What is IR35? - The Complete Guide
IR35 was put in place in April 2000 and is a piece of anti-avoidance legislation aimed at preventing disguised employment; this is where someone who would otherwise be employed performs their duties through a company and enjoys the tax benefits associated with this.
An employee would leave his employment on a Friday afternoon and return to work the following Monday to do the same job. Instead of being an employee of his original employer he would be employed by a personal service company of which he would be a controlling shareholder/ director and through this his services would be supplied. The intermediary would invoice the original employer for these services and would receive a gross payment.
Through coming to the above arrangement the original employer would avoid paying Class 1 NIC at 13.8% and the worker could arrange his payments between salary and dividends in order to minimise his tax and NI liabilities. The government, therefore, introduced anti-avoidance legislation, known as IR35, in April 2000 with the purpose of countering this problem.
To find out if your contract falls inside IR35 use our IR35 Checker.
How IR35 Could Affect you?
If you are caught by the legislation then IR35 will prevent you from using traditional tax-planning techniques (small salary and high dividends) to minimise your tax obligations – instead it will require you to pay almost all of your fee income out as a salary so that you are taxed essentially the same way as an employee would. The IR35 status of an engagement is determined by looking at whether the engagement would be one of employment or self-employment in the absence of the service company.
In a nutshell, if an individual acts like an employee, is treated like an employee and essentially does the same job as an employee then it is only fair for them to pay tax like an employee.
How to Determine Employment Status?
There is no definition in law over what constitutes employment or self-employment; we therefore refer to case law judgements to establish the components of what makes up employment or self-employment. The leading case in this area is Ready Mixed Concrete (1968); it was found in this case that in order for employment to exist, there must be three factors: Control, Personal Service and Mutuality of Obligation. If any one of these factors is absent then the engagement cannot be considered one of employment and the individual will be seen to be self-employed.
The working practices would be examined along with the contract under which the person is engaged - it is therefore important that the actual working practices of the contractor are reflected in the contract.
Right of Substitution
The need for one particular person to carry out a role is an essential element of a contract of employment. It therefore follows that if a contractor has the freedom to choose whether to perform his/ her duties themselves or to hire somebody else to do it (on a reasonably unfettered basis) for them, is self-employed.
Mutuality of Obligation
The expectation for continuous work to be provided to a person and the expectation for all work provided to be completed characterises an employment relationship. If, therefore, there is a clause contained in a contract setting out an obligation for the client to offer further work and for the contractor to accept it, there would be a mutuality of obligation in the contract and it would be caught by the IR35 legislation. Rolling contracts’ or indeed contracts that are continually renewed could therefore fail this test.
Right of Control
Control concerns what has to be done, when and where it has to done and how it has to be done. In an employment relationship, each of the above is dictated to the employee, if a person maintains autonomy over these things it would therefore indicate self-employment. If the client can move the contractor according to their priorities or exercise significant control over how they perform their duties (through supervision, monitoring, checking and appraisal) as opposed to complete freedom over how to complete a project, then they would be seen as employed rather than self-employed.
Example of Employment Status
The establishment of employment status can be illustrated (at a very basic level) by comparing the working practices of a self-employed plumber against those of somebody who is employed by a firm of plumbers. See the following examples:
|Control||If, I’m called out to fix a drip in somebody’s pipe, there may be several,techniques available to fix this type of leak and I can choose whichever,method I wish. Providing it meets with industry standards and stops the leak,then the client should be satisfied, neither the client nor any other party,will have influence over how I fix the pipe, the method shall be my own.||If ,my employer sends me to fix a pipe for their client, despite there being a variety of methods available to fix the leak, I must use the method,prescribed by my employer. I don’t have full autonomy over how I fix the pipe,as I am controlled by my employer.|
|If, I take on a job to fix a leaking pipe, but on the same day I'm asked to,unblock a drain – I can accept both jobs but send one of my friends (also a,plumber) to complete one of the jobs for me. There is no requirement for me,to personally provide the service to either client – provided the leak is fixed,and the drain is unblocked then both clients are happy.||If, I am sent to one of my employers clients to fix a leaky pipe, if I can’t,attend for whatever reason then I can’t call one of my plumber friends to go,and fix the pipe for me as my employer requires me to carry out any work,personally.|
|If, I am offered a job to fix a pipe, I am not obliged to accept the work and if,I do accept then the client isn't obliged to offer me more work after the,pipe has been fixed. If I am offered more work after I have fixed the pipe,then I am not obliged to accept it.||The firm are obliged to provide me with a leak to fix and likewise I am obliged,to go and fix it. Once I have fixed the leak, they are obliged to offer me,more work and I am obliged to accept it and if they can’t provide me with a, leak to fix then they are obliged to pay me anyway.|
There are some secondary factors which are considered persuasive but not binding in case law – these look at whether it appears that the company is genuinely in business. These factors wouldn’t affect the outcome of an IR35 enquiry but could be used to support the decision made as a result of the primary factors. We recommend that each contract that you have is reviewed to whether IR35 applies or not. We recommend independent specialists who can review your contracts for a competitive rate.
