What is IR35: A guide to off-payroll legislation in the UK

What is IR35? IR35 is a piece of tax legislation first introduced by HMRC in 2000, which determines whether contract workers (also known as freelancers) are operating as such or should instead be classified as “deemed employees” by the companies they work for and, therefore, taxed as such. IR35 has important legal and tax implications both for contractors and the companies hiring their services, and failure to comply with IR35 can result in hefty fines and penalties imposed on companies which incorrectly classify their employees and contractors.

In April 2021, a new series of IR35 legislative reforms came into force in the UK, governing the misclassification of contractors as employees to prevent tax avoidance within private companies. Prior to April 2021, IR35 had applied solely to the public sector.

The rulings caused a huge deal of debate at the time of their introduction, with some calling them the death knell of independent working practices, and others praising the strong action against nefarious employers taking advantage of their workers and legislative loopholes.

Since 2021, however, the negative effects of IR35 on contractors have been well-documented, including one report which showed over a third (35%) of contractors in the UK left self-employment following the 2021 changes to IR35.

What is the purpose of IR35?

The term IR35 describes tax legislation from HMRC which aims to prevent the misclassification of employees as contractors, for the purpose of tax avoidance by both the worker and the firm hiring them.

IR35 applies to workers who supply their services to companies via an intermediary (such as a limited company or personal service company [PSC]). This arrangement traditionally enabled contractors to pay lower tax and NI rates, whilst the companies hiring them could also benefit, as they avoided paying the employer costs and benefits applicable to employees. IR35 was introduced to try and stop contractors and hirers from exploiting this relationship for tax avoidance, in situations where the contractor should in fact be treated as a taxable employee.

In other words, IR35 deems whether contract workers are in fact disguised employees with the same taxation obligations as a standard employee. Workers who fall ‘inside IR35’ are defined as employees by HMRC and must pay tax accordingly – potentially leading to a 25% reduction in the worker’s net pay. Those who fall ‘outside IR35,’ however, are considered to be legitimate contractors and can continue to operate under the same arrangement as before.

IR35 became law as long ago as 2000 when the Intermediaries Legislation first came into force as part of the Finances Act. In the intervening years, HMRC struggled to enforce the legislation due to its complexity and uncertainty around employment status rules. So, in 2017 the IR35 revisions were announced in the hope of greater clarity and more cases being successfully brought against those abusing the system. The initial set of reforms applied solely to the public sector, but in 2021 a further set of IR35 revisions expanded the reach of the legislation to cover companies and contractors operating in the private sector, too.

What changed in April 2021?

Both the older and newer IR35 legislation hinge around the classification of “deemed employees” – that is, whether the worker is truly a contractor or whether they are in fact a “disguised employee”. This remains the central concern of IR35.

The IR35 legislation introduced in April 2021 brought into force alternative tax treatments, which mean that private companies are now responsible for assessing their contractors’ employment status. Should an employer deem a contractor ‘inside IR35’, then they should pay employment tax and NI contributions to HMRC, over and above the fees paid to the worker.

Prior to April 2021, IR35 applied only to public companies, and prior to IR35, the duty of employment classification fell to the contractor in question, rather than the hirer. Today, IR35 applies to both private and public companies (with the exception of ‘small’ private companies – to be further discussed later in the article), both of which must take full responsibility for the correct IR35 classification of contractors they engage with.

Explaining the nuanced terminology of IR35

Let us take a moment to define some of the terminology utilised by IR35 legislation, so that you are better equipped to comply with IR35 in your business practices.

Off-payroll working rules, IR35, and Intermediaries Legislation

IR35 is the more common name for tax legislation introduced by HMRC, though it is also sometimes referred to as ‘off-payroll working rules’ as well as by its predecessor’s name: ‘The Intermediaries Legislation’.

Inside and outside IR35

Being ‘inside’ IR35 means that a contractor’s relationship with a client is deemed an employer-employee relationship for tax purposes. In other words, the relationship is regulated by, or ‘inside’, IR35.

Being ‘outside’ IR35 means that a contractor’s relationship with a client is deemed to be independent, and so is not regulated by, or is ‘outside’, IR35.

Employer terminology

Employers must keep up to date with all IR35 legislation, but they are not always referred to as ‘employers’ in IR35 terminology or discourse. Instead, you may also read of employers being referred to as ‘clients’, ‘end clients’, ‘hirers’, or ‘companies’.

Contractor terminology

Likewise, contractors may be referred to by different terms under IR35, including ‘self-employed workers’, ‘independent contractors’, and ‘freelancers’.

Deemed employee vs disguised employee

A ‘deemed employee’ is a contractor who is deemed to be an employee of a hirer for tax purposes according to IR35 legislation.

A ‘disguised employee’ is a contractor who should be deemed an employee for tax purposes according to IR35, but is presently operating in ‘disguise’ as an independent contractor.

What criteria distinguishes a deemed employee from a contractor?

There are a number of different factors which are used to determine whether a worker is a legitimate contractor or should be deemed an employee for tax purposes. These factors include:

• The amount of supervision, direction, and control that takes place from employer to contractor.
• The way in which the remote worker or contractor is paid.
• Whether the contractor is provided with equipment, to perform their contracted services or provides their own.
• Whether the contractor is engaged in contracts with more than one client.
• The level of financial risk and control the contractor bears.
• Whether contractors report to the employer or not, and whether the employer can dictate the manner in which the contractor’s work is conducted.
• How ingrained contractors are within the organisation engaging their services.

