In today’s enterprise environment, it’s common for businesses to outsource some of their responsibilities to third-party contractors. This is particularly true for IT departments requiring various requirements, from website design to bespoke software development, cyber security, and customer resource management. The list of IT services is endless, and the market is segmented with specialists who can provide on-demand expertise for projects without hiring employees.
Before 2021, for the private sector, it was easy; if you wanted to hire a contractor, you just hired one. Now, things are a little more complicated thanks to the so-called “IR35 reforms” or, more formally, the Off-payroll working legislation.
What is IR35?
IR35 is a colloquial term that entered the lexicon in April 2000 and is a shortcut non-statutory term to describe legislation that seeks to combat tax avoidance via what’s termed “deemed employment”.
Traditionally, the most common way to operate as a contractor was where contractors would own their own limited companies, which invoiced clients, thereby generating company revenue. Although the hirer will typically pay more to hire a contractor than a permanent employee, they don’t have to give them any rights, they can fire at will, and they don’t have to pay National Insurance Contributions (NICs) on top of what they pay the contractor’s company. Whereas, if they paid an employee, employers NICs of 13.8 per cent are due on top.
The contractor company then pays corporation tax on the profits and distributes profits as dividends. Dividends only attract income tax. Before the dividend tax regime changes in 2016 and subsequent rises in dividend taxes, contractors paid less tax on company income than an employee paid on a salary. These days, there’s still an advantage for those earning £50,000 to £80,000 a year, but after that, it’s marginal. According to HMRC, the perceived tax loss is mainly due to employer’s NICs.
The original legislation failed due to its lack of compliance and unenforceability. When HMRC investigated, most limited companies were not capitalised, so there was nothing to collect, the cost of litigation wasn’t commercial, and even when cases went to tax tribunal, HMRC lost more cases than it won.
HMRC finally convinced Parliament a change was needed. The clients had to become the IR35 tax police.
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What are the ‘IR35 Reforms’ and Off-payroll working?
In 2016, the “IR35 Reforms” started being consulted by HMRC under the new label of “Off-payroll”. People who are “on-payroll” are taxed like employees. The Off-payroll bunch are the contractors.
New rules, called Off-payroll working (“OPW”), arrived in the public sector in 2017 and were rolled out to the private sector for medium and large companies in 2021. Small companies who hired contractors were spared the pain – where a contractor works for a small client, the original rules still apply. But it’s only a matter of time.
According to the UK’s Companies Act 2006, a company is “small” if two or more of the following conditions are met:
- the company does not have a turnover of more than £10.2 million
- the company does not have a balance sheet total of more than £5.1 million
- the company does not have more than 50 employees.
The new rules shift responsibility to the organisations engaging contractors, who need to conduct status assessments, and if “Inside IR35”, they need to make the appropriate deductions before the money is paid to the contractors’ limited company.
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Am I inside or outside IR35?
HMRC quickly built a basic online tool called Check Employment Status for Tax (CEST) to help organisations determine whether the off-payroll working rules apply. However, the tool has been largely criticised for many reasons, including it’s not being kept updated, its inaccuracy, misalignment with the law, bias towards deemed employment results, and evidence of HMRC ignoring its results.
In the interests of full transparency, my firm was the first to build an online IR35 status tool in 2016 – and some might argue that we would criticise CEST. That said, all the concerns are objectively demonstrated in a detailed report, with reference to multiple independent Government sources, including the CEST source code. I advise you to do your research and reach your own conclusions.
Are self-employed workers a risk to your business?
Contractors are only a risk to your business if you get the status determination wrong, pay a contractor’s company gross when it should have been deemed employment, and HMRC later intervenes and issue a tax bill. If you have a robust assessment regime in place, that should not happen.
In terms of the financial impact, under the new rules, which are being updated in April 2024, retrospectively back to April 2017, the extra tax to pay should roughly be equal to what the employers’ NI bill would have been because the tax the contractor is likely to be paying (or paid) is taken into account.
At the time of writing, we have yet to see the final mechanics of how offsets will work, but the underlying principles have been published. The best way to demonstrate this is by way of an example:
Depending on the rates paid to the contractor will depend on the extra percentage of tax payable by the deemed employer. A rule of thumb for now, until we see the statute, might be 12.5 per cent to 15 per cent.
For firms that hire, say, 100 contractors, if they get a few determinations wrong, with the rest being okay, the extra tax to pay, as a percentage of the whole annual contractor workforce cost, will be about 0.1 per cent to 0.2 per cent. The problems arise if the client makes a catastrophic error with the assessment regime, which should not happen if the client takes good advice.
What steps should employers take to ensure they are IR35 compliant?
Clients must ensure they have a robust assessment regime and follow best practices. Here are 10 essential tips:
- Conduct robust status assessments using principles aligned with the status case law.
- When assessing, ensure you gather data using a collaborative approach to involve the relevant people in the process.
- When creating a Status Determination Statement (SDS), ensure it is comprehensive, provides correct information, and arrives at the conclusion using reasonable care. Share the SDS with other parties in the supply chain and workers.
- Pay careful attention to your contractual paperwork. If HMRC investigates, poorly drafted generalised contracts will significantly increase the risk of poor outcomes.
- Implement a consistent process that reduces the risk of human error and bias.
- Once the engagement starts, monitor the engagement (use automation) and gather material evidence that will help strengthen proof of compliance should HMRC investigate.
- Keep updated on IR35 matters and emerging case law updates.
- Do not expect HMRC to stand by the results of its CEST tool.
- Seek specialist advice if you do not have it in-house. IR35 is a legal problem, not an accounting or insurance problem.
- Beware of firms claiming to have IR35 expertise when they want to cross-sell you something else. A quick sense check might ask: “When did you last help defend an IR35 enquiry or defend at a tax tribunal?”
Generally, provided firms put proper processes in place and align themselves with expert partners for critical support, they should not have a problem.
What should contractors do about IR35?
For many contractors, the terms offered are primarily dictated by firms which may have a stronger bargaining position. Where the services required by firms are of low demand and high supply, firms may choose to hire “on-payroll” only. In those instances, contractors could seek to work remotely for overseas firms (the new rules don’t apply) or limit their purview to small clients (the new rules don’t apply).
Firms can choose whatever policy they want to adopt and don’t have to engage with the legislation if they don’t want to, leaving the contractor the only option to vote with their feet.
Conversely, where the demand for specific skills and the supply is low, firms are more likely to engage with the legislation and hire “Outside IR35”, provided the law supports that stance.
Whichever engagement model firms offer, contractors need to understand the structural implications for their earnings and how they will be taxed, then quote their rate accordingly.
Set up your own IT consultancy
Lastly, one tactic used by contractors is to build their own consultancy using an associates model, where the business is won and then requires a project team to implement. Because the consultancy is the “client” when services are fully contracted out, the client does not need to worry about IR35. Contractors who branch out to build their own small consultancy are advised to implement a robust regime as if the legislation applies anyway – otherwise, if they come to sell the business one day, they may get a nasty surprise when the buyer conducts due diligence.
Dave Chaplin is CEO of IR35 compliance solution IR35 Shield and author of IR35 & Off-Payroll Explained. IR35 Shield is a leading consultancy in IR35 matters with over 20 years of experience in the contracting market. IR35 Shield helps defend taxpayers at IR35 tax tribunals and are experts in the crucial area of employment status case law
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