IR35, ‘Off-Payroll’, and How to Compliantly Hire Contractors in the UK
What is IR35?
Introduced in April 2000, IR35 was created by the UK government in an attempt to close a tax loophole by redefining the relationship between contractors and companies.
Traditionally, in the UK, independent contractors (sometimes referred to as ‘freelancers’) have established themselves either as sole traders or limited companies. When operating as a limited company, and offering their specialised services to a client through a third party, these contractors pay less taxes on their earnings than employees do.
The UK government believed that some people were deliberately falsifying this type of contractor-client relationship in order specifically to exploit the accompanying tax benefits, when in fact they should have been classified as employees and been paying appropriate employee taxes.
Thus, IR35 refers to the tax legislations with which His Majesty’s Revenue & Customs (HMRC) judge a relationship between employer/client and contractor. If HMRC deems the relationship to fall “inside IR35” then the contractor is found to be a “deemed employee” or “disguised employee”, and must be treated as such (including the application of penalties and back taxes, where necessary). If HMRC deems the relationship to fall “outside IR35”, then the contractor is found to be operating legally as an independent entity, and does not have to pay the same taxes as an employee.
What is Off-Payroll?
The original IR35 legislation was, at best, complex. In the years between IR35’s inception in 2000 and the introduction of the ‘Off-Payroll Reforms’ in 2017, HMRC struggled to enforce IR35. Moreover, since IR35 relied heavily on historic employment and case law, it was equally difficult for clients and contractors to comply with the legislation.
Thus, in 2017, the UK Government introduced an ‘Off-Payroll’ tax reform, which aimed to clarify the original IR35 legislation and correct some of its original issues. These reforms were initially implemented in the public sector, but have since been introduced to the private sector as well.
There are two significant changes to IR35, as introduced by ‘Off-Payroll’, which merit further discussion:
- The shifting of responsibility for diligent classification from contractor to end-client
- The sharing of tax contributions for those contractors classified as “inside IR35”
Under the original IR35 legislation, it was the duty of contractors to assess their own IR35 status; the responsibility is now that of the end-client or company. Similarly, it used to be the case that contractors deemed “disguised employees” inside IR35 carried the full burden of paying both employer’s and employee’s National Insurance Contributions (NICs) – meaning that their original income was reduced by up to 25%. Under the ‘Off-Payroll Reforms’, the end-client or company must now contribute to the contractor’s NICs just as they would for their full-time employees.
Who do the IR35 and ‘Off-Payroll’ tax legislations affect?
IR35 (which we shall use to refer to all IR35 legislation from now on, including ‘Off-Payroll’ tax) affects any and all companies seeking to engage the services of a limited company contractor in the United Kingdom (which is to say, Northern Ireland, Scotland, Wales and England). IR35 also affects contractors operating as limited companies, and any third parties – such as recruitment and talent agencies – acting as intermediaries between client and contractor.
As a foreign company seeking to engage the services of independent contractors in the UK, you must familiarise yourself with the minutiae of IR35 legislation. Nonetheless, its complexity should not put you off working with said contractors – the legislation is designed to close a tax loophole and protect workers’ rights, not to make it more difficult for international entities to operate in the UK. If necessary, you can always work with a trusted Employer of Record (EoR) or global business expansion consultancy firm like Mauve Group to streamline the entire compliant contractor-hiring process.
The only businesses exempt from IR35 legislation are those defined as “small businesses” by the Companies Act 2006. This includes any business which has at least two of the following:
- Less than £10.1 million in annual turnover
- Less than £5.1 million in gross assets
- Less than 50 employees
The exception to the exemption are small businesses who engage contractors through an agency or personal services companies (PSCs), which remain liable for tax payments.
How to check the IR35 status of a contractor whilst demonstrating reasonable care
In essence, IR35 is the HMRC’s tax equivalent to distinguishing between independent contractors and employees for employment law purposes. The classification parameters for independent contractors and employees differ around the world, from country to country and state to state.
To determine correct classification of contractors in the UK, there are clear “tests of employment” which you can use, as collected in the government’s online CEST (Check Employment Status for Tax) tool.
In addition to correctly classifying your contractors, it is equally key that you do so whilst demonstrating “reasonable care”. Should you ever be challenged by HMRC, being able to demonstrate this may be the difference between facing legal action and/or hefty fines, and not being penalised at all.
