The new IR35 rules and regulations came into effect for UK contractors in April 2021. These could have a big impact on contractors who supply their services to businesses through their own company/sole proprietorship and companies that employ workers or have contractors in the UK.
Over the last decade, it has become more and more popular for individuals to work as a contractor due to the flexibility that applies to this type of contract, but also due to the difference in taxation. Most contractors today operate through their own limited company or sole proprietorships to receive payment from clients and to pay less in taxes. The IR35 was implemented as a result of the UK government suspecting that a lot of contractors were exploiting the tax system by operating as contractors when they should have been classified as employees.
In this IR35 guide, we explore:
What is IR35?
The IR35 rules apply to contractors that work for one company all the time. An inspector from Her Majesty's Revenue and Customs (HMRC) will look at the relationship between the contractor and the business to understand what work is carried out and how. The written contract between the contractor and the business will be ignored by the inspector as they want to find out the real relationship. As a result, they will create a notional (hypothetical) contract that reflects the actual working relationship in place.
A HMRC inspector will use the notional contract when considering whether IR35 regulations apply. This means they’ll decide whether the contractor is providing services to a business (IR35 does not apply here) or is, in reality, an employee (IR35 applies).
Let’s start by explaining some of the main terms we’ll be using in this article:
Pay as you earn. This is HMRC’s system to collect Income Tax from independent contractors.
HMRC’s tool to check employment status for tax.
Also known as “Limited companies” or “PSC”. A legal entity/company set up to provide the services of one contractor. The contractor/freelancer is normally the company’s only shareholder and director.
An intermediary will usually be the worker’s own Personal Service Company, but could also be any of the following: a partnership, a personal service company or an individual. Based on HMRC's definition, one of the following three cases need to apply for something to be considered an intermediary: a worker has material interest in the intermediary, the worker has received a chain payment from the intermediary, or the worker has rights which entitled, or which in any circumstances would entitle, the worker to receive a chain payment from the intermediary.
You may therefore be affected by these rules if you are:
A worker who provides services through an intermediary
A company that receives services from a worker through an intermediary
An agency providing worker’s services through an intermediary
Who is affected by IR35 and when does it apply?
The IR35 rules apply to contractors/freelancers that use an intermediary to provide a service to one company under the same terms and conditions as an employee. For example, a developer that goes to work at the same place every day to the same duties with the same employer, might be considered a disguised employee under the IR35 rules. It also applies to companies that deal with contractors, either directly or through an intermediary.
With the new IR35 regulations, every medium and large business is now responsible for setting the tax status of its contractors. If a contractor is providing services to a small company in the private sector, then the contractor’s intermediary will be responsible for deciding the contractor's employment status and if IR35 rules apply. Anyone that meets the definition of “employee” without the existence of a PSC is termed a “deemed employee” and will be subject to employment taxes.
If HMRC decides the contractors’ tax status is wrong, then the company is responsible for any fees and penalties. It’s really important for UK contractors and businesses employing UK contractors to make sure their tax status is right. If a worker is deemed an employee instead of a contractor then they will have to pay employee taxes which equals additional 25% more tax.
What does IR35 mean for freelancers?
Basically, if IR35 applies to you, you may be termed a “deemed employee”. When you are termed a “deemed employee”, it means that you are being classified as an employee and not a contractor when it comes to what type of tax you need to pay. Based on the classification of IR35, this implies that you are falling inside the IR35.
Inside IR35: Contractors who are not correctly classified as contractors and that should be deemed employees instead. These contractors are required to pay tax at the same rate as an employee within the same tax bracket. Companies that work with a contractor that falls inside IR35 must pay taxes as if the contractor were one of their employees.
Outside IR35: Contractors who are correctly classified as contractors and that are not avoiding paying all relevant taxes. These contractors are considered self-employed and are free to pay themselves in whatever way they find to be most efficient for their tax liability, whether that be directly or through an intermediary. The IR35 does not apply.
In order to decide whether a contractor falls inside or outside the IR35, it is important to look at the relationship between the contractor and the business to understand what work is carried out and how. The written contract between the contractor and the business should almost be ignored and one should rather focus on assessing the actual working relationship which is carried out in practice.
An important thing to note is that being termed a “deemed employee” does not automatically give the contractor any type of employment rights, such as benefits and paid time off. The classification of IR35 is only related to taxation.
