With so many misconceptions about IR35 and so much misleading advice currently out there for freelancers, we have put together this guide to advise exactly what IR35 means for freelancers and what action they should take ahead of the planned roll-out.
What is IR35?
IR35 is the name given to tax legislation that aims to identify people who are avoiding paying the level of tax that they should be.
More specifically, the IR35 legislation targets those who supply their services to their clients via their own company – typically known as a ‘personal services company’. HMRC believe that many such freelancers and contractors should actually be categorised as ‘deemed employees’ or ‘disguised employees’ rather than ‘self-employed’, and therefore from a tax perspective they should be taxed in the same way as a permanent employee.
The name ‘IR35’ comes from the press release that HMRC issued announcing the tax reform, which is actually officially known as the Off-Payroll Working Rules and has been in effect in the public sector since April 2000.
The rules are now due to be implemented in the private sector in April 2020, which is expected to have a huge impact on the UK’s growing freelance workforce.
Why is IR35 being implemented in the private sector?
The government is applying the IR35 rule to the private sector in order to tackle the problem of ‘deemed employment’, which they see as a tax avoidance strategy used by certain freelancers and contractors.
This strategy involves the freelancer providing their services via a limited company, invoicing the client via that company and then avoiding tax by paying themselves a minimum salary below the basic personal allowance and then taking dividends from their limited company to top up their ‘salary’. This practice means that both the freelancer and the client are able to avoid the tax payments and NI contributions that would have to be made by permanent workers.
HMRC are implementing IR35 to ensure freelancers and the companies that hire them are paying the appropriate tax.
How freelancers can determine their IR35 status
The big question for freelancers now is whether they fall into the scope of IR35 or not. The important thing to remember, though, is that it is not the freelancers who will be judged on their IR35 status, rather the contract between them and the client will be judged.
The government have put together a quick tool you can use to find out if the relationship you have with a client may fall within the IR35 regulations or not. Before you use the tool, you are advised to think about and prepare information regarding:
- Details of the contract
- Your responsibilities
- Who decides what work needs doing
- Who decides when, where and how the work is done
- How you will be paid
- If the engagement includes any corporate benefits or reimbursement for expenses
Use the tool here: https://www.gov.uk/guidance/check-employment-status-for-tax
Although the tool is useful to get an indication about your IR35 status, it does not provide an official or final judgement. If you are concerned about whether you are inside or outside of IR35 then the best course of action is to seek professional advice from your accountant.
What does ‘outside IR35’ mean?
If your contract is deemed to be outside IR35, then HMRC consider you to be self-employed and you do not have to take any further action when it comes to paying yourself and paying tax.
Freelancers and contractors who work outside the scope of IR35 are responsible for making sure their personal and company taxes are calculated correctly and paid on time.
From April 2020, your end client will be responsible for evaluating and determining your status.
If you are subsequently judged to be outside IR35 then you are viewed to be a genuine business operating outside the IR35 rules – which means you can basically carry on as normal, pay yourself a salary, draw the remaining income as dividends and remain responsible for your own tax affairs.
What does ‘inside IR35’ mean?
If your contract is deemed to be inside the scope of IR35 then you are considered to be an employee in terms of your tax status. This means you are required to pay tax at the same rate as employees in the same tax bracket.
As tax and employment legislation is currently separate, you are not automatically entitled to any employment rights despite being deemed an employee for tax reasons.
If you are judged to be operating inside IR35 than you are required to pay the appropriate tax – which will typically involve a ‘deemed payment’ of income tax at the end of the tax year.
If you are found to be ‘inside IR35’ after an IR35 enquiry, HMRC will request you pay the income tax, National Insurance, interest and potentially a penalty which should have been paid during the accounting period in question. As this could potentially run into the tens of thousands, it is important to make sure you are prepared for IR35 as much as possible.
How to prepare for IR35
To prepare yourself for IR35, you need to be aware of the criteria HMRC will be using to classify freelancers as either ‘inside’ or ‘outside’ IR35.
Long-term contractors and freelancers who run a limited company will be required to make sure their client contracts accurately reflect the working practices and relationship they have with the client. These contracts will have to be checked for each project at renewal and they must feature clear evidence that supports your self-employed status.
If HMRC decide to query your IR35 status they will look at the detail of your contract as well as investigate the working practices you follow with your clients – so it is important to familiarise yourself with what they may be looking for.
From 6 April 2020, freelancers will be assessed by their clients who will determine whether the new Off Payroll Working Rules apply to them or not. Freelancers can use the HMRC’s ‘check employment status for tax’ (CEST) tool to try and get an idea on what their IR35 status could be, but the tool is not fool-proof and may not provide an accurate classification depending on your circumstances.
Determining whether the IR35 rules apply to your contract or not is a complicated matter. There are three main principles that need to be taken into account when determining your IR35 status:
- Supervision, Direction and Control: This relates to the degree of supervision your client has over what you do, how and when you do it etc. as well as the extent they direct and control the contracted work that you do.
- Substitution: Are you able to send someone in your place to do the work i.e. a ‘substitute’, or are you and only you required to do the work?
- Mutuality of obligation: Is there an obligation between you and your client e.g. are you obliged to accept work they offer and/or are they obliged in any way to offer you work?
