at source if you are inside IR35. For the time being these new changes only affect the public sector, we will have to wait and see if the government plans to roll it out to the private sector. So, what is the definition of a public sector client? Basically, if an organisation is obliged to respond to ‘Freedom of Information’ requests, it is then a public sector organisation for the purposes of these new IR35 rules. These will typically include government bodies such as local councils, the BBC, the NHS, Channel 4, schools, the police, Transport for London and certain other organisations. Working through an agency doesn’t put you outside of these rules, as it is the end-client which is relevant. HMRC have issued a new online tool to help clients assess if an engagement is caught by IR35 or not – there is a link to this tool below – however at the date of publication of this article this tool was still in ‘Beta’ and there has been some concern as to how accurate it actually is. https://www.gov.uk/guidance/check-employment-status-for-tax This online tool is not mandatory and is meant purely to help clients make a decision on engagements. Freelancers and contractors who work in the private sector may also want to use this tool to help them assess if their engagements are caught within IR35 or not – however per our previous advice this tool is still at a very early stage and its reliability with regards to how well it represents historic employment status tax case law is still very much up for debate, so we would recommend using it alongside the traditional IR35 guidance detailed earlier in this article. Example of being caught inside IR35 in the public sector with the new rules Let’s consider an example of a limited company contractor working for a public sector organisation and the role has been deemed to be caught inside IR35 under the new rules. If we assume the contractor is VAT registered on the standard VAT scheme and they raise an invoice to the client of £2,000 +VAT, so £2,400 in total. The client will process the £2,000 as if it were a salary and will deduct income tax and national insurance from this figure – let’s assume for simplicity the tax and employees national insurance come to £600. The client will pay the limited company contractor the full VAT amount of £400 and will pay the £2,000 less the £600 deductions, so in total they will pay £1,800. Of this £1,800 the contractor has to pay the VAT of £400 to HMRC which leaves £1,400 which can then be drawn out of his personal service company by the contractor. As this income has already been taxed at source there is no corporation tax for the company to pay on this income. The public sector client will give the contractor a P60 or P45 so that the contractor can include the earnings on their personal tax return, like they would with any other employment. What are your options if you are caught by the new IR35 public sector rules? If a public sector client deems that your engagement is caught by IR35 what are your options? Well, there are a few: Keep working through your limited company and accept that you will have tax and national insurance deducted at source, so overall you’ll be paying more tax (perhaps you could try and negotiate a higher rate with the client to help offset this) Open a dialogue with your client to make sure that they have correctly assessed the IR35 position and see if anything can be changed in the working practices and contract to move the engagement outside of IR35 Consider changing to work through an Umbrella company so you don’t have to operate your own company, although this usually works out quite expensive Move to the private sector! Summary As you can see from this article, IR35 is a complicated area and nothing is 100% certain. The 2017 rule changes for the public sector are still very new and it remains to be seen whether the government plan to roll these out to the private sector. Our advice is to make sure you have a contract in place that covers the key factors and also make sure the reality of your day to day role is true to your contract. The above IR35 guide is intended to give you an overview of how it works but we would always suggest speaking with an IR35 specialist.