How to know if you are considered an employee or a contractor?
Below you will find three factors that will determine whether the IR35 rules apply or not. To make it easier for you to understand, we’ve also added some questions that you can ask yourself to test whether you should fall inside or outside IR35.
1) Control and direction
A contractor will be considered an employee if they have a line manager or supervisor that controls their working hours and workload. If a contractor is going to be considered falling outside the IR35 framework, the company will need to show that they have no influence over how the contractor works and performs.
Ask yourself: Does the company have control or supervision over what, how, when and where you perform your work according to the contract? If yes, it’s likely that you fall inside IR35.
2) Substitution/personal service
A contractor that works for one company only and provides the business with exclusive access to their services, is considered an employee. If a contractor is going to fall outside IR35, the person doing the work should be replaceable or changeable and the work done should not be down to one specific person only.
Ask yourself: Do you have to do the work yourself or can someone else do it? If the work needs to be done by you specifically, IR35 will apply.
3) Mutuality of obligation
A contractor that is obliged to undertake work being given from an employee on a constant basis, is considered an employee. If a contractor is going to fall outside IR35, the person should be allowed to reject projects or tasks that fall outside the scope of the original contract. The mutuality of obligation questions also comes up when the initial contract expires. A contract renewed over and over could be considered employment.
Ask yourself: If a client offers you work, do you have to do it? If the answer is yes, the IR35 will apply.
In addition to these, there are also a couple other areas to consider:
Provision of equipment: If you are being provided equipment to do the job, this could be considered an employee requirement.
Financial risk: If the financial risk is on the company, then the contractor could be considered an employee.
Payment: If a monthly fixed rate is set, this could add to the argument that a contractor should be deemed an employee.
Exclusivity: If a contractor has only one client and is not able to take on extra work, the contractor is most likely deemed an employee.
How to interpret the IR35 rules in practice?
To try and make it even easier for you to understand how these rules apply in practice, we’ve created four examples of situations below. It is important to note that these are only examples and we highly encourage everyone to research their own situation and to visit the UK government's own website for the complete legal framework and further information.
1. A contractor considering to take on a second project/role with a new client
Sanjit works as a part-time developer for a UK SaaS company and has been there for six months already. His manager tells him that he is not able to accept the second role due to his current contract.
Sanjit is now deemed an employee because he is unable to accept other work or projects and must be set up on PAYE.
2. A contractor with a PSC is recruited through an agency
Adele is a front-end developer working for a UK tech company for two years. Adele was originally hired through an agency and she operates through her own PSC. The payroll team in the company determines Adele’s contract to fall inside IR35 due to the fact that she provides her services to one company only and her working conditions are similar to that of an employee.
Adele is deemed an employee for tax purposes and the agency that pays her PSC will also be subject to employee taxation and National Insurance Contributions.
3. A contractor hired on a full-time contract
Vasilis is a lead developer that has spent the last nine months working full-time for a large tech company. He was hired on a 12-month contract through his own PSC. The tech company is his only client.
The payroll team uses HMRC’s CEST tool and determines that Vasilis should be deemed an employee due to the fact that he only works for one company and is not able to take on other projects due to the full-time nature of the contract. Vasilis is set up on PAYE for the final five months of the contract.
4. A contractor working for multiple clients
Susan has been commissioned to assist on a project. She works through her PSC and is paid at intervals throughout the project. She works for non-competing clients during the project.
Susan is categorized a contractor and falls outside IR35 due to the following:
She is paid for work completed not by the day
She works at a location of her choosing
She can work for multiple clients during the same time period
Working as a contractor in the UK after IR35
The IR35 regulations can’t be avoided by either firms or contractors with UK links and it is important that both individuals and businesses take action to ensure a clear distinction between employees and contractors. Although IR35 might cause some bumps in the road for some independent contractors, it is important to remember that the regulations were created to close a tax loophole and not to make it more difficult for contractors to do business in the UK. Talk to an IR35 specialist to ensure you stay compliant and continue to harvest the fruits of being an independent contractor.
If you are looking to become a contractor, check out this breakdown of 3 most common contract types to get you started on your research. If in doubt, contact a payroll company like Deel that can help you sort out your contract.