IR35 is legislation that specifically relates to the employment status of contractors, their relationship to clients, and taxation. As we offer both employment law services as well as some banking and finance law advice especially with the 6 April 2021 changes in the private sector, we're often asked for IR35 legal advice by employers, SMEs, startups 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?
- What are the recent changes to IR35?
- IR35 in the public sector
- IR35 in the private sector from 6 April 2021
- What if IR35 does apply?
- How has Covid-19 affected IR35?
What is the aim of IR35 legislation?
The IR35 legislation comprises of the Social Security Contributions (Intermediaries) Regulations 2000 (the Regulations), which deals with National Insurance Contributions (NICs) and Income Tax (Earnings and Pensions) Act 2003 (ITEPA) which deals with income tax. The aim of this legislation was to deal with what HMRC saw 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 service company) 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 limited company to supply services to a client, were in effect employees of a particular client rather than independent contractors.
What is the IR35 rule?
If an individual falls within the IR35 legislation, whatever their contract says and whether an individual holds an office with the client, they must pay income tax and NICs as if employed. From 6 April 2021 where the ‘fee payer’ (person or business paying the Personal Service Company (PSC)) determines that IR35 applies, the fee payer must make statutory deductions to the payment for the worker’s services including income tax, NIC’s and the Apprenticeship levy, if relevant.
The Regulations relating to NIC payment apply if:
- An individual personally performs services for a client (or is obliged to do so).
- Those services are provided using an ‘intermediary’ defined as:
- a) an individual from which a worker or associate receives or is entitled to receive payment or benefit not chargeable to income tax, or the worker must be paid directly by the intermediary and the payment can ‘reasonably be taken to represent’ payment for the services provided by the worker to the client; or
- b) a company which is not an associate company of the client and that the worker has a ‘material interest’ (more than 5% share capital or voting rights in a company or they and an associate do) in the intermediary company or the payment or benefit received by the worker from the intermediary can ‘reasonably be taken to represent’ payment for the services provided by the worker to the client; and c) a partnership and the worker receives payment as a member and either
- i) the worker alone or with immediate family is entitled to at least 60% of the profits of the partnership and most of the partnership’s profits relate to a single client (or the client and its associates); or
- ii) the income of any partners is decided by reference to that partner’s income through providing services under the arrangement in question. If the worker receives payments or benefits other than as a member then the worker must be paid directly by the intermediary and the payment can ‘reasonably be taken to represent’ payment for the services provided by the worker to the end user client.
- Had the arrangements been made directly between the individual and the client, the individual would have been considered an employee by the client ‘in employed earner's employment’ for NIC purposes.
If a worker falls within the principles of IR35 under the Regulations, the worker and the intermediary are treated as employee and employer for NIC purposes. Generally, NICs will be due under these regulations only where the income falls within IR35 for tax purposes, but this will not always be the case because the NIC regulations are more widely drafted. Confusingly, the approach taken to determine whether income tax is payable is different to that of the Regulations.
Income tax is potentially payable where:
- Chapter 8 of ITEPA applies in principle to the arrangement – which means that an individual personally performs or is obliged to perform services for a client using an intermediary and if the arrangements had been directly between the individual and the client, the client would have been considered an employee of the client for income tax purposes.
- Contractual arrangements are to be taken into account and unlike the Regulations for NICs, all third parties are considered ‘intermediaries’, but there will only be a ‘relevant engagement’ involving that intermediary in certain circumstances.
- There is a ‘relevant engagement’ - if a worker is treated as having undertaken one or more relevant engagements the worker and the intermediary are treated as employee and employer for income tax purposes. There is a ‘relevant engagement’ if Chapter 8 applies in principle, the individual or an ‘associate’ is entitled to receive a payment or benefit, which is not employment income and conditions in relation to the intermediary are satisfied. The conditions are:
- in the case of a company intermediary - the client and the intermediary are not both under the control of the worker and either the worker has a material interest in the intermediary, the payment or benefits received by the worker from the intermediary can ‘reasonably be taken to represent’ payment for the services of the worker to the client.
- in the case of a partnership intermediary - a worker receives payment or benefits as a member and either the worker alone or with immediate family members is entitled to at least 60% of the profits of the partnership or most of the partnerships profits relate to a single client or that client and its associates or the income of any partner is calculated by considering income of that partner and its services under the arrangements in question. If the worker receives payments or benefits other than as a member, the conditions must be that the worker is paid directly by the intermediary and payment can ‘reasonably be taken to represent’ payment for the services provided by the worker to the client and this is also true where the intermediary is an individual.
When does IR35 apply?
From an employment law perspective you must look at whether the worker would (for tax or NICs purposes) have been an employee of the client if they had been working directly for it. If they would, then the intermediary and the worker will be caught by the IR35 rules.
