What is IR35?

Qdos Contractor has specialised in IR35 tax rules since it was introduced in 2000, providing advice, representation and insurance against the legislation for contractors, recruitment agencies and businesses engaging independent workers.

Reviewing on average over 2,000 contracts every month, and having successfully represented more than 1,600 contractors in IR35 investigations, Qdos is recognised as a leading IR35 expert.

IR35 is a complex tax legislation which is easily misunderstood and administered incorrectly.

This guide will enable you, as a contractor, to:

• Understand IR35 and how it might impact you
• Determine your IR35 status
• Encourage accurate determinations of your IR35 status by your clients
• Dispute an inside IR35 determination provided by a client
• Pay the correct tax when inside IR35
• Pay the correct tax when outside IR35
• Handle an IR35 enquiry by HMRC
• Object to an HMRC opinion on whether IR35 applies

Read on to see IR35 explained simply.

What is IR35?

In this section, we’ll help you understand what IR35 is, why it came into force and explain both the ‘inside IR35’ meaning and the ‘outside IR35’ meaning.

We’ll also explain the off-payroll working rules (IR35 reform) and the impact this has on contractors providing their services to public sector bodies, and medium-large private sector businesses.

IR35 explained in layman’s terms

IR35 is a piece of UK tax legislation.

It’s designed to close a loophole in the tax system where workers could use the setup of a limited company structure in order to pay less tax.

Where, despite a contract being with a limited company, the reality is more like an employer-employee relationship, the worker should be taxed as an employee. This is referred to as a ‘deemed employee’.

The IR35 legislation looks to identify ‘deemed employees’ and ensure they are taxed correctly, however IR35 can impact those operating genuinely through a limited company structure due to the subjective nature of the legislation.

It impacts UK personal service companies (PSCs) – a term which has not been clearly defined by HMRC but, broadly speaking, refers to limited companies with a sole or majority director/shareholder who provides the services of the company.

Why was IR35 introduced?

The government thought contractors were exploiting the tax system by leaving employment roles to create limited companies and return to the same role in a contracted relationship, therefore benefitting from the tax advantages of a company setup. Namely, contractors using a limited company can take the majority of their earnings in the form of dividends, which is taxed at a lower rate than income tax.

Exploiting the tax system in this manner is considered a form of tax avoidance which HMRC defines as “bending the rules of the tax system to gain a tax advantage that Parliament never intended.”

The then Chancellor of the Exchequer, Gordon Brown, enforced the IR35 legislation in 2000.

Since then, contractors judged to be employees (‘deemed employees’) have had to pay tax at the equivalent rate to employees, which is likely more than they’d have had to pay if they were deemed limited companies.

While ‘deemed employees’ must pay the equivalent level of tax as typical employees, they do not get access to any of the benefits typical employees enjoy, such as sick pay, holiday entitlement, or company pensions. Many critics of IR35 describe this as unfair.

Why does IR35 compliance matter?

If HMRC finds that you have been working on a self-employed basis, described as ‘outside IR35’, when, in actual fact, the service you provide your client reflects that of employment, described as ‘inside IR35’, you’ll be required to pay the missing tax back to HMRC, plus interest and any penalties.

Given HMRC can investigate as far back as six years, being found non-compliant can have huge financial consequences.

Between 6^th April 2017 and 6^th April 2023 however, the rules differ. Under the off-payroll working rules (a reform made to the application of the IR35 legislation), the liability for compliance sits with another party in the contractual chain such as the client or recruitment agency where applicable, unless working for a small company in the private sector. This amendment is to be repealed as of 6^th April 2023 and contractors will be responsible for determining their own employment status as well as be liable for any incorrect tax payments.

What does ‘outside IR35’ mean?

If your contract is deemed outside IR35, you are considered self-employed for tax purposes and are free to pay yourself in the most tax efficient way, which is typically through a mixture of salary and dividends taken from your company.

Contractors working outside the scope of IR35 are responsible for making sure all their personal and company taxes are calculated correctly and paid on time.

What does ‘inside IR35’ mean?

If your contract is deemed inside IR35, you’re considered an employee for tax reasons. This means you’re effectively required to pay tax at the same rate as an employee in the same tax bracket.

Tax and employment legislation are currently separate. So, whilst you may be considered an employee for tax purposes, you are not automatically entitled to employment rights.

What are the implications of working inside IR35?

