An essential IR35 briefing for contractors
IR35 legislation allows HMRC to collect additional payment from contractors in certain circumstances. The way in which IR35 operates in the private sector is set to change and this could have a significant impact on many contractors across the UK. This guide provides an overview of IR35 legislation and what it means for all contractors, along with an explanation of the anticipated changes in the private sector.
What is IR35?
IR35 is a piece of legislation designed to seek additional payment from contractors who HMRC believes are working in “disguised employment”. This is when a contractor’s working arrangements and contract are similar to those of an employee but, unlike an employee, the contractor enjoys the tax benefits of working through an intermediary, such as a company or partnership. When a contractor meets the criteria of disguised employment, they are deemed to be “inside IR35” and are required to make additional payments to HMRC.
When is a contractor deemed to be “inside IR35”?
The question of whether a contractor is deemed to be inside IR35 depends on a variety of factors relating to both the contract itself and the contractor’s working practices. There are three employment tests designed to help contractors and engaging organisations make this assessment, along with a number of additional factors that HMRC takes into consideration.
The employment tests
The “direction, supervision and control” test
This test focuses on the level of autonomy given to the worker. HMRC considers contractors to have more autonomy when it comes to choosing the work that they do, while employees are more likely to be assigned tasks by their employer. This does depend on the individual's skill and expertise, however, as a highly skilled employee is likely to enjoy a greater degree of autonomy than a less experienced contractor.
The “direction, supervision and control” test asks the following questions of a contractor’s working practices and the wording of the contract itself:
- Direction: is the worker told how to do the job at hand?
- Supervision: is the worker supervised while they carry out their work?
- Control: does the engaging organisation have control over aspects of the worker’s working practices, such as their work schedule?
If the answer to any of these questions is “yes”, then there’s a chance that the contractor might be inside IR35.
The “substitution” test
The test of substitution considers whether the engaging organisation would be prepared to accept someone else to do the contractor’s work in the event of them being unavailable. If the engaging organisation would not be prepared to do this and would only accept the personal service of that particular contractor, it would suggest that a traditional employment relationship might be in place and that the contract could therefore be inside IR35.
The “mutuality of obligation” test
Mutuality of obligation (MOO) means that one party - the employer - is obliged to provide work and the other party - the employee - is obliged to accept it. Unlike employees, contractors have no obligation to accept work and unlike employers, the companies that engage them have no obligation to provide it. As MOO is a feature of an employment relationship, if it is present in a contract it suggests that the contract might be inside IR35.
When assessing a contractor’s working practices and contract, there are certain factors that would indicate that MOO isn’t present and that an employment relationship, therefore, doesn’t exist. These include:
- the use of specific projects with set end dates
- the ability for either party to stop the work with very little notice
The ‘CEST’ checking tool
HMRC developed the Check Employment Status for Tax (CEST) tool to help contractors and the companies who engage them to check whether a contract and the contractor’s working practices fall inside or outside IR35. However, some questions were raised relating to the initial version of the tool and its exclusion of the mutuality of obligation test. An updated version of the CEST tool was released in November 2019.
Additional factors that might affect a contractor’s IR35 status
HMRC doesn’t just consider the outcome of the three employment tests when assessing a contractor’s IR35 status. It looks at a wide range of factors that might indicate that the contractor is “part and parcel of the organisation” and that a traditional employment relationship might, therefore, be in place. These factors include:
- the contractor having an email address at the engaging organisation
- the contractor having permission to use company equipment
- the contractor receiving the same company ‘perks’ as their employed colleagues
- the contractor being line managed in the same way as their employed colleagues
What are the consequences of being inside IR35?
Contractors who are inside IR35 and work through an intermediary in the private sector are currently required to declare this to HMRC. If the intermediary is a limited company, the company would add a deemed payment in the contractor’s salary and deduct tax and National Insurance accordingly. If the intermediary is a partnership, the partnership would work out the deemed payment and deduct tax and National Insurance in the same way. The partner would then report this amount on their individual Self Assessment tax return as if it were income from employment.
If a contractor fails to declare their IR35 status and HMRC challenges this in an investigation, the contractor may face a penalty. Penalties are levied as a percentage of the additional tax that the contractor is liable to pay and are determined by HMRC’s perception of the contractor’s intent and the degree to which they “failed to take reasonable care” to declare their IR35 status. If a contractor knows that they are inside IR35 but chooses not to take action, they are likely to be fined more than if they had simply made a mistake in failing to declare their IR35 status.
In the public sector, the onus is on the engaging organisation to assess the IR35 status of its contractors. Anyone who the engaging organisation deems to be inside IR35 is usually brought on to the organisation's payroll as an employee and is then taxed accordingly.
Whose responsibility is it to determine if a contractor is inside IR35?
When IR35 was introduced to all contractors in 2000, it was the contractor’s responsibility to determine whether they were inside IR35. However, in 2017, the government rolled out changes to IR35 rules in the public sector which put the onus on public authorities to decide whether their contractors are inside or outside IR35.
In the private sector, it’s currently the contractor’s responsibility to determine if they are inside IR35. However, anticipated reforms to IR35 legislation in the private sector mean that for large or medium-sized companies, the onus will soon be on the engaging organisation to make this assessment. It’s expected that the new rules will be introduced in April 2021.
Who will the new rules affect?
The new IR35 rules will affect contractors who provide services to large or medium-sized companies in the private sector. According to the draft legislation, a company is deemed large or medium-sized if it meets any two of the following conditions:
- the company has a turnover exceeding £10.2 million
- the company’s balance sheet total exceeds £5.1 million
- the company has over 50 employees
Please note that a company’s size is determined by the size of the group of company it belongs too. This means that if a small company is part of a larger group of companies that meets the above conditions, the small company will be deemed to be large or medium-sized.
What impact will the new rules have?
Assuming the reforms are implemented as expected in April 2021, if any large or medium-sized private sector company deems a contractor who is working through an intermediary to be inside IR35, the company will have a decision to make. It could either:
- terminate the contract
- change the contractor’s working arrangements in such a way that the contractor will no longer be inside IR35
- make the contractor an employee and pay them through the company’s payroll, deducting tax and National Insurance through PAYE
When similar reforms were introduced to the public sector in 2017, The Register reported a “mass exodus” of IT contractors from the public sector, while other news sites claimed that IR35 had made it extremely hard for the public sector to hire for contract roles. However, a report commissioned by HMRC contradicts the news reports, claiming that the change was not substantial and that IR35 had not affected the public sector’s ability to fill contract vacancies.
Who can I contact for advice about IR35?
If you’re concerned about IR35, you should speak to your accountant. If your contract or working practices suggest that you’re inside IR35, your accountant will be able to talk you through your options.