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 are:
- 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 worker 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. Further, if a worker or the client have the right to dismiss each other 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 they are employed. If a worker 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, whereas a contractor should be taking the financial risk of purchasing 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 contractor supervises and to all intents and purposes takes on staff of the client and becomes part of the organisation, this looks more like a 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 will be the reality of the situation that is relevant. 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 is to ensure that it is not linked too closely to one particular client and to make this as much like an employment contract between the individual and the intermediary, as possible. The worker should work for clients as the intermediary determines and be paid salary and benefits as 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 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?
This means that an individual is truly self-employed and not regarded as an employee and does not have to pay income tax and NICs, as an employee would. The implications of not being an employee are more wide-ranging than this, however, 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.
What are the recent changes to IR35?
Since its introduction in 2000, the IR35A legislation has seen quite a few changes. Below we set out some of the more recent changes you may or may not have been aware of.
|Timing||Details of IR35 changes|
|From 6 April 2021||From 6 April 2021 there will be changes relating to non-compliance with off-payroll working rules (IR35) in the private sector to largely mirror the changes which took place in the public sector on 6 April 2017. From 6 April 2021 the end client of ‘fee payer’ will be responsible for deciding the employment status of the contractor and so whether PAYE deductions are required to be made before the worker is paid and if required the fee payer should make those deductions|
|From 6 April 2017||All payments made to Public Service Companies (PSCs) by public authorities or in relation to contracts with agencies and third parties that contract with the PSC to supply the services of a worker are subject to deduction of payroll taxes if deemed employment status applies. An employment agency that contracts with a PSC to supply workers in the private sector is not under an obligation to deduct tax and NICs from payments to the PSC unless there is direction, supervision and control and the monies received by the worker are under the contract. If the intermediary is not in a position to judge whether the monies received by the worker are related to that contract, it does not have to make payroll deductions. The intermediary just needs to report the gross payments made, so that the PSC can account for tax and NICs under the IR35 rules, if required.|
|From April 2016||Travel expenses to and from any assignment where the individual is subject to direction, supervision or control by any person are subject to tax and NICs and the employment intermediary is responsible for making any necessary deductions and accounting to HMRC.|
|From April 2016||If, following a liquidation, the trade or business is carried on by one of the former shareholders directly or through another company, the liquidation distribution will be treated as income rather than capital.|
|Since 6 April 2014||Businesses have been entitled to claim a deduction from their liability to employers’ NICs (which since 6 April 2016 has been £3,000) but this does not apply to NICs on deemed earnings and is not available to companies whose sole worker is the director and shareholder, even if the worker is being paid an actual, not just a deemed, salary.|
IR35 in the public sector
The public sector includes such bodies as the NHS or government, but businesses to which services are contracted out by public authorities do not fall within the new rules. Therefore, pharmacies and dentists' practices that provide goods or services under the NHS were not automatically covered here, but may be after 6 April 2021 as part of the private sector, if they hit the below criteria.
The public sector has in place a new regime for all relevant payments made on or after 6 April 2017 (whether or not the services relating to the payment were performed before that date), which targets PSCs, partnerships and individuals acting as intermediaries in providing the services of an individual to personally perform services for a public authority. This is to ensure that, if there is really an employer and employee relationship, this is reflected correctly in terms of tax and benefits.
A public authority must look at whether a worker is deemed to be an employee if the contract for the supply of the individual’s services is through an intermediary that is either:
- a company where the worker has a material interest (more than 5% of the shares and votes); or
- a partnership where the worker is a member and is entitled (alone or with members of the worker's immediate family) to at least 60% of the profits or where the worker's share of the profit is linked to the payments under the contract and the majority of the partnership's income comes from a single client and its associates; or
- an individual.
The worker must notify the client whether or not any of the above conditions is met by the intermediary (services provider). If fraudulent documentation is produced by the services provider and from that, the client concludes that the new IR35 legislation does not apply, liability for payroll deductions will not be the responsibility of the public authority and will pass to the services provider.
Having established that the intermediary meets, or is treated as meeting, one of the conditions, the public authority must consider the nature of the work performed under the contract and the terms under which it is performed.
The public authority is responsible for determining whether an individual should be deemed an employee. Deemed employment status will apply if the worker personally provides, or is under an obligation personally to provide services to a public authority similarly to an employee or if, through the contract, the worker is an office holder of the public authority or an associated entity. Whilst there may be issues with HMRC’s online ESS which uses information gathered about the worker the intermediary and public sector client and their relationship to determine employment status, HMRC will be bound by the output of the service unless used fraudulently. The link to HMRC’s online ESS, is here. The public authority should then report the results to the worker and if applicable another fee earner. If the worker asks for the reasons behind the decision in writing, the public body must respond within 31 days. If they don’t, responsibility as deemed employer passes to the client and they will be responsible for paying the tax and NICs due.
