IR35 is legislation that specifically relates to the employment status of contractors, their relationship to clients, and taxation. As we offer employment law services, we're often asked for IR35 legal advice by employers, SMEs, start-ups and entrepreneurs.
Here we’re explaining:
- What is the aim of IR35 legislation?
- What is the IR35 rule?
- When does IR35 apply?
- What if the contract says that IR35 does not apply?
- Does IR35 apply to sole traders?
- Does IR35 apply to office holders?
- What are the Managed Service Company (MSC) rules?
- What does it mean to be outside IR35?
- IR35 in the private sector
- What if IR35 does apply?
What is the aim of IR35 legislation?
The aim of the IR35 legislation is to prevent avoidance of income tax and National Insurance Contributions (NICs) through the use of an intermediary between a worker and a client, such as a professional services company (PSC) when in reality what is happening is an employment relationship. This is known as ‘disguised employment’. The IR35 legislation comprises of the Social Security Contributions (Intermediaries) Regulations 2000 (the Regulations), which deals with NICs and Income Tax (Earnings and Pensions) Act 2003 (ITEPA) which deals with income tax. The aim of this legislation is to deal with what HMRC sees as tax avoidance by individuals choosing to pay NICs, dividends and corporate tax of partnerships or limited companies, which are significantly lower than employee income tax and NICs, by supplying their services through an intermediary (such as a personal services company (PSC) and paying themselves dividends rather than a salary. Put simply, IR35 is designed to look at whether in actual fact contractors working usually through a PSC to supply services to a client, would in fact be employees of the client were it not for the existence of the PSC.
What is the IR35 rule?
If an individual falls within the IR35 legislation (ie they would have been classed as an employee of the client but for the use of a PSC), whatever their contract with the client says and whether an individual holds an office with the client, income tax and NICs are due on the fees paid to the individual, as if they were employed by the client. From 6 April 2021, it is the responsibility of the ‘fee payer’ (i.e. person or business paying the PSC, typically the end client) to determine that IR35 applies and account for income tax, NIC’s and the Apprenticeship levy, if relevant, to HMRC.
When does IR35 apply?
From an employment law perspective you must look at whether the individual would (for tax or NICs purposes) have been an employee of the client were it not for the existence of an intermediary in the relationship between the individual and the client. If they would, then the intermediary and the individual will be caught by the IR35 rules, though the end client may be ultimately liable.
Employment status has been an area of confusion for some time, but there are some aspects which Courts and Tribunals particularly look at when considering if an individual is employed and if on balance, when those factors are considered the employment relationship looks more like that of employer and employee and not contractor and client, then IR35 is likely to apply. The factors that are considered include (but are not limited to):
- Mutual intention – if both parties state that their intention is that the relationship is that of contractor and client this can assist, but must also be borne out in the reality of the situation.
- Control – what degree of control does the client have over what, how, when and where the worker completes the work? The more control over the worker that the client has the more likely the arrangement looks like an employer and employee relationship and IR35 is likely to apply. It is the right to the control rather than the actual levels of control exercised which is the main consideration, but clearly if a great deal of control is being exercised in reality, this will point towards the individual being an employee. Clearly ‘what’ is to be delivered is something that the client will have a say in, but this should be collaborative. The more important aspect of control is the mode of working. So, things to avoid giving the client control over (so as not to fall within the IR35 provisions) are requested starting and finishing times or specific days of work, no specific timings or length of breaks specified by the client, or any other specific control such as wearing of a uniform.
- Substitution – is personal service of an individual worker required or is there the right for the worker to send a substitute who does not regularly provide the services for the client to carry out the work for the client in their place? If there is a clause in the contract between the client and the company that the company is providing a service and that if the named individual cannot or is unwilling to perform the work, that someone else will, especially if this can be done without the permission of the client and/or that the worker can bring a helper to assist in providing the services (at their own expense) should they wish, this points towards the worker not being an employee, but the absence of this type of clause does not mean that there is an employer and employee relationship. A Court or Tribunal may also look at whether in reality the right is exercised.
- Mutuality of obligation – in an employer and employee relationship there is an obligation for an employer to offer work to the worker and the worker to accept all of that work and be paid for it by the employer. Typically, in a contractor engagement the individual and the client have the right to terminate the relationship at short notice. If there is a longer notice period, this is more likely to point towards an employer and employee relationship. Equally, an open-ended relationship is more likely to point to an employer/employee relationship than a shorter fixed term might do.