When working inside IR35, you’ll need to pay National Insurance Contributions (NICs) and Income Tax on your earnings.

For those engaged by a small private sector client, or any client from 6^th April 2023, this is paid via a ‘deemed payment’ which is the payment you will be required to make to HMRC at the end of the tax year, taking into account the extra tax you must pay as a result of working inside IR35.

Like many things related to IR35, calculating the ‘deemed payment’ is fairly complex. That’s why, in many cases, contractors seek professional help in doing so.

Contractors working inside IR35 in the public sector and those working inside the rules for medium and large companies in the private sector , do not need to work this out until 6^th April 2023. Your fee-payer will do this on your behalf and deduct the NICs and Income Tax from your invoice before paying you.

More commonly however, the fee-payer will prefer an alternative working arrangement such as use of an umbrella company.

An umbrella company enables contractors to have the flexibility and independence of contract work, but with employment under the umbrella company. This, in turn, solves complex payroll and administration issues for fee-payers administering the off-payroll working rules.

The off-payroll working rules (IR35 reform)

Despite introducing IR35 over two decades ago with the aim of preventing ‘disguised employment’, the Government thinks contractors still abuse the system – to the extent where they believe just one in ten contractors who ought to be operating inside IR35 actually are. As a leading authority on IR35, Qdos disagrees strongly with the Government on this figure.

The off-payroll rules are an amendment to the existing IR35 legislation which place the responsibility of determining whether IR35 applies or not onto the organisation hiring the contractor. As a part of this reform, the liability for paying the appropriate tax also becomes that of the fee-payer, which is usually the recruitment agency in the supply chain.

These rules have applied to public sector bodies since April 2017, and, as of 6^th April 2021, were rolled out in the private sector for medium and large businesses only. This part of the legislation however will be repealed as of 6^th April 2023. From this date, contractors will once again be responsible for their own status.

When working with a company that HMRC considers ‘small’ in the private sector, contractors remain responsible for setting their IR35 status and all of their taxes.

HMRC defines a small company as one which does not exceed two or more of the following criteria; an annual turnover above £10.2 million, a balance sheet total over £5.1 million, or more than 50 employees.

IR35 reform is considered controversial because clients are largely inexperienced with regards to making status decisions. Often in the public sector, this resulted in inaccurate IR35 assessments as public sector bodies made decisions with the view of protecting the liability that they now carry.

Determining your own IR35 status

In this section, we’ll help you get a clearer idea of what’s taken into account when deciding whether your contract should sit inside or outside IR35, how to avoid working as a ‘disguised employee’, along with the help you can get to understand your own IR35 status.

IR35 status can be difficult to determine without professional help – this is because whilst there are recognised tests to consider, the exercise is about painting a full picture rather than running through items on a checklist. Making holistic status decisions like this are challenging without extensive experience.

1. Consider the factors which contribute to IR35 status

This is where it can get slightly complicated, given there are a number of factors to consider when setting IR35 status, very few of which determine the outcome on their own.

Above all else, for a contract to sit outside IR35, it must paint the picture that it is one business providing a service to another business – not an employee and employer relationship.

IR35 tests

There are, however, three key tests which are considered most important. These are:

i. Personal Service

• Is the service you provide your client a personal one or do you offer a genuine business to business service?
• Do you have the right to provide a substitute worker to perform the duties, as any other business would be able to?

ii. Control

• To what extent does your client control the services you carry out, if at all?
• Do you fall under the direct control of your client or are you able to dictate how the work is carried out?

iii. Mutuality of Obligation

• Is there an obligation for the client to provide consistent and paid work and are you obliged to accept this work?

Other IR35 factors

There are plenty of other aspects of your working engagement to consider. These range from whether you use the client’s equipment or your own to whether you carry financial risk just like any other business:

Financial risk

• Do you hold business insurance?
• Would you be liable to rectify any faults or unsatisfactory work at your own time and cost?

Non-exclusivity

• Do you carry out concurrent contracts?
• Are you contractually barred from carrying out services for other clients?

Equipment

• Do you provide your own equipment?
• Is the equipment necessary for the job?

‘Part and parcel’

• Are you part and parcel of your client’s organisation (an integral or essential piece)?
• Do you have a contractor ID badge?
• Do you have your company or your client’s in your email signature?
• Are you on employee lists?

Business trappings

• Do you have your own business cards?
• Do you have any employee benefits such as holidays or sick pay?

