What Does ‘Inside IR35’ Mean?
Before COVID-19 turned us upside down, the government’s proposed changes to the IR35 regulations were set to start in April 2020. Now they have been postponed to April 2021, so there’s some extra breathing space to get your head around what it means for you and your clients.
Understanding IR35 rules is quite an undertaking for workers, agencies and businesses alike. The prospect of having work contracts redefined as ‘inside IR35’ brings the stress-inducing possibility of a higher tax bill for businesses and individual taxpayers.
You could be in any of these three positions—and so might your clients. So let’s walk through it together and see what it means from each different perspective.
Here’s What We’ll Cover:
What Is IR35?
IR35 is a group of tax laws within the Finance Act. The Inland Revenue (now the amalgamated Her Majesty’s Revenue and Customs, HMRC) announced it in 2000 in a press release called IR35. The name has stuck, even though 2017 saw the introduction of replacement legislation, off-payroll working.
‘IR’ stands for intermediaries legislation because it deals with three-party employment situations involving a client, worker and third-party limited company or agency. HMRC’s aim is to tackle the possible tax avoidance that can be facilitated by employment intermediaries.
The laws exist to make sure that everyone who works for a company pays their National Insurance contributions (NICs) and income tax, whether they are directly employed by the business, or paid through an employment intermediary. In other words, employees being paid through pay as you earn (PAYE), and workers that are ‘off payroll’ and paid through a third party should all be paying similar tax liabilities.
Through this legislation, HMRC wants to identify contracts that have people working through an intermediary, but would be ‘deemed employees’ if the middle company didn’t exist. In effect, the only reason for the third-party agency is to avoid income tax and NICs.
Genuine independent businesses operating on a contract basis are not the targets.
Who Is Impacted by IR35 Changes?
Time for some more definitions. There are three parties involved in this type of business relationship and IR35 changes will impact everyone:
- Employment intermediary: HMRC’s term referring to any possible third party, like a personal service company (PSC), limited company, employment agency, or partnership. During this explanation, we’ll use a combination of PSCs, agencies and employment intermediaries.
- Client: This is the end client that uses the services provided.
- Worker: The people delivering those services, called workers, contractors or freelancers.
There we have it—worker, employment intermediary and client. Are you directly affected? Do any of your clients fit into one of these categories? Each party with a responsibility to the others and to HMRC.
Why Does HMRC Need the IR35 Rule?
HMRC needs the IR35 regulation because it is losing revenue in the current system through tax avoidance.
If a contractor sets up a PSC, they can then sell their services to the end client and be paid through the PSC, instead of directly. This means that the client doesn’t need to pay employers’ NICs and the worker doesn’t have to pay income tax or employee NICs. So both parties legally save, but HMRC loses out massively.
This doesn’t mean that people aren’t paying any tax. You may be legitimately set up as a self-employed freelancer, submitting your annual self-assessment tax return, and paying on profits and NICs bills on time. But if your contract lands you inside IR35 regulations, you will have to pay income tax as an employee, and a different rate of NICs. The huge worry for those of you who are self-employed is that this means a 25% increase in your bill.
Who Decides If I’m Outside or Inside IR35?
Originally, employment intermediaries were responsible for deciding if a worker’s contract was inside or outside IR35.
In 2017, the rules were amended and clients in the public sector were given responsibility for deciding contract status for the purposes of IR35. Private sector companies could still rely on third-party agencies for this decision.
But now this is about to change.
What Changes Are Being Made to IR35 and Why?
The big change to IR35 is that medium and large companies in the private sector will now assume responsibility for deciding who is in or out of IR35.
HMRC estimates that if this change isn’t implemented, it will lose £1.3bn every year by 2023-24. That’s several million reasons for the change.
Who Is Most Affected by This Change?
Undoubtedly, the medium and larger companies in the private sector that have a new legal responsibility to administer. HMRC defines them as being companies who fit at least two of these criteria:
- More than 50 employees
- Over £5.1m total on their balance sheet
- Annual turnover of £10.2m
If your business falls into this category, you will have to make a decision on each contract agreed with an agency worker: Are they inside or outside IR35? You will need to use the set ‘tests’ to determine your workers’ employment status and keep new records called status determination statements. Your FreshBooks integrated payroll will save you some time here. You’ll also need a process in place to deal with disagreements after you inform your workers.