Ostensibly, the more control an employer can exert over a contractor, and the more dependent that contractor is on the employer for their livelihood, the more likely it is that the contractor will be reassessed as a ‘deemed employee’ inside IR35.

The best way to determine a worker’s status is to use the government’s employment status tool and seek out the advice of payroll specialists.

How does IR35 affect contractors?

Genuine contractors should not be impacted by IR35, and those who operate independently of an intermediary company or recruiter need not be concerned with the legislation. It is crucially important, however, that contractors who do operate via an intermediary - i.e. ‘off-payroll’ - are completely clear about the factors determining worker classification.

The most obvious impact of IR35 is on those contractors who are reassessed as deemed employees – this could mean that tax and NI obligations will need to be paid on their income. Deemed employees are also due certain employee benefits such as sick and holiday pay, and so a sudden change to full employment may be a shock for workers accustomed to the flexibility and reduced tax obligation attached to being a contractor.

The newest iteration of IR35 does, to some extent, move responsibility of classification away from the contractor and onto the engaging firm – however, contractors should remain abreast of their own situation and status, so that changes do not come as a surprise. Any change to employment status will, of course, affect the contractor’s limited company or any contractual relationship with a third-party “umbrella” payroll company.

How does IR35 affect companies and employers?

The largest impact of IR35 on the private sector has been IR35 worker status assessment becoming the full responsibility of the employer.

All but ‘small’ companies in the UK fall under IR35 legislation and are, therefore, advised to engage the right support to help them to correctly assess their workforce, both now and in future. They should have in place the correct internal procedures, to ensure the right contracts and payroll arrangements are made while managing the expectations of their workers.

Note: A ‘small’ company is defined by HMRC as having not more than 50 employees, not more than £10.2 million in annual turnover, and not more than £5.1 million as their balance sheet total.

Companies should be wary of simply actioning a blanket shift of all contractors into IR35 – the legislation is intricate. Each case requires thorough consideration, and this type of action can result in contractors paying employee-level tax without the employment rights they are due in return.

Case studies: How IR35 has been affecting companies

Since the changes to IR35 introduced in 2017 and 2021, numerous companies in both the public and private sectors have had to pay large sums of money to HMRC to compensate for backdated tax contributions missed as a result of incorrectly classifying employees as contractors.

Take, for example, these bills issued by HMRC to public bodies like the Home Office:

• £29.5m bill to the Home Office for incorrectly classifying deemed employees as ‘outside IR35.’
• £87.9m bill to the Department for Work and Pensions (DWP) for historic errors in classification and liability for missing tax and NIC, plus interest, for the years 2017-2021.
• £12.5m bill to the Ministry of Justice for similar.

If found to have incorrectly assessed contractors as being ‘outside IR35’, when in fact they should be deemed employees, HMRC can use IR35 to penalize public and private enterprises to the tune of backdated tax and NI contributions, as well as often hefty fines. This is one of many reasons it is imperative that companies stay on top of IR35.

How does IR35 affect intermediary recruiters?

As of April 2021, tax liabilities have been moved from the worker to whomever pays the fees – in some cases, this means recruitment agencies. This has caused some controversy because while the end client or engaging party (AKA the employer) is still responsible for assessing IR35 status, recruiters or fee-paying organisations could still be liable for extremely large tax bills if end clients make slapdash IR35 decisions.

HMRC has stated that if there is evidence of negligent behaviour on the part of end clients, they too may be liable to be penalised. It is, therefore, imperative that workers, any third-parties, recruiters, and end clients all work together, and keep constant open lines of communication to ensure correct decision-making when dealing with IR35 assessment.

What is the future of IR35?

For a time in 2022 it looked as though former Prime Minister Liz Truss’ government would repeal, or at least seek to reassess, the changes made to IR35 legislation in 2017 and 2021. The complexities of the legislative language, combined with the negative effects of IR35 on the UK’s contractor workforce, seemed to necessitate a repeal.

However, a rollback of IR35 legislation never came, and in October 2022 Chancellor of the Exchequer Jeremy Hunt declared that the 2017 and 2021 reforms were here to stay.

For now, and the foreseeable future, both contractors, recruitment agencies, and end client employers should ensure they fully understand IR35 and know how to compliantly assess employee status – either for themselves or of those contractors they engage. This applies also to ‘small’ companies, which HMRC may seek to remove IR35 exemption status from.

How to safely comply with IR35 as a contractor, hirer, or intermediary

IR35 legislation seeks to prevent non-compliance and associated underhand practices with regard to employment tax, and despite its complexities or perceived flaws must be carefully complied with.

Any organisation engaging UK contractors should make themselves abundantly understanding of the newest IR35 rulings and ensure their classifications and internal processes are compliant to the letter of the law.

Contractors operating via a third-party intermediary or through their own personal service company should do the same. The nature of their relationship(s) with clients can directly impact their take-home pay, as well as their right to employee protections and benefits, depending on whether it is deemed ‘inside’ or ‘outside’ IR35.

The right support is vital – for advice on what IR35 could mean for your or your workers’ specific circumstances, get in touch with a Mauve Payroll expert today via the Contact Form.