A contractor “inside IR35” is an individual operating as a limited company contractor, when in fact they should be classified as an employee. In other words, a worker “inside IR35” is a “deemed employee” of yours, and should be treated as such for tax purposes.
Determining factors for classifying individuals as being “inside IR35” include:
- Control: The client has control over what, how, when and where a worker works.
- Substitution: The personal service of the worker is required, and no substitute could be sent in their place.
- Mutuality of obligation (MOO): The client is obliged to offer the worker work, and the worker is obligated to take it.
Other factors which traditionally separate independent contractors from employees include:
- Dependency: An employee is legally, financially, and technically dependent on their employer.
- Exclusivity: An employee typically works exclusively for their employer.
- Longevity: An employee has an indefinite contractual relationship with their employer.
If a so-called “contractor” is found to in fact be a “deemed employee” inside IR35, then both the worker and their client are required to pay tax contributions (NICs and income taxes) as if that worker were an employee. Responsibility for tax payments may instead fall to the intermediary third party (such as the recruitment agency), unless the end-client is found to not have taken “reasonable care”.
Contractors “outside IR35” are those who are legally operating as limited companies, and who therefore need not concern themselves with adhering to IR35 legislation. These workers are responsible for their own self-assessment tax returns, and thus for their own tax and NICs. The clients who engage their services need not treat them as employees for tax purposes.
Compared to “deemed employees” inside IR35, factors determining the “outside IR35” status of independent contractors are as follows:
- Control: The contractor has control over what, how, when and where they work.
- Substitution: The personal service of the contractor is not required, and they could instead send a substitute in their place.
- Mutuality of obligation (MOO): The contractor is not obligated to accept work offered by a client.
- Dependency: A contractor is not legally, financially, nor technically dependent on any one company or client.
- Exclusivity: A contractor typically works for several clients at once.
- Longevity: A contractor’s engagement with clients is typically short-term, sporadic, or on a project-by-project basis.
Reasonable Care and the SDS
As discussed, it is imperative that companies looking to engage independent contractors in the UK must show “reasonable care” when evaluating the IR35 status of each prospective worker.
To do so, a Status Determination Statement (SDS) must be filled-out and signed by all parties (intermediary, client, and contractor) at the beginning of each engagement. The SDS should contain all pertinent information regarding the classification of the contractor as being either inside or outside IR35, and should demonstrate the care taken to evaluate this at the same time.
Due diligence can be demonstrated in the SDS by including information including:
- Whether or not the contractor has other clients
- Whether or not the contractor carries the burden of financial risk
- What the contractor’s working practices, location, and hours are, and how these factors compare to those held by full-time employees at the client company
The UK government has stated that it will not enforce IR35 penalties for those who accidentally misclassify, provided they can demonstrate they took reasonable care when completing the SDS, and that the “deemed employee” signed-off on the SDS without asking for amendments to be made (which they have the right to do, for up to 45 days after the original SDS is issued to them).
Differences between labour laws and compliance with IR35
It is important to briefly note that classification as a “deemed employee” inside IR35 is not – as the law currently stands – the same thing as being classified as an “employee” in UK law. Thus, whilst “deemed employees” and their clients must pay the same tax contributions as they would for/as a full-time employee, these individuals are not entitled to the same rights as employees (such as sick pay and holiday pay).
- IR35 refers to a series of tax legislations issued by the UK’s tax authority, HMRC, which seek to correctly differentiate between legitimate limited company contractors and those individuals whose relationship to their client is essentially that of an employee, and should be treated as such for tax purposes.
- Being “inside IR35” means you, or the contractor whose services you employ, can be classified as a “deemed [or disguised] employee” and must pay the same taxes as an employee in your wage bracket.
- Being “outside IR35” means you, or the contractor whose services you employ, are acting lawfully in a client-contractor relationship, and need not withhold/pay the taxes of an equivalent employee.
- Failure to adhere to IR35 legislations may result in fines, penalties, legal fees, back taxes and a damaged reputation.
- IR35 affects any medium-to-large companies, intermediaries (i.e. agencies), and limited company contractors seeking to do business together in the UK (including those international entities looking to expand into the UK by hiring an independent contractor’s services).
- The most cost-effective and compliance-assured means of adhering to IR35 tax legislation in the UK is to employ the services of expert global business consultants like Mauve Group, whose experience can help you minimise risk across your entire enterprise.
The information provided has been checked for accuracy as of the date of publication, and is intended as a general guide and for information purposes. It is subject to unanticipated and unexpected changes and does not constitute legal advice.