Should I use an umbrella company, instead of working inside IR35?
There are of course fewer benefits from working through a limited company when operating inside IR35, for example you can’t take dividend payments from your company. However, this is only fair as there are fewer burdens than if you were to be working outside IR35, such as some contractors working inside IR35 still receive holiday pay, sick pay and attend staff training days.
Some of the benefits of working inside IR35 over using an umbrella company include:
- The Flat Rate VAT Scheme could increase your take home pay. For example if you were an IT contractor on a contract worth £100,000, you could increase your annual income by £2,054 by using the scheme. Unfortunately, this scheme is only available to limited company directors and cannot be used by an umbrella company.
- Nixon Williams charges £95 plus VAT per month and takes care of all your personal and business taxation needs. This is much less than many umbrella companies who can easily charge over £100 plus VAT a month, especially if your umbrella solution charges you a percentage based on your contract rate.
- HMRC will give you a 5% tax relief on your income which is intended to help with the administration costs of your company, such as accountancy fees, use of home, cost of seeking contracts, and training and computer costs. If you choose to work through an umbrella company you would not be entitled to this 5% allowance and would need to pay 100% tax on your income.
- In addition to the 5% allowance for administration costs you could also claim for costs such as travel, pension contributions, direct training and umbrella/accountancy fees. However you can also claim for these through an umbrella company.
- Once your limited company is set up you can use the company for your next contract too, which could be outside IR35.
Calculating your take home pay inside IR35
If working inside IR35, you would need to pay full income tax and National Insurance on your entire salary.
At the end of the tax year, you will need to work out your ‘deemed payment’. In a nutshell this is your turnover, minus your 5% allowance for the running costs of the company.
If you have any allowable expenses such as travel, pension contributions, direct training and accountancy fees, these would be deducted before turnover is calculated.
Once you have calculated your turnover minus 5%, you will need to take into account any salary or Employers' NIC paid throughout the tax year.
If you are left with a deemed payment figure higher than zero, you will need to pay further tax on this amount to HMRC. Don’t worry, a good accountant should be able to help you work out these figures and ensure you’re working as tax efficiently as possible.
It’s always difficult for an accountant to give you an exact take home pay figure, as there are so many factors to consider that vary from contractor to contractor, such as:
- If you are registered for the Flat Rate VAT Scheme.
- If you expense the whole 5% tax relief for operating costs. (If you choose not to, you will be liable for a small amount of corporation tax on the difference.)
- If you have a pension and how much you pay into it
- Expenses that you have incurred to carry out your contract, such as travel costs.
Inside IR35 versus umbrella take home pay examples
Taking some of the above factors into consideration, the table below will show you roughly how much you could save working inside IR35 versus contracting through an umbrella company.
Take home pay inside IR35
Umbrella Take home pay
Difference in Take Home Pay
These examples assume the contractor:
- Has worked 44 weeks per annum
- No expenses claimed
Who is responsible for ensuring that the contract is IR35 compliant?
As the director of your limited company it is you, not your end client, who is responsible for ensuring that you are complying with all relevant legislation including IR35.
If you have any questions about IR35, becoming a contractor or would like an IR35 contract review, then please get in touch with a member of our new business team, who will be happy to answer any questions that you may have. Our new business team can be contacted on 01253 362062 or firstname.lastname@example.org.
If you are new to contracting you may also find these pages useful:
- Limited company or umbrella company
- Advantages and disadvantages of a limited company
- Specialist Sectors
- A guide to contractor expenses
- Starting up as a contractor
- Moving from permanent to contracting
- Offshore tax avoidance schemes
- Contractor's guide to pensions