IR35 explained – A guide for contractors

What is IR35?

Briefly explained, IR35 is tax anti-avoidance legislation introduced by the UK government in April 2000. IR35 was designed to prevent contractors from reducing taxes through a limited company while maintaining a permanent position with an end-hirer.

It was a response to a common tax loophole called “Friday to Monday scenarios”. The authorities had noticed that workers were leaving permanent employment and then returning to the same employer as PSC contractors, thus benefiting from a more favourable tax rate. The difference was about 20 percent more income. In other words, HMRC lost valuable tax revenue. Thus, was born the ‘intermediary legislation’ called IR35.

What does “inside IR35” mean?

When a contractor or freelancer is deemed to be working inside IR35, it means that the nature of their engagement with a client is seen as being akin to that of an employee rather than a genuine business-to-business relationship. As a result, the contractor is subject to PAYE (Pay As You Earn) taxation and National Insurance Contributions (NICs) in a manner similar to that of an employee. The client or the intermediary organization (such as the contractor’s PSC) becomes responsible for deducting income tax and NICs from the contractor’s earnings before paying them.

Being inside IR35 changes the way your income is taxed. As an inside IR35 contractor, your income must be taxed under the PAYE system. Compared to contractors deemed outside of IR35 process funds through a registered business and are able to use tax advantages to increase their income retention.

Determining whether a contractor is inside or outside IR35 involves assessing the contractual arrangement and the working practices between the contractor, the client, and any intermediary involved. The determination focuses on factors such as control, mutuality of obligation, substitution rights, and the presence of other hallmarks of employment.

History of IR35

The IR35 rules became law in 2000 through the Finance Act 2000. And the rules were fiercely opposed, particularly by the Association for Independent Professionals and the Self-Employed (IPSE), which immediately sought a judicial review. The UK High Court ruled in favour of the government and the appeal was lost in late 2001. Business organisations and related groups continued to lobby against the rules, arguing that the classifications were ambiguous, unfairly targeted, and worked against independent professionals.

The government responded in 2015 with the reform of the IR35 system, the creation of the IR35 Forum, and other measures designed to bring clarity to contractors attempting to navigate the legislation. As a result, an entire contractor support industry emerged, consisting of IR35 contract review services, tax protection insurance companies and employment relations experts who provide assistance to professionals seeking clarity on their status.

However, it is worth noting that the grounds for IR35 were not specifically UK law. Many European countries control and manage who can be self-employed, above all ensuring that all workers have access to social security benefits (unemployment benefit, medical care and pension).

IR35 changes in April 2021

Now that we have an idea of what IR35 means and why it was introduced, we can talk about why it’s so popular right now. In April 2021, the relationship between the contractor and the client changed significantly as HMRC transferred the responsibility for determining the contractor’s IR35 status to the client. Prior to that, the determination of IR35 status was the responsibility of the contractor.

This meant that private sector companies employing contractors had to check their IR35 status and pay PAYE and National Insurance Contributions if those workers fell “inside” IR35. This has been a big change, as now the client may face financial penalties if they do not take reasonable care to determine the status of the PSC contractor before engaging them.

The impact of IR35 reform on the private sector

Next, our IR35 guide takes a deeper look at the reform and its implications, and why the new legislation caused so much debate. While certain groups felt it would be the end of contracting in the UK, others were open to work with it.

With the new legislation, many clients were no longer willing to take the financial risk of hiring a PSC contractor. The IR35 change led to some large organisations already issuing a statement saying that after April 2021 they would not hire PSC contractors due to the financial risk. This did upset many professional contractors as they were now being told how to run their own business, and no one really likes being told what to do, especially when it affects your income.

You can read more about how the IR35 Private Sector Reform has affected both the contractor and the client.

Determination of IR35 status – am I inside IR35?

The legislation is very grey and it can be difficult to determine whether you are inside IR35. If you desperately need straight answers, you can read the “Captured by IR35?” guidance where we have collected few key questions for contractors.

However, IR35 is a complex legislation and determining your status is not as simple as answering a few questions or using a checklist. Analysing your situation requires a thorough evaluation of several key employment areas that include:

Employee Benefits
Contractors rarely receive supplemental insurance, holiday pay, gym memberships, training courses, sick leave, and other extra benefits. Receiving any of these additional benefits may indicate that your business relationships extend beyond a typical contracting role

Role Substitution
In some situations, permanent employees have a clause in their contract that prevents another employee from taking their role in certain circumstances. Similar clauses in a contractor’s contract may indicate that the role is protected in a similar manner, suggesting that the job is a permanent requirement.

Location/Schedule
Does your working arrangement require you to be present at a specific physical location on certain days and times during the week? If your end-hirer has you on a regular schedule, this may indicate a relationship that leans more towards a “permanent” employee status.

Business Risk
Contractors operating outside IR35 typically take on a level of financial risk that may require maintaining professional indemnity insurance – a form of liability insurance designed to protect you from costs you may face if the client suffers a reputational or financial loss as a result of your work.

In a typical contractor arrangement, any defects or errors caused by your work must be fixed or corrected by your company at its expense. This is in sharp contrast to a permanent arrangement where the employee does not suffer financial loss if their work causes damage to the employer.

Equipment Provision
Contractors using their own equipment may be able to demonstrate that they are acting independently, but this area is somewhat unclear given the cybersecurity threats. Contractors working in IT or data-related fields may be eligible for allowances in this regard.

Termination
Does the end-hirer have the right to dismiss you without providing a fixed notice period or termination payment? Contracts that include additional payment provisions or advanced notice may be deemed permanent when compared to contractor relationships that can be terminated without notice.

Incorrect IR35 status may result in penalties

Until recently, non-compliance with the IR35 rules was entirely the responsibility of the PSC contractor. The new reform brought the client into the mix. In the IR35 guide for contractors “Consequences of incorrect IR35 status” you can read more about the risks and consequences of wrong IR35 status.

Payroll services are the saviour of the IR35 reform!

In our IR35 guide, we have covered the what, why, who and how of the IR35 Private Sector Reform. In the final part of our IR35 guidance, we explain more about the benefits of payroll services in IR35 reform, and how Cool Company can remove most of the struggle surrounding it.