IR35 and UK Tax Reform

May 17, 2018

tax form

IR35. If you've never seen this code, it probably looks as meaningless as it does harmless. But don't be misled. If you're an MEP professional and you're used to subcontracting for a large company to make your living, it could have a big impact on you.

IR35 is a tax reform that targets people who work on a contracting basis. Toughened IR35 rules were introduced into the public sector in April last year, and it seems pretty certain that they'll be rolled out to the private sector by as early as April next year. That looks likely to happen even though they appear to have caused chaos and hardship to many in the public sector, forcing thousands of contractors to pay much higher levels of tax and slashing their incomes by as much as 25%.

We think it's wise to be forewarned so that you can be forearmed, should this happen. Here's our quick guide to IR35 and what it means.

What IR35 is and why it was introduced

IR35 is a tax reform that was originally introduced by the former Chancellor Gordon Brown, way back in 1999 in response to Treasury concerns that a new form of tax avoidance was on the rise. In 1999, Her Majesty's Revenue and Customs (HMRC) went by its old name of the Inland Revenue. That's where the"IR" bit of the name comes from. The number 35 simply refers to the press release HMRC used to announce its introduction.

IR35 - or "intermediaries legislation" as it's more properly called - came into effect in 2000 as part of that year's Finance Act. It was subsequently integrated into the Income Tax (Earnings and Pensions) Act 2003 and the Social Security Contributions (Intermediaries) Legislation 2000. It targeted "disguised employment".

HMRC inspectors had come across growing numbers of cases where organisations were engaging workers not as straightforward salaried staff with a contract of employment, but as "self-employed" freelancers, many of whom worked through a personal service company (i.e. a one-man-band firm they'd set up as an employment intermediary). In itself, that's neither illegal nor immoral. But HMRC was concerned that in many cases, this method of engagement was effectively being misused as a way to disguise employment.

The example the Revenue frequently cited was the 'Friday to Monday' phenomenon: an employee leaves their employer at close of business on a Friday only to step straight back into the same role in the same workplace on Monday morning - but this time engaged as a contractor trading through a personal service company. In that capacity, they paid much less tax on their income.

This not only deprived the Exchequer of tax yield, it undermined workers' rights as well by allowing unscrupulous employers to pressurise people into working as contractors so that they, the employers, could dodge paying national insurance contributions and avoid responsibility for statutory employment benefits like paid sick leave, paid holiday leave, paid parental leave, maternity allowance and employer's pension contributions.

That was what IR35 sought to stamp out. But in practice, it fell well short of that laudable aim.

The problems with IR35

The point at issue is that many skilled people, like MEP professionals, IT experts, management consultants, teachers, nurses and so on, freely choose to work on a flexible contracting basis, partly because they can command better pay rates for their talents that way, and partly because they were seeking an improved work-life balance. Nothing wrong with that, you might think. But IR35 opened a door to HMRC, enabling them to seek to convert a legitimate one-person small business into a disguised employee.

The rules are underpinned by IR35 case law (i.e. decisions that have been made by judges in the past over actual individual disputes and which now act as precedents for further disputes). This makes them exceedingly complex because the tests of employment that are now used have actually evolved over literally decades of case law.

What this boils down to is that an HMRC inspector can effectively ignore the wording of the contract in force between a contractor and their client and focus instead on the actual nature of the working relationship which case law says forms a "notional contract". If an inspector, or subsequently a judge, determines that the notional contract is in fact one of employment (i.e. business to individual employee), then IR35 applies. The rules don't apply if the notional contact is a purely business-to-business arrangement.

We'll say a little more about the principal tests of employment in IR35 after the next section.

New, rebooted IR35 tax reform

From April 2017, new IR35 tax reforms came into effect in the public sector. The biggest change was that responsibility for determining a contractor's IR35 status, which previously had rested with the individual freelancer, was shifted to the end client or the recruitment agency which had supplied the worker. This has resulted in a huge amount of confusion, not least because HMRC recommends that those who engage use the Revenue's own online assessment tool: Check Employment Status for Tax (CEST).

The tool has been heavily criticised by IR35 experts for oversimplifying the assessment process and for omitting mutuality of obligation entirely from its considerations. Many public sector bodies, desperate to be compliant with the new rules and to avoid subsequently being faced with hefty penalties and backdated tax and NICs billed, made blanket decisions, contrary to guidance, and placed all their contractors inside IR35. Many of these workers suffered huge cuts in income as a result, and the likelihood is that many will legally challenge these indiscriminate determinations.

Despite these concerns, the government is consulting on extending the new rules to the private sector, and most experts believe this will in fact happen, perhaps by April next year.

The three principal tests of employment

It would be most advisable to check your working arrangements now to see if you think any of the following apply to you:

  • Control

If the client has a high level of control over what, how and where the worker undertakes work, IR35 is likely to apply as this is characteristic of an employment relationship. Where control is low or non-existent, IR35 won't be indicated.

  • Substitution

If the engager requires work to be personally undertaken by the worker, this indicates employment and IR35 is likely to apply. Where the worker is free to send a substitute, IR35 is unlikely to apply.

  • Mutuality of obligation (MOO)

If an employer is obliged to offer work and the worker accept it, IR35 will likely apply as this is characteristic of employment. If an employer is free to stop offering working and a worker is free to decline it, IR35 is unlikely to apply.

What if IR35 applies to your working arrangement?

The fact is that the case law aspect of IR35 is incredibly complex and expert knowledge of employment law is essential to making correct interpretations of the tests. Neither the independent contractors who find themselves under investigation nor the HMRC tax inspectors doing the investigating can possibly be expected to have this level of expertise.

Our advice, if you suspect these conditions apply to you, is to begin with a free, independent IR35 assessment tool which is based on case law (Contractor Calculator has one available here - it only takes about 15 minutes to complete).

If you find that you're probably inside IR35, it may be that you and the organisation you're subcontracting with should consult a tax and IR35 expert, such as Qdos Contractor. By doing so, you might be able to reshape your contract so that fall outside of IR35.

It's better to prepare now than be hit hard when the new rules come to the private sector.

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