These three principles remain the same regardless of whether you work in the private or public sector. You’ll need to demonstrate that they don’t apply to your contract and working practices to avoid being affected by IR35. If your contract with an end client is a contract for services, rather than a contract of employment, it’ll usually fall outside the scope of IR35. For example, if you can send another person (‘substitute’) to perform the services agreed in your contract, then there’s no obligation of personal service and IR35 shouldn’t apply.
Other factors that may be taken into account when determining if your contract falls within the scope of IR35 include:
- How you are paid: A freelance contractor will usually receive payment when work tasks are completed, or when project milestones are reached, whereas an actual employee tends to be paid at regular intervals e.g. at the end of every month. If your client requires a weekly or monthly invoice, then it should include a breakdown of all the work completed, the amount of hours worked and the hourly rate charged.
- Other work: If you are obliged by your client to only work for them and not have any other clients, then you are likely to be seen as an employee rather than a contractor.
- What equipment you use: Unless there’s a good reason for using equipment provided by the client (e.g. health and safety or security) then you should use your own equipment to carry out the work you are contracted to do.
- Corporate involvement: If you are involved in any way in your client’s corporate structure, then you may be affected by IR35. Even the smallest involved, like having your own security pass to enter the building, could impact your IR35 assessment.
What to expect from an IR35 enquiry
If HMRC choose to investigate you, it can help to know exactly what the process is.
There are four main steps to the HMRC IR35 enquiry process:
- The opening letter
- Your initial response
- HMRC meeting or correspondence
- The final decision
All IR35 enquiries begin with a letter from HMRC, which will state the time period the investigation will focus on e.g. the tax year(s) or accounting period. You should be aware that HMRC can go back as far as six years into a limited company’s accounting history, but usually the opening letter will initially focus on just one specific tax year.
The initial letter will typically request:
- A breakdown of the company’s income during the requested period
- Analysis of business expenses – usually travel expenses
- Copies of all contracts that were in place during the specified time period
- An explanation of the reasons why these contracts should be placed outside of IR35
- Contact details of end client(s)
The next step is for the freelancer to respond to the HMRC’s letter, which is your chance to provide them with all the correct information in such a way to satisfy them that you are in fact a freelancer and should be judged as one.
As this step is so important, we advise taking professional advice before replying to HMRC.
If your response to the opening letter fails to satisfy HMRC, they will move onto a further investigation – which usually involves them requesting a meeting between you and two HMRC compliance officers.
It is important to remember that HMRC cannot insist that you have a meeting, and therefore cannot compel you to accept one, so if you feel uncomfortable about a face-to-face meeting with them you can request that the enquiry continues by post correspondence only.
Whether you take the meeting or continue to deal with HMRC via correspondence, this stage usually involved a bit of ‘to-and-fro’ as HMRC request more evidence and more explanations regarding your work, your contracts and your relationships with your clients.
If HMRC are satisfied with all the evidence provided, they will conclude their enquiry. If not, they will move on to speaking directly to your client(s) to test the evidence supplied by yourself.
The final stage is when HMRC make their decision based on all the evidence they have gathered since your response to the initial letter. If they judge that you are ‘inside IR35’ then you have the right to appeal – although this should be seen as a last resort due to the potential costs involved. Before you consider an appeal, you can request an independent review and/or refer to HMRC’s Alternative Dispute Resolution (ADR) service.
How to avoid IR35
All freelancers and contractors who provide their services through intermediaries such as umbrella companies or their own limited companies are at risk of unwittingly falling inside the scope of IR35. Therefore, taking measures to try to avoid an IR35 investigation is essential. Below we’ve outlined some of the actions you can take to try and ensure that IR35 doesn’t apply to you and your contracts:
- Keep up to date with your tax returns
Submitting a late or incomplete tax return, or one with errors, will put you on HMRC’s radar and could arouse a tax inspectors’ suspicions that you may be making other mistakes.
Taking measures such as hiring an accountant to create and submit your tax returns should help to reduce the risk of you being targeted for an investigation.
- Try to avoid taking on jobs that replace a former employee
When starting a role with a new client, always do so with the understanding that your role is for a contractor.
If the contract you take on is to fill a role that was previously done by a full-time employee then it is likely that your client may expect you to work like an employee – which could increase your risk of being inside IR35.
- Have your contracts reviewed professionally
Although there is no such thing as an IR35-proof contract, it is still recommended that you have your contract reviewed by a professional.
An expert will help to identify any badly worded clauses in your contract that could arouse suspicion and trigger an IR35 enquiry.
- Try to make sure you are not named individually in the contract
Your relationship with clients should always be operated under a ‘contract for services’ arrangement through your limited company as a business-to-business service provider.
Therefore your contract should only refer to your limited company name as the entity that is providing the service, not your individual name. Reference to your own name could lead to HMRC interpreting your working relationship as an employment ‘contract of service’.
- Keep ongoing records of your contracts and the work you do
If you end up being the subject of an IR35 investigation, it is easier to explain your past and current working relationships if you can back it up with evidence.
Keeping a record of work-related documents, emails and even your old notepads can help add substance to your claims and could make all the difference if you find yourself face-to-face with a tax compliance officer.
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