2. Review your contract and working practices

Referring to the IR35 factors above, you can then review your contract’s written terms and mark each clause which takes reference to any of the IR35 tests.

It’s also important to note that your contract should reflect the reality of the engagement (your working practices).

Should a clause be found not to translate in real life, HMRC may ignore your contract entirely.

Indicators of an outside IR35 engagement

While your IR35 status shouldn’t be determined based on one condition of your contract alone, the following signs point towards a genuinely self-employed engagement and one that sits outside the legislation:

• You have the right to provide an able substitute in your place
• Your company carries financial risk and is liable for any mistakes you make
• You do not fall under the control of your client and have the freedom to carry out the work as you see fit, when possible
• You are not ‘part and parcel’ of the client’s organisation and do not enjoy benefits similar to an employee
• Your contract has a start and end date

Indicators of an inside IR35 contract

Again, while individually these factors may not result in being caught by the rules, here are a number of indicators of a contract that could be determined inside IR35:

• You have no right to provide a substitute
• There’s an obligation for your client to provide work and an obligation for you to accept it
• Your client dictates how, when, and where you provide the service
• You have a rolling contract, with no fixed start or end dates

3. Collect evidence

To further support your status, it’s advised to maintain evidence throughout your contract, whether this is your email signature differing to your client’s employees, or as far as a document signed by your client which confirms the reality of your engagement with regard to the IR35 tests (confirmation of arrangements).

Examples of evidence include:

Absence

Evidence that you gave professional courtesy in informing your client of absence as opposed to requesting permission.

Tasks

Evidence of refusal to undertake work not included in the contract, or evidence that a new contract schedule was created for any such work.

Office

Evidence of any times you were treated differently to an employee or were sent home due to closures/system failures whilst employees were required to stay.

Substitution

Evidence of when you activated your right to send a substitute. It can also be useful to take note of any time another contractor did this at your client, as it can prove that the client would honour the contractual terms of your agreement.

Client determinations of your IR35 status

In this section, you’ll find what to expect from your client when determining your status under the off-payroll rules (IR35 reform) effective until 6^th April 2023, as well as how to minimise the likelihood of an incorrect determination.

How your client determines your status

Below we outline the steps a client will usually take to determine your IR35 status. Whilst the process is slightly different, the factors remain the same.

1. Your client will likely advertise the role with a preliminary indicative status based on limited factors:

i. Identify reasons for the status and how it might change

Find out from the client/agency what the reasons are for the status advertised and if it will be assessed again once commencing the contract, as well as how they intend to do this.

ii. Consider the financial implications of an inside IR35 status

If advertised as inside IR35, consider that the advertised day rate will have income tax and NICs deducted before it is paid to you – reducing the take home value.

2. Your client will assess your IR35 status in usually one of two ways:

i. HMRC’s IR35 tool – Check Employment Status for Tax (CEST)

HMRC introduced CEST in the run up to public sector IR35 reform in 2017.

It was built with the intention of helping clients determine the status of contractors they engage, the vast majority of whom were inexperienced with regards to the IR35 legislation.

Many contractors do not trust the tool to offer well-informed IR35 advice, and the tool has received widespread criticism for several reasons, including its checklist approach and over-reliance on certain factors.

ii. Independent IR35 assessment services

These services provide independent assessment for clients to assess their contractors’ statuses fairly and compliantly.

The services on offer can vary greatly. Whilst your agency or client will make the decision on which service they choose to use, ideally the chosen service will:

• provide an independent assessment where the contractor is provided with the initial set of questions, putting contractors at the forefront of IR35 decision-making,
• be reviewed by an experienced IR35 consultant and subsequently approved by the client,
• include information-sharing via an online portal and,
• protect the clients’ liabilities to encourage fair assessment.

3. Your client will issue you with a ‘Status Determination Statement’:

A ‘Status Determination Statement’ should be issued to you before or on the day of starting work for the client. It must include the decision made as well as the reasons behind this decision.

Failure to provide you with this will mean that the client has failed in their obligations and will be considered the fee-payer (liable for any incorrect deduction of tax) until it has been provided.

How to encourage accurate assessments from your client

Qdos advises that joined-up thinking and collaboration between all parties in the supply chain is key when setting IR35 status.

While you will not be the party that sets IR35 status, that’s not to say you cannot work with your client to increase the chances of it being set accurately.