HMRC has already said that it won’t be sufficient just to avoid any accusations of tax avoidance by saying everyone is in IR35. There must be evidence that you’ve done this on a contract-by-contract basis. There are a lot of preparations to be made.
Employment intermediaries will continue to make this decision for clients that are considered small businesses.
What Are the IR35 ‘Tests’?
There are three crucial tests that are applied to determine the employment status of each contract. Let’s consider them from the perspective of a worker.
1. Do I Control How, When and Where I Work?
Yes, my task is given by the client, but I decide where I work and the timetable I follow to meet the deadline. This answer means that you are outside IR35. The alternative, where you are directed when are where you work, is inside IR35 because it is the same as an employee.
2. Mutuality of Obligations
What? This means that the client’s company is ‘obliged’ to find you more work after the current contract is completed. And you are obliged to take it. If this mutuality of obligation is in your contract, it will be considered inside IR35.
3. Substitution Clause
To make sure that you are outside IR35, you need a substitution clause in your contract. This means that you don’t have to complete all the work yourself, you can appoint a substitute. Definitely not something you can do as an employee, no matter how many of us wish we could!
As a client faced with new responsibilities, these are the questions you need to interrogate each contract with.
Has COVID-19 Affected the IR35 Changes?
The impact of COVID-19 has led to a delay of the IR35 changes. They were due to come into effect in April 2020. But within the government’s £330bn COVID-19 package, announced on 17th March in the House of Commons, this was delayed until April 2021.
Steve Barclay, Chief Secretary to the Treasury, said: “The government is postponing the reforms to the off-payroll working rules, IR35, from 6 April 2020 to 6 April 2021 … in response to the ongoing spread of COVID-19 to help businesses and individuals.”
In one way, this gives everyone more time to prepare—but while we endure the multiple impacts of a global pandemic.
Is It Better to Be Inside or Outside IR35?
It’s not really a question of better or worse. It’s just a case of what is.
- What is your actual employment situation under your current contract?
- Should these contractors really be hired by your company?
- Are you seeing the bonuses of being self-employed, or are you basically an employee without any of the rights and benefits?
The key factor is that you are operating in accordance with the law. If you are, there’s no need to worry. If you’re not sure because all the complexities are rather confusing, take some time to figure it out.
If you’re outside IR35, you’re working as a proper business. You get paid your agree fee as usual, pay yourself a salary, take dividends, and sort out your own tax affairs with HMRC.
If you’re inside IR35, it means that you are considered an employee of the end client, not your intermediary. After being informed by the client, your agency will have to deduct income tax and NICs from your wages before you receive them. This doesn’t mean that you have any employee protections.
We’re sure you agree that the best thing to be is legally compliant.
What Expenses Can You Claim Inside IR35?
If you are inside IR35 and carry on using your limited company to administer payment, you can apply HMRC’s IR35 5% expenses rule. This only applies to contracts with private company clients, not those in the public sector.
All intermediaries getting income through IR35 contracts make a Schedule E calculation at the end of each year. This is the total of the income made through IR35 contracts. You are then entitled to apply HMRC’s expense allowance of 5% of this figure. This is designed to cover the following administration costs:
- Interest on bank accounts and overdrafts
- Postage, printing, stationery
- Tax and accountancy advice
- Premises, including working from a home office
- Admin support
- Hire purchase payments
- Public liability and employer’s insurance
- Costs of finding contracts
You just add it in as a flat rate claim for these expenses. There is no requirement to provide proof of expenditure.
And FreshBooks has all your other work expenses organised, as usual.
Do You Pay Corporation Tax Inside IR35?
If you are only working on contracts that are inside IR35, then your corporation tax bill should be zero. This is because your income from IR35 contracts is considered a business expense, and your income is being taxed before you see it.
HMRC IR35 rules say: “When you calculate corporation tax liability, deduct the amount of the deemed employment payment and Class 1 employer’s National Insurance contributions due on it. This deduction is only allowed when you calculate the taxable profits for the accounting period in which the deemed employment payment is treated as paid.”
The situation becomes more confusing if you have some contracts inside IR35 and some outside. In this case, you will pay 19% corporation tax on your profits from work done outside IR35.