Inside or outside IR35? How to compliantly hire contractors in the UK
Learn to navigate a complex piece of UK tax law: IR35. Knowing whether your contract falls inside or outside IR35 will help ensure you only pay the tax you’re due.
Introduced in April 2000, IR35 was created by the UK government in an attempt to close a tax loophole, one through which they felt independent contractors were avoiding tax — disguising employee contracts as freelance contracts through an intermediary limited company.
When operating as a limited company and offering their specialised services to a client through this third party, contractors were paying less tax on their earnings than employees, despite their contract with the client resembling an employer-employee relationship.
IR35 refers to the tax legislations with which HMRC judge the relationship between an employer or client and the 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. They may instead continue to benefit from the tax environment established for freelancers. As such, it is well worth knowing for yourself whether you stand inside or outside IR35.
What is ‘Off-Payroll’?
The original IR35 legislation was 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.
Under the ‘Off-Payroll Reforms,’ the end-client or company must now take full responsibility for the classification of a contractor contract as either inside or outside IR35. Similarly, the company must also contribute to the contractor’s NICs, just as they would for 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. 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, though 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
Note: 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.
Comparing inside IR35 and outside IR35: status and definition
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.
In contrast, 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.
Comparing the core metrics used by HMRC to assess IR35 status
A good place to start when assessing the IR35 status of a contractor whose services you employ is always the contract which you and they signed before commencing the work. However, it is critically important to understand that contract definitions alone are not enough to distinguish between inside and outside IR35 status in the eyes of HMRC.
Instead, HMRC uses a few different metrics by which to assess the classification of contracts and contractors. Key tests of employment, which may classify individuals as being either inside or outside IR35, include:
- Supervision, Direction, and Control
- Supervision: The extent to which the client oversees the work being conducted, i.e.: supervises the work, including the extent to which the contractor performs their work to a set standard.
- Direction: The extent to which the client directs the ways in which the work is to be done, including the provision of instructions, guidance, and advice.
- Control: The extent to which the client is able to control the workload, performance, working materials and working practices of the contractor, including their ability to move the contractor between jobs.
- Substitution: The degree to which the personal service of the contractor is required, and whether or not a substitute could be sent to complete the work in their place.
- Mutuality of obligation (MOO): An assessment of obligations between parties. There are three main obligations which you must consider:
- The obligation of the client to offer the contractor work.
- The obligation of the contractor to accept work offered by the client.
- The obligation of the contractor to give the client a notice period before ending the contract, of a similar length to that of an employee contract.
Let us now take a closer look at how these tests of employment would look in an inside IR35 situation, as well as in an outside IR35 situation.
Supervision, Direction and Control
If any of these phrases are used in a contract between client and independent contractor, there is strong reason to believe that the relationship should be defined as “inside IR35.” The main difference between inside and outside IR35 with regards to supervision, direction and control is that a client operating inside IR35 would be able to exercise these elements, whilst operating outside would not.
The client is able to supervise your work and set a clear standard for the contractor to work to.
The client is able to offer clear direction in terms of how the work should be performed, where, when, and with what.
The client has full control over the contractor’s workload, performance, and schedule.
The contractor supervises their own work and works to their own standards.
The contractor directs their own work, choosing at their own indiscretion how, where, when and with what to perform the work.
The contractor has full control over their own workload, performance, and schedule.
The test of ‘substitution’ asks whether the contract between client and freelancer depends on the presence of a specific freelancer, or whether they are able to send a substitute in their place.
This is in essence a difference in definition between a contract of service and a contract for services. The former suggests a relationship in which the contractor must appear to conduct the work contracted themselves: a relationship which would most likely be deemed inside IR35 by HMRC. The latter, on the other hand, suggests that the contractor can send a substitute to complete the work, and does not have to be there in person: a relationship likely to be considered outside IR35.
The contractor must show up and complete the work by themselves. No substitute worker will be accepted by the client.
The contractor may send any substitute they wish to in their place, provided the substitute completes the contracted work.
Mutuality of obligation (MOO)
Similarly, relationships inside IR35 tend to exist on the basis of mutual obligations: primarily the obligation to offer and accept work. In contrast, truly outside IR35 relationships would establish no such obligations.
Obligation to offer work
Obligation to accept work
Obligation to give employee-length notice period
The client is obliged to offer the contractor a certain type and amount of work.
The contractor is obliged to accept any work offered them by the client.
The contractor is obliged to give a notice period to the client similar in length to that in an employee contract.
The client can offer any type and amount of work to any number of different contractors.
The contractor can choose whether or not to accept any work offered them by the client.
The contractor is not obliged to give a notice period to the client at all, or at least not of a similar length to that in an employee contract.
Comparing additional tests sometimes used by HMRC to further assess IR35 status
In addition to the core metrics discussed above for separating inside and outside IR35 relationships, you and HMRC can further test IR35 status by exploring the following factors.
- A contractor inside IR35 is legally, financially, and technically dependent on their employer.
- A contractor outside IR35 is legally, financially, and technically independent, and so not dependant on their employer for wages or materials, etc.
- A contractor inside IR35 typically works exclusively for their employer.
- A contractor outside IR35 typically works with several different clients at once.
- A contractor inside IR35 has an indefinite contractual relationship with their employer.
- A contractor outside IR35 will typically work on a project-by-project basis, or otherwise provide services on a short-term freelance contract.
Penalties applied to those caught operating inside IR35
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, however, instead fall to the intermediary third party (such as the recruitment agency), unless the end-client is found to not have taken “reasonable care”. Tax contributions may also be collected retroactively by HMRC to cover the duration of the relationship between contractor and client.
Reasonable Care and the SDS
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 that you took reasonable care to classify contractors may be the difference between facing legal action and hefty fines or not being penalised at all.
To exert reasonable care, 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 necessarily entitled to the same rights as employees (such as sick pay and holiday pay). Nevertheless, the potential penalties involved in being deemed inside IR35 – including back payments of missed NICs – can resemble those applied to cases of employee misclassification.
- 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.
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