First and foremost, however, you need to be sure of your IR35 status before you discuss it with your client. Therefore, it’s well worth considering having your contract reviewed by a specialist. Armed with this information, you will be well-placed to put forward a compelling case for belonging outside the rules.

Disputing an inside IR35 determination provided by a client which I believe is incorrect

If you feel your client has incorrectly placed you inside IR35, you have every right to challenge this decision.

HMRC has introduced a ‘client-led disagreement process’ which is designed to give contractors the opportunity to overturn what they see as inaccurate status decisions.

If you disagree with an IR35 decision, you must contact your client who has 45 days to respond to your dispute with their reasons for making the decision. From here, your client will be required to confirm or change their decision and, if necessary, provide a new status decision. If your client fails to do this, they will become the fee-payer, meaning the IR35 liability will transfer to them if they don’t carry it already.

If the contractor still disagrees with the status decision after the initial appeal, HMRC encourage following steps to reclaim tax via the Self-Assessment route. Until this is put into practice however, it remains unclear how effective this will be.

Paying tax when inside IR35

In this section, we explain the tax implications of working inside IR35 and outline how you’ll be required to pay this additional cost.

What tax do you pay when operating inside IR35?

You’ll need to pay National Insurance Contributions (NICs) and Income Tax on your earnings, similar to that of an employee.

This is completed at the end of the tax year by calculating the ‘deemed payment’.

You will need to work this out yourself from 6^th April 2023 or if you are currently engaged by a small business in the private sector. For those working inside IR35 within the off-payroll working rules until April 2023, your fee-payer will deduct the relevant tax and NI from your fee before paying you, or offer an alternative working arrangement such as becoming a temporary employee of the agency or using an umbrella company.

What is the ‘deemed payment’?

The ‘deemed payment’ is the amount you’ll need to pay any additional tax on at the end of the tax year as a result of working inside IR35.

Under the off-payroll rules, these taxes are deducted by the fee-paying party in the supply chain before they pay your invoice.

So, in other words, you don’t need to worry about calculating what HMRC calls the ‘deemed payment’ until the end of the 2023-2024 tax year. Until then, this is the responsibility of the fee-paying party in the supply chain, which will be either your client or the recruitment agency you work through.

Like many things related to IR35, calculating the ‘deemed payment’ is fairly complex. That’s why, in many cases, contractors seek professional help in doing so.

However, if you want to do this yourself, you should follow the steps below:

Deduct the 5% allowance for expenses from the relevant income (for income before 6th April 2021 only)

Contractors working inside IR35 are entitled to a flat rate 5% allowance to account for expenses such as administration costs of running a business. This allowance has been removed with the reform so, for income after 6^th April 2021, you will not be able to claim this.

Add any direct payments from the client

You might have been paid some benefits directly and not via your personal service company (PSC). These should be added to the calculation.

Deduct other allowable expenses and pension payments

You can still claim certain other expenses, such as professional indemnity insurance and personal pension payments.

Any pension payments made by the PSC to an approved scheme for the worker’s benefit should also be deducted.

Deduct capital allowances and pension payments

Deduct capital allowances and pension payments

If your PSC purchased plant or machinery necessary for the purposes of the engagement, you can claim this allowance, but only for the proportion it was used for the inside engagement.

If you also used the plant or machinery during outside IR35 engagements, you’ll need to reduce the allowance by the relevant percentage.

Deduct Employers NIC

You’ll need to deduct any Employers Class 1 and 1a National Insurance contributions already paid to HMRC by your company on your salary and benefits.

Deduct your salary and benefits already paid

Your salary and benefits which have already been paid will have already been taxed as employment income so you will need to deduct this when working out your deemed payment.

Calculate and deduct Employers NIC

On the amount you have left, you will need to calculate and deduct the Employers NICs due. Whilst this is deducted in order to arrive at the deemed payment, you will also need to pay HMRC this additional Employers NIC.

Following the IR35 reform, the fee-payer in the supply chain (the organisation paying your PSC) will be responsible for paying this instead.

Pay tax and NICs on the deemed payment

You now have the deemed payment amount. On this, you must pay the additional tax and NI due, and report it to HMRC on a Full Payment Submission (FPS) by the end of the tax year.

Paying tax when outside IR35

As we briefly explained earlier on in this guide, as a contractor working outside IR35, you remain responsible for paying your taxes.

Because the service you provide is considered to be a genuinely self-employed one, you can draw money from your limited company in a more tax efficient manner, usually through a combination of salary and dividends.