Where the off-payroll working rules apply, the fee-payer (the public authority, agency or other third party who is responsible for paying the worker’s intermediary) must:
- calculate a deemed direct payment (payment to the worker’s intermediary minus any VAT, minus direct costs of materials that have, or will be used for the services, minus expenses the intermediary has paid which would have been deductible from taxable earnings if the worker was employed. No 5% general deduction, previously claimable by the PSC under IR35 rules, will be available) to account for employment taxes associated with the contract
- deduct those taxes from the payment to the worker’s intermediary
- report to HM Revenue and Customs (HMRC) through Real Time Information (RTI) the taxes deducted
- pay the relevant employers’ NICs.
If the person paying the intermediary is outside of the UK, different rules apply and advice can be found here.
The deemed employer is not required to provide the worker with monthly payslips, but must give him a P60 at the end of the tax year and a P45 at the end of the contract. The public body will need to report to HMRC the pay and deductions it makes, as it does for workers on the payroll, using a Full Payment Submission (FPS) and pay and report employer Class 1 NICs due relating to these engagements. As the worker will have a primary employment with their own intermediary, the services they provide to the public body are likely to be treated as a secondary employment. This means the basic rate of tax will be deducted, until HMRC issues a different tax code.
Just because a worker is deemed as an employee for tax purposes this will not confer any employee rights on the individual. In addition, it is the PSC, not the deemed employer, that will remain responsible for the payment of benefits such as Statutory Sick Pay, Statutory Maternity Pay and for the operation of pensions auto-enrolment.
As a result of the changes, public authorities’ payroll taxes will cost an additional 13.8% in employer's NICs and 0.5% apprenticeship levy on top of the payment to the intermediary in the short term. Public authorities will have negotiated contracts under the previous rules and would have assumed that the worker and PSC would take responsibility for income tax and NICs. An employer is not able to recover secondary NICs from payments to a deemed employee and so public authorities are likely to want to negotiate new contracts or encourage the worker to provide services not through a PSC, but using another method (for example, under an umbrella company).
IR35 in the private sector from 6 April 2021
On 18 March 2020 the Government announced that the introduction of IR35 legislation in the private sector was to be delayed, until 6 April 2021, as it was looking at focusing efforts on survival of business’ rather than increasing compliance during the uncertainty caused by the Covid-19 pandemic. It is unlikely that this legislation will be delayed any further, as it may assist with economic recovery.
From 6 April 2021 the off-payroll working rules are extended to large and medium-sized companies in the private sector. This means that medium or large-sized organisations which have a turnover of more than £10.2million, a balance sheet total of £5.1m and/or more than 50 employees will be subject to largely the same provisions as those introduced in the public sector relating to IR35 in 2017. Small companies are not included under the IR35 changes.
Personal Service Companies (or ‘PSC’s’) will no longer have to determine the status of payments made after 6 April 2021 (regardless of when the work was carried out by the contractor), that responsibility and the accounting for tax and national insurance contributions will shift to the end user client or 'fee-payer'. 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 after 6 April 2021.
The rules will not apply to offshore companies without a UK presence, which will be excluded from the off-payroll rules. The rules will also 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. Where your business changes a contractor’s status as a result of carrying out a status determination exercise, the contractor may disagree with the status change and make a complaint through your business’ status disagreement process. You will need to ensure that you respond within 45 days of receiving such a complaint and may wish to seek professional advice at an early stage if you are changing the status of a contractor.
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 end client ‘fee payer’ to make deductions for tax and NICs.
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.
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 income tax, NICs, penalties and interest. Our specialist employer solicitors can advise you in respect of IR35.
If a contract will almost certainly fall under IR35, the easiest thing to do is likely to be to pay out of the intermediary, the company’s fees less legitimate expenses and pension contributions as a PAYE salary. This will mean the worker is being paid like an employee through the intermediary and IR35 will not apply.
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, on a self-employed basis or as a worker; or requiring contractors to go through an agency or other intermediary with no PSC in the chain.
How has Covid-19 affected IR35?
Covid-19 is likely to have had an impact on how your businesses use contractors and how contractors carry out work for your business. If there had previously been a presumed mutuality of obligation but due to a lack of work for your business you have given less work to contractors, this could indicate there never was a mutuality of obligation. Further, if contractors previously worked on your business’ site, using its equipment and was expected to comply with the same rules and working hours as employees so that they were difficult to distinguish from employees, the way in which people have worked in the period since the end of March and how they have been paid may offer more clarity as to whether someone should correctly be identified as a contractor or employee.
Oversight and control over contractors by businesses is likely to have been much less during the last 6 months due to the impact of Covid-19 and so where roles might have originally been assumed to be within IR35 when assessed ready for the introduction of IR35 in April 2020, this might now need to be reassessed before the new introduction date in April 2021 to reflect the reality of any changes in the working relationship. You must have a consistent approach and an audit trail when looking at whether contractors fall within IR35 and have a clear plan around how any disputes with contractors about employment status will be resolved. If you require assistance with any of this, our employment solicitors can help.