HMRC’s main aim when introducing the IR35 legislation was to prevent tax avoidance through the use of personal service companies (PSCs). More specifically, IR35 was brought in to target those fulfilling the role of an employee whilst working under the guise of a limited company and thus incurring less tax payments. Otherwise known as ‘disguised employment’.
Before the legislation’s introduction, there was nothing to stop a worker leaving their role as an employee on any given Friday and returning on the following Monday completing the same role for the same company but as a limited company contractor. Hiring businesses engaged in this practice, and in some industries actively encouraged it, in order to reduce their own employers’ national insurance bill as well as employment obligations such as holiday and sick pay.
Read more about what IR35 is and how it came about.
IR35 has been in existence for over 20 years. Gordon Brown announced the introduction of new measures designed to combat tax avoidance via the use of ‘personal service companies’ in the 1999 budget. The result being that in April 2000 the intermediaries legislation, otherwise known as IR35, was enforced.
The term ‘IR35’ stands for the Inland Revenue’s (now known as HMRC) 35th press release: Inland Revenue 35 in which the measures were announced.
IR35 status is determined by taking a holistic view of the hypothetical contract between the individual providing the services and the end client. This means that if you removed the contractual chain between the two (personal service company and any third parties), would the individual be akin to an employee of the end client business or still be seen as a genuine business arrangement?
IR35 is a notoriously complex legislation and has proven to be a source of contention since its inception due to its ambiguity.
That being said, what exactly determines IR35 status? The key status tests used for determining whether IR35 applies are rooted in historic case law, principally the case of Ready Mixed Concrete Ltd (1969):
- Personal service - is the working arrangement a personal one or does the contractor provide a business-to-business service?
- Control - does the worker fall directly under the control of the engager or does the individual dictate how the work is carried out?
- Mutuality of Obligation (MoO) - is there a mutual obligation for the client to provide consistent and paid work and an obligation for the individual to accept this work?
To this day, these three key status tests remain the principle criteria for many employment status cases, and will be considered in the context of the actual day-to-day relationship as well as the contractual terms which exist along the supply chain.
Read more about the different status tests here.
In 2017, HMRC introduced unpopular reform to the legislation which saw all public sector bodies become responsible for setting the IR35 status of the contractors they engage. As part of these changes, the IR35 liability transferred from the contractor to the fee-paying party in the supply chain, which is often the recruitment agency. This means that contractors no longer set their own IR35 status in the public sector and do not carry the liability for any mistakes.
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Contractors operating outside the scope of IR35 are able to pay themselves marginally more tax efficiently, usually through a combination of salary and dividends. In simple terms, clients pay the contractor an agreed fee for their services, who will maintain responsibility for paying their taxes, just like any other small business owner.
Those who are determined to be inside IR35 will have to pay full PAYE tax and NICs.
Under the off-payroll working rules, this is deducted at source by the fee-payer (usually the recruitment agency) from the contractor’s fee and paid directly to HMRC. For contractors not subject to the reformed rules, this is paid via self assessment.
There is an important distinction to be made between being ‘caught inside IR35’ as a result of a HMRC investigation in comparison to providing services for a role that is determined to be inside IR35.
Being inside IR35 simply means that you must pay the relevant tax and NICs according to this status as outlined above. On the other hand, a contractor considered ‘caught inside’ of the IR35 legislation would mean that an outside-IR35 status was applied incorrectly and, following an investigation, was found to be inside IR35 after the fact. In this instance, all income received within the period of the investigation is reclassified as employment income and the resulting liability plus interest and a potential penalty will be owed back to HMRC. Under the off-payroll rules, this liability sits with the fee-payer should every party of the engagement have met their obligations.
For more information about what happens if you are caught ‘inside’ IR35, take a look at our ‘IR35 Investigations Guide’.