Just like any other small business owner operating through a limited company, you’ll be required to complete a self-assessment in which you pay any income tax and NI owed.

You’ll also need to pay your annual corporation tax, which is due on any profit your company makes, and tax on any income you draw as dividends.

Handling an IR35 enquiry by HMRC

Given HMRC can investigate as far back as six years, being found to have been wrongly working outside IR35 can cost contractors vast sums with the repayment of tax, plus interest and sometimes even penalties. Even with the introduction of the off-payroll rules, contractors will remain liable for tax years prior to 6^th April 2021.

In this section, we’ll walk you through the steps of an IR35 enquiry with what you should and shouldn’t do at each stage.

It’s well known that HMRC can be heavy-handed when investigating your IR35 status, which also makes the prospect of handling an IR35 enquiry on your own and without representation, rather daunting. The complex nature of the IR35 legislation doesn’t make things any easier either.

Therefore, the vast majority of contractors engage an IR35 specialist to handle their case, while many also take out IR35 insurance well in advance to cover the costs of this.

1. Opening Letter

IR35 enquiries tend to open with a letter being sent from HMRC to the contractor.

In this, the Revenue will focus on a particular contract taking place in a specific tax year or your company’s accounting period.

HMRC will request a number of things from you. This includes;

• an analysis of your company’s income falling within the period of enquiry,
• details of your company’s expenses within this period,
• copies of contracts that took place in this period of time,
• reasons why the contract was deemed to fall outside IR35 and the contact details of your client.

Even at this stage, we advise you to contact an IR35 specialist who can assist you in your response. It is, after all, vital that every correspondence with HMRC is well considered.

Contractors engaged by a client subject to the off-payroll rules won’t be contacted in relation to services provided after 6^th April 2021. Because it will be your client who sets your IR35 status, HMRC will approach them, not you.

2. Meeting

Once all of the necessary information has been submitted to HMRC, the tax office will usually request a face-to-face meeting.

It’s important to understand that you are not obliged to attend such a meeting with HMRC. In fact, we often advise contractors that such an invitation is rejected and that you ask HMRC to submit their questions in writing. Having HMRC’s questions clearly written down will allow you additional time to consider your responses more carefully and ensure you are giving accurate information.

3. Client Contact

Once you have provided your responses to HMRC’s questions they tend to take some time to analyse all of the documentation.

It’s at this stage that HMRC may request contact details for your end-client to verify your working practices.

Prior to providing these contact details it’s advised that you speak with your contact at your end-client to advise them of the situation.

As a result, it may be that HMRC are not satisfied with the information they have collated and have further questions, in which case these can also be requested in writing.

In some more complex cases, for example where there were no written contract or information could not be retrieved from the end-client, it could take some time for HMRC to collect all the information it needs.

4. Decision

After HMRC has considered all of the information provided, they will give their determination.

Should HMRC consider you to be outside of IR35, they will simply close the enquiry down.

If HMRC thinks you belong inside IR35, they will then make their demand for the retrospective PAYE tax and National Insurance, plus interest and a possible penalty.

Objecting to an HMRC opinion on whether IR35 applies

If HMRC find you as inside IR35 following an enquiry, all is not lost. You do have the right to appeal this decision.

In this section, we will outline the steps you can take to object to HMRC’s opinion on whether IR35 applies.

There are two ways to go about challenging HMRC’s view of your tax status:

1. Alternative Dispute Resolution (ADR)

The first step of appeal is via HMRC’s ‘Alternative Dispute Resolution’ (ADR) service where the case will be independently heard by another inspector, and an impartial HMRC official with no involvement in your case will mediate.

We have found the ADR process to be worthwhile, but should the appeal not be resolved, this can be progressed to Tax Tribunal and further, the Civil Courts.

2. IR35 Tribunal

You can escalate your case to an IR35 tribunal, where you can appeal a decision made by HMRC in court.

Given the costs associated with doing so, many contractors choose to take out IR35 insurance such as tax liability cover which covers legal advice and representation fees as well as the liabilities found owing.

In recent years, contractors who have challenged HMRC in an IR35 tribunal have, on the whole, been successful. For example, HMRC has won just one in fourteen IR35 tribunal cases outright since 2010.

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Qdos provide a full range of services in respect of the IR35 legislation, including comprehensive IR35 insurance, contract reviews, enquiry defence, consultancy services, and compliance solutions for the reform.