What is IR35?
IR35 is tax legislation introduced under the Labour governments of Tony Blair (and more directly, under the chancellorship of Gordon Brown) as part of the Finance Act of 2000. The goal of IR35 was to combat tax avoidance done by workers acting as a limited company to supply their labour, thereby operating as contractors rather than employees. The establishment of a ‘personal service company’ allowed many workers to set up a corporation and offer the same work to their employer without the need for taxes nor employee benefits.
If the worker would be an employee were the intermediary not used, they are classed by HMRC as ‘disguised employees’. IR35 was implemented in 2000 to address a perceived rise in the number of disguised employees.
If a worker is found to have been a disguised employee, they are liable for ‘deemed payment’, i.e., retrospective payments on income tax, PAYE, and National Insurance contributions for the period that they operated as a disguised employee. This can equate to 25% of earnings during the period (and in some cases, potentially more).
With the development of the gig economy, the aftermath of the 2009 financial crisis, and an increasingly interconnected world, successive governments have attempted to further close the loophole and more clearly define the boundary between employee and contractor. Predominantly, this is an attempt by the government to maximize tax revenue, although there is also an element of companies shirking benefits by classing employees as contractors - seen most notably in recent unrest at Uber.
Employee vs Contractor
HMRC uses three distinct tests to determine the IR35 status and whether a worker is a permanent employee or a contractor, dating back to a precedent case in 1968 (Ready Mixed Concrete [South East] Ltd. v Minister of Pensions). In effect, all three tests center on the independent nature of the worker. The three criteria are:
1. Control
The independence of the worker (i.e. whether they are employed or self employed) is defined, in part, by the control the worker has over the work being done. For example, if the client can compel the worker to work at a given time, in a given location, and in a given manner, then he or she is deemed to be employed.
2. Substitution
If the worker can send someone else in his or her place (assuming a comparable level of competence), then the worker is more likely to be regarded as a contractor - most employees cannot send a proxy to their job.
3. Mutuality of Obligation
If there is a compulsion from both parties to offer and accept work, then the relationship is more likely to be an employee/employer relationship. In a contractor situation, a client has no obligation to give work, and a contractor can refuse it.
These boundaries are naturally not always clear cut and can vary greatly depending on project and industry. As such, the government in 2017 introduced an online tool (available here) - Check Employment Status for Tax (CEST), designed to allow workers to input information and determine whether they are employed or self employed.
The CEST tool has come under criticism from business owners and employees for its misclassifications and inaccuracies, in particular owing to the fact that the tool defines all contractual relationships as having a mutuality of obligation - thus forcing many contractors into employment status. HMRC undertook an extensive consultation period before drafting its most recent round of legislation, although it is unclear the extent to which this led them to change their position.
What are the implications for contractors?
The implication for contractors is - as expected - financial risk. Contractors are potentially liable for large tax bills should they misclassify (or be misclassified by HMRC). In the vast majority of cases, being able to genuinely demonstrate that you are independent of your client using the three criteria above will help avoid the ‘deemed payment’ and there is a number of test cases working through the courts that will clarify case law. However, you can take further steps to insure yourself and solidify contractor status in the eyes of HMRC.
One of the best strategies for any contractor is to diversify their income. By demonstrating multiple clients, a contractor will have a far stronger case that they are, in fact, a contractor. For a contractor working exclusively with one client over an extended period of time, there is less scope for arguing that you are independent of that organisation, particularly under the capricious CEST classification.
Further advice from many tax lawyers is to create warranties and indemnities in any contract, placing the liability for IR35 costs on the client. The ability for a client to sign off on this is, however, a different matter.
Public vs private sector contracting
As of April 2017, IR35 applied differently to contractors depending on whether they were working in the private or public sector. The off payroll working rules kicked in for all public sector organizations (with knock-on effects for contractors) in 2017. This created a three year period where the rules between private and public sectors differed (before the April 2021 reforms closed the gap).
The ‘off payroll’ rules that applied to the public sector were predominantly targeted at Personal Service Companies (PSCs), which effectively create a corporation centered around one single individual. While the most headline-worthy examples of this have been those who used PSCs to claim a BBC salary, the largest number of these were those working within the NHS. In both cases, the government’s clamping down on these PSCs has met with a great deal of controversy, and the grey areas of sweeping legislation are yet to be fully tested.
What is certain is that during this period, the public sector saw a decline in contractor projects, compounded also by the ongoing uncertainty over the 2016 Brexit referendum result. These two factors have resulted in an estimated £27 billion of IT, technology, and other digital projects being paused.
As can perhaps be expected, in the period between 2017 and 2021, many contractors have switched to working with the private sector. However, the extension of the 2017 reforms to the private sector in the 2018 budget (before the impact of the public sector expansion had been fully tested) has meant that many UK industries are seeking to make fairly rapid changes to their processes, as are many contractors.
2021 Reforms
The October 2018 Budget (full text available here, responses to the legislation here) applied many of the public sector ‘off payroll’ rules to the private sector. These rules came into effect in April 2021. The key parts of the Chancellor’s text read:
‘Responsibility for operating the off-payroll working rules will move from individuals to the organization, agency or other third party engaging the worker.’ This means that, as a contractor, it will be the responsibility of the business with which you are contracting to check compatibility, using HMRC’s CEST tool.
However, while large companies will undoubtedly be the slowest to respond to these changes, and will have the most difficulty, SMEs are exempted:
‘Small organizations will be exempt, minimizing administrative burdens for the vast majority of engagers, and HMRC will provide support and guidance to medium and large organizations ahead of implementation’.
‘Small organizations’ or small businesses are defined by government legislation as ones that meet all of the following three criteria:
- It has fewer than 50 employees
- It has a turnover of less than £10.2 million per annum
And
- It has total assets of not more than £5.1 million
[All information is taken from the Companies Act, 2006, and correct as of June 2022]
Some good news is that IR35 rules are not implemented retrospectively, meaning that previous work completed as a contractor (even if, under the new rules, would not have been eligible) will not be retrospectively docked PAYE contributions.
It is likely, given the relative confusion of implementation, particularly relating to flaws within the CEST system, and the ongoing confusion over the Brexit process, that there will be further tweaks required to the legislation. This ongoing uncertainty is detrimental to both the UK business environment and to contractors, and it is likely that there will be a drop off in contracting projects, particularly for large companies not exempt from IR35 implementation.
What to do
Looking outside of the UK for contracts is a way of offsetting the domestic risk. Using platforms like wellpaid.io will give you the opportunity to search for clients offering outside IR35 positions.
Furthermore, although the burden (and the liability) for IR35 compliance will shift to the company in April 2021, there will be knock-on effects for contractors. Therefore, working with SMEs is a preferable option (where possible).
One final item to consider for contractors who subcontract parts of their projects - if you meet the threshold for a non-exempt business, you will also be responsible for CEST-checking your contractors. This will only affect a minority of contractors but should be something to be conscious of, particularly if future legislation amends the thresholds, or removes the SME exemption.