- Financial risk and reward – if a worker is an employee they have no financial risk because the employer assumes this risk. If an individual is able to prove that they have the opportunity to profit from how they organise their work and have financial risks like other directors operating similar companies, such as a failure of clients to pay, penalties or carrying out additional work for no extra reward where it falls below client standards or over-runs beyond a fixed fee quoted, purchasing assets for the company, or paying significant sums for training or insurance, this is more akin to a contractor/client relationship. If a contractor is regularly receiving a consistent sum of money, like a wage, and not a sum for completion of a project, this would point more towards an employer and employee relationship, whereby IR35 might be applicable.
- Equipment used at work – an employee would always expect an employer to provide any equipment required to carry out work under an employment contract or at least be reimbursed for it if they have purchased it themself, whereas a contractor should be taking the financial risk of purchasing without reimbursement and using their own equipment which should be an asset of their business. Where this is not the case it is more likely that the relationship will fall within the principles of IR35.
- Becoming part and the parcel of an organisation – if a client supervises and integrates the individual intothe organisation such that the individual becomes part of the organisation (eg provides them with a workplace email address, subjects the worker to its own internal policies and invites them to staff socials etc), this looks more like an employment relationship that would be caught by IR35.
- Employee benefits – it may seem obvious, but a self-employed contractor who is a company director of a limited company, must not receive any employee benefits of any kind (including holiday pay, sick pay, membership of a firm's pension scheme, right to a car parking space and canteen facilities, free training courses or equipment training, or any other benefit that would put the contractor in a similar position to one of their employees) otherwise this would indicate an employer and employee relationship caught by IR35. The government has introduced a CEST tool, which is a good starting point when looking at status determination of workers.
What if the contract says that IR35 does not apply?
The contract or label provided by the parties to the contract will not be conclusive. It is the starting point, but it is really important how the relationship plays out in practice which is key. There are two main contracts generally where IR35 might be a consideration: the contract between the client and intermediary company and the contract between the intermediary and individual. In respect of the latter, the key consideration to reduce the likelihood of IR35 applying is that there should be an employment contract between the individual and their intermediary such that the individual is genuinely employed by the intermediary. It’s common for there to be a warranty in the main agreement between the intermediary and the client that the individual is an employee of the intermediary, but it’s important that this plays out in practice too. The individual should work for clients as the intermediary determines and be paid salary and benefits at the intermediary’s discretion (this is more likely not to be investigated by HMRC if it looks to be a competitive package for the particular market the individual operates in). Whilst there is current debate about control (in respect of disciplinary and grievance processes, for example) it is generally regarded as safer for the individual to be subject to the rules of the intermediary rather than the client, to avoid IR35.
Does IR35 apply to sole traders?
No, IR35 does not apply to sole traders, but there are 'status' rules. The client company receiving the worker’s services would be responsible for any liability arising from HMRC questioning the worker’s status as a sole trader.
Does IR35 apply to office holders?
Under the Finance Act 2013 two new tests were introduced in order that income tax and NICs could be chargeable and an office holder could be deemed to fall within IR35. The first is: if the arrangements had been directly between the individual and the client, the individual would have been regarded as an ‘office holder’. The second is where the worker is an office-holder under the client and provides services to the client relating to the office, even when they provide other services (for example, as a consultant) which relate to the office.
What are the Managed Service Company (MSC) rules?
These rules require MSCs to automatically operate PAYE and NICs on sums paid to workers irrespective of whether, ignoring the intermediate company, an employment relationship might exist between the worker and client. This means that MSCs are less common as an intermediary for workers to provide services to a client, than they used to be, as they are not a tax efficient way for workers to provide the services and so an umbrella company is now more popular.
What does it mean to be outside IR35?
For tax purposes, this means that an individual is truly self-employed and not regarded as an employee of the client and does not have to pay income tax and NICs on fees received from the client, as an employee would. If the individual is genuinely self-employed, then for employment law purposes the implications of not being an employee of the client are more wide-ranging than this, for example, as self-employed contractors do not receive certain employee benefits such as sick pay or holiday pay or the right to join the employer’s pension scheme.
IR35 in the private sector
On 6 April 2021, the off-payroll working rules that applied in the public sector were extended to large and medium-sized companies with a UK connection in the private sector. This means that medium or large-sized organisations which meet two or more of the following conditions will be subject to largely the same provisions as those introduced in the public sector relating to IR35 in 2017: (i) an annual turnover of more than £10.2million, (ii) a balance sheet total of over £5.1million ; and (iii) more than 50 employees. Small companies (ie companies that don’t meet the conditions above) are not included under the IR35 changes.
