IR35 - How to Protect Yourself

Copyright (c) 2010 Richard Barlow

• IR35 is the UK tax legislation preventing self-employed individuals avoiding tax by setting up a personal service company to conceal employment. IR35 was introduced to ensure these individuals were taxed as if they were still employed. Although falling foul of IR35 is expensive, experience over the past decade has shown it is relatively easy for self employed individuals to stay IR35 compliant by taking a few simple precautions in the way they operate.

The IR35 intermediaries' legislation was introduced on the 6th of April 2000. HMRC state 'The aim of the legislation is to eliminate the avoidance of tax and National Insurance Contributions (NICs) through the use of intermediaries, such as personal service companies or partnerships, in circumstances where an individual worker would otherwise - For tax purposes, be regarded as an employee of the client; and For NICs purposes, be regarded as employed in employed earner's employment by the client' (HMRC 2010).

Personal service companies are usually limited companies set up by one individual who is the sole share holder, director and employee. The HMRC designation personal service company does not have a strict definition in law. The personal service company is sub-contracted by another company (contractor) to provide some type of service. The service is obviously performed by the individual who set up the personal service company given that they are the only employee. The problem HMRC have with this structure is that depending on the facts it appears that the person performing the service on behalf of the personal service company is actually acting as if they were an employee of the contracting firm. The tax advantage arises from the fact that the contractor pays the personal service company leaving its sole shareholder/director to choose a tax friendly amount to take out the business as salary or dividends. This is advantageous because the personal service companies profits will be taxed at the corporation tax rate rather than as employment income which depending on the sums involved usually attract national insurance and a higher rate of tax to boot.

Being caught within IR35 allows HMRC to look through the legal form at the economic substance of this arrangement which is that of employment of the individual by the contractor. HMRC will then levy tax and national insurance at a rate commensurate with that of an employee on the 'deemed salary' i.e. any amounts that have been taken out of the personal service company by the individual over the past 5 years. HMRC will only allow a flat rate deduction of 5% of turnover to cover all administrative expenses. A substantial tax liability is likely to be the final result.

The criteria which HMRC apply in making a decision about employment status are of primary importance in deciding if a business possibly does't comply with IR35. Regrettably HMRC have kept the criteria they use under wraps and simply state that each judgement is based on the accumulation of detail pertaining to each case. Manoeuvring to stay outside IR35 is a tricky business, however, 10 years in operation has allowed case law to reveal how specific situations are likely to be interpreted. For this reason getting appropriate legal advice is definitely advisable when entering in to any new contract.

A range of steps can be taken to reduce the risk of being captured by IR35, the primary areas of concern are as follows. The most important line of defence is making sure the wording of the contract document itself is IR35 compliant. Both the contractor and the sub-contractor must then act according to the terms of contract otherwise HMRC will contend the written contract is superseded by a notional contract which better reflects reality and thus brings the subcontractor inside IR35.

HMRC scrutinise the elements of any relationship between the sub-contractor and contractor in making a decision. Areas they focus on include; Control - is the sub-contractor independently working towards a goal stated in the contract or can the contractor tell the sub-contractor exactly what to do and when to do it? Control indicates employment. Mutuality of obligation - is the contractor obliged to provide work and is the sub-contractor obliged to then do it? Mutuality of Obligation indicates employment. Right of substitution - can the sub-contractor sub-contract his work to a third party or is he obliged to provide personal service? The right of substitution indicates self-employment. Financial risk - will the sub-contractor suffer financially if he under performs? Exposure to financial risk indicates self-employment. Equipment - is the sub-contractors work equipment provided by the contractor? Having to provide your own equipment indicates self-employment.

The temporal nature of the relationship is also an important consideration. If the sub-contractor has been working solidly for one contractor for a long period (usually years) and his contract has been repeatedly rolled over this is likely to indicate employment.

Is the sub-contractor treated as a permanent part of the company? For example, does he use the staff canteen? Does he have his own parking space? Does he have a company email address? Does he appraise company staff? Does he have decision making powers within the company? Does he have a company business card? Does he sign in and out? Does he wear the company uniform? Etc. The more integrated in to an organisation he is the more likely he will be found inside IR35. HMRC really do go in to this level of depth when investigating breaches of IR35 and once found guilty the burden is then on the taxpayer to prove his innocence usually at significant cost.

Recently in 2007 new legislation came in to force to crack down on Managed Service Companies (MSC) which had been one way of using composite company structures to circumvent IR35. These companies were set up and run by a service provider specialising in administering MSC's. For a fee a number of separate sub-contractors could subscribe to the service, be appointed shareholders of the MSC and could take an optimal amount of salary and dividends to avoid paying employee taxes and national insurance. The law now states that all contractors working for MSC's should be taxed as employees and any unpaid taxes can be collected from the third party administering the MSC.

HMRC allow the operation of PAYE umbrella companies which are similar to MSC's but the sub-contractors are only employees rather than shareholders. The service these companies provide only ensures that each sub-contractors PAYE and national insurance is calculated accurately and paid on time for them.

Currently the most effective option for contractors wanting to stay outside IR35 is the use of specialist accountancy services which ensure the company is set up correctly, contracts are IR35 compliant and ongoing company administration is taken care of properly. Although such a service comes at a cost the tax savings can still be very significant and in addition the service providers usually have IR35 insurance which would cover the cost of back tax in the event that HMRC decided a contractor was in breach of IR35.

From an economic perspective one can argue that IR35 has regrettable implications as it undermines the incentives, responsiveness and flexibility contracting brings to the UK economy for the sake of a relatively small short term increase in tax revenues. The contracting tradition of the past century perhaps suggests that in the long run HMRC might have been better off accepting a smaller slice of a larger pie.

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