What IR35 is and why it exists
Part 1: IR35 regulations have been around longer than you think - but what's all the fuss about?
It is quite common that contractors set themselves up as limited companies, offering their services through the company and taking their earnings through a combination of a very small salary and then the rest by dividends. This allows contractors to take advantage of the slightly beneficial tax rates that dividends allow. The main saving in this scenario is national insurance. Neither the contractor as employee, or the client as employer, pays any national insurance contributions. HMRC therefore lose out on their target yield from taxation.
IR35 and Off-payroll working legislation therefore attempts to close this gap and applies to contractors operating via limited companies. It does not apply to sole traders (self-employed) or PAYE employees as both already pay employment based taxes including NI. IR35 regulations have been highly disputed as unfair to the contractors and were replaced in part by the Off-payroll regulations for certain companies.
Both legislations look at the factors for each engagement to work out if this is essentially an employee/employer relationship or an actual contracting relationship. There are several tests to take into account and it should be done on a case by case basis - not a blanket approach. The three main tests are;
Personal Service and Substitution test - has the company hired the specific individual or the limited company to deliver the services
Control test - Does the company hiring the contractor ‘control’ the individual - ie hours, method of work etc
Mutuality of Obligation (MOO) test - Does the contractor have to accept the work given or can choose the accept the work, and does the company have to provide work tot the contractor
There are also other factors to consider:
Part and Parcel - is the contractor a required role within the hirer’s company
Financial risk - Can the contractor potentially suffer financial loss
In business on your own account (IBOYOA) - Can the contractor demonstrate that they are in business in their own right
Provision of equipment - who provides the tools the contractor needs in order to fulfil their role.
Intention of the parties - Did the parties intend to create a contract of employment or not
HMRC has also created an online tool to aid in making a determination - however in some legal cases and tribunals, it has often given the incorrect answers. This is called CEST - Check Employment Status for Tax tool.
There are a few main differences between IR35 and Off-payroll working rules; For IR35, The contractor is the person responsible for assessing their own IR35 status. They should assess their position at the end of each contract when all evidence is available. In addition to paying the employee NICs, their limited company should also pay the employer NICs element. This means that the contractor bears the full cost of the equivalent employment taxes.
For Off-payroll, the responsibility for the assessment resides with the hiring firm. The agency in the supply chain closest to the contractor as the ‘fee-payer’ is the liable party for the payment of taxes via PAYE. The hirer bears the contract cost plus the employer NICs element - which means that the contracts are now more expensive from a total cost point of view. Hirers should assess the position at the beginning and during the term of the contract to ensure that the contract doesn’t drift from the initial assessment. Upon each assessment, hiring companies should provide the contract with a Status Determination Statement (SDS).
Off-payroll rules do not apply to ‘Small Companies’. Instead, IR35 remains in place for them. Small Companies are those as defined in the Companies Act 2006 as;
Annualised Turnover of less than £10.2m
Balance Sheet Assets of less than £5.1m
Average Number of Employees of up to 50
To compare an £80,000 contract caught ‘inside IR35’ as opposed to one ‘outside IR35’ we must first consider what the contractors expected earnings look like. If we assume that the contractor has set themselves up as tax efficient as possible, this is how we expect their earnings to look (using 2019/2020 rates);
Salary £8,060, just under the NI threshold
Company profits after 19% corporation tax are £58,271
The same profits after dividend tax are £50,301
Total take-home pay is £58,361
If we now look at the impact of being caught inside IR35, we must consider that the £80,000 is the full amount include the budget to cover the employers NI element. Therefore;
Net Pay £49,914
The take-home pay difference is £8,446 less.
Therefore, IR35 succeeds in it’s aim by increasing it’s previous yield of £21,639 from corporation and dividend tax to £30,084 through employment based taxes - at the full cost to the contractor.
If we now look at how this applies if Off-payroll rules were applied instead using an £80,000 contract;
Hiring company would pay the £80k contract plus an additional £9,849 via employers NICs
Contractors net payment would be £54,933
Total tax yield would be £34,915 - and this is the highest of all the possibilities.
Now that we can see the differences in the calculations, we can appreciate how IR35 regulations were considerable frowned upon by those caught inside it as the financial burden on them was so great. Off-payroll regulations have attempted to spread the burden between the hiring company and the contractor to better reflect the “as-if-payrolled” treatment to ease the pressure on the contractor - but also in a way that yields them the maximum tax payable.
The key question from here is then down to rates and budgets. If there was an £80k spend budget, does that now need to increase by circa 14% to cover the NICs or are contracts cut to manage the total costs? Meanwhile do contractors accept they’ll be taking home less pay or will their rates increase? Let’s also not forget that contractors are often paid more in reflection of the lack of employment benefits and employment rights - therefore if take home pay reduces, is it still enough to want to waive those rights or would ‘normal’ employment be an overall easier option?
So far we’ve covered what being caught inside these regulations could look like. How then we do we get, and stay, outside of the regulations and remain tax-efficient? In our next session we’ll be looking into types of contract.