As part of the introduction of the off-payroll working rules to the private sector, PSCs are no longer responsible for determining the employment status of the contractor or for operating tax and NICs on fees (regardless of when the work was carried out by the contractor). Responsibility for determining the employment status of the contractor shifted to the end client. This involves the end client determining the worker’s deemed employment status and issuing a ‘status determination statement’ (SDS) (with reasons for reaching its conclusion about the worker’s employment status) to the worker and to the entity with which the worker contracts (usually the PSC). The end client must take reasonable care in producing the SDS. If the end-client fails to provide the SDS or fails to take reasonable care in preparing the SDS, the end client will be the deemed employer and would need to account to HMRC for tax and NICs. A crucial step for end clients is therefore the assessment of the worker’s deemed employment status and issuing the status determination statement. The status determination statement has to be passed down to the next entity in the supply chain. Failure to do so can result in an entity being deemed to be the fee-payer in the supply chain and therefore responsible for accounting for taxes and NICs to HMRC. A statutory dispute resolution process applies meaning a worker or deemed employer can make representations to the end client that the SDS is incorrect, which the client must respond to within 45 days failing which it will become the deemed employer. Consequently, if you are an end client and a contractor or deemed employer in the supply chain disagrees with your SDS and initiates the statutory dispute resolution process, you will need to ensure that you respond within 45 days of receiving such a complaint. You may wish to seek advice from one of our employment solicitors at an early stage if you are changing the status of a contractor.
Responsibility for actually accounting to HMRC for tax and NICs on fees paid to the intermediary has now shifted from the intermediary to the 'fee-payer' (which is usually the end client, but can sometimes be another entity in more complex supply chains, such as an agency). There is also a new legal obligation on the end user client to respond to a request for information about their size from the agency or worker. From 6 April 2024, a statutory set off mechanism is introduced to allow end clients and fee-payers to offset tax and NICs liabilities against taxes paid by the intermediary. Previously, where HMRC disagreed with a SDS assessment (ie a worker is incorrectly classified as falling outside of IR35), HMRC would recover arrears of tax and NICs from the end client or fee-payer. There was no mechanism for the end client or fee-payer to offset the tax and NICs against amounts already paid by the intermediary on the fees as part of its own income and corporation tax assessment. This could result in taxes being paid to HMRC twice in respect of the same contract, resulting in complex resolution processes as between the end client, the intermediary and HMRC. Under the new off-set mechanism, end clients or fee-payers can now offset their tax and NICs liability against income or corporate tax paid by the intermediary.
The rules do not apply to offshore companies without a UK presence, which will be excluded from the off-payroll rules. The rules also do not apply to contracts entered into before 6 April 2021 and new investigations into PSC’s will not be commenced into employment status by HMRC for those arrangements in place before that date unless fraud or criminal behaviour is suspected.
What if IR35 does apply?
In summary, as explained above, if IR35 applies, the sums received by the intermediary for the worker’s work for the client, are in effect treated as employment payments to the worker and it is the responsibility of the ‘fee payer’ (usually the end client in simple supply chains) to make deductions for tax and NICs and account for these to HMRC.
Whilst the indicators to determine employment status in an Employment Tribunal are largely the same as those used by HMRC for tax purposes, it cannot be assumed that just because an individual is deemed to fall within IR35 (meaning that the intermediary must make the necessary PAYE deductions of an employee) that the individual is an employee of the client. Employment status for employment and tax purposes are two separate things.
It is worth ensuring that you know where you stand in respect of IR35 and seek legal advice from the start of a contract, as HMRC can go back at least six years and evaluate past contracts to see if the legislation relating to IR35 applies, and where applicable demand arrears of income tax and NICs and potentially apply penalties and interest. Our specialist employer solicitors can advise you in respect of IR35.
If you are an end user and you are concerned that your contract with an intermediary will fall under IR35, contact our specialist employment tax team for further guidance
If you do not wish to have the complications of PSC’s and IR35 going forward, there are other options for working relationships for the supply of labour which do not involve this, such as recruiting the contractor as an employee, contracting with the individual contractor directly without using a PSC on a genuinely self-employed basis or as a worker; or requiring contractors to go through an agency or other intermediary with no PSC in the chain.
Should you have any questions about employment status and IR35, please contact our employment team for advice.
