IR35 was brought in to prevent the payment of less tax and national insurance by using a personal service company or partnership to provide services through rather than being a direct employee.
For example, by using a personal service company it has been possible to extract income from the company in the form of dividends rather than salary so saving substantial amounts of national insurance. In addition, shares of the company may be split with the spouse of the worker to help avoid higher rate tax and there is far more that can deducted in the way of tax deductible expenses by operating through a company rather than as an employee.
The regulations are applied where a worker supplies services through a relevant intermediary (which can be a company, partnership or individual), to a client and had the worker contracted directly with the client, the income would have been treated as employment income for tax purposes. The status tests outlined below are used to help determine whether the worker would have been treated as an employee or self-employed if they had contracted directly.
Large amounts of tax and NIC are at stake. Every case needs to be judged on its merits and several factors need to be considered in coming to a conclusion on whether a contract is caught or not.
HMRC can provide an opinion on whether the contract is caught by IR35 or not, but do not provide opinions on draft contracts. Unsurprisingly perhaps, the view of HMRC often tends to come down on the side that the contract is caught by IR35 but very often their view has been shown to be wrong and should not be accepted without further investigation. Whether HMRC should also be asked for their opinion also needs consideration.
We can help advise you on how to stay on the right side of the law.
A company is a relevant intermediary for the IR35 rules if…
- the worker (together with his close family and business partners) controls more than 5% of the company; OR
- the worker receives payments or benefits which are not salary but which could reasonably be taken to be payment for services provided to the client
For partnerships the IR35 rules are only applied when any of the following apply…
- a partner (together with his close family) has more than 60% of the profits;
- most of the partnership profits come from the work of a single client;
- where a partners share of the profits is based on their income from the relevant contracts.
Any salary paid during the year has PAYE operated on it in the normal way during the year.
However, where there is income that is caught by IR35, then to the extent that it exceeds any salary to which PAYE is already applied plus taxable benefits, the excess will be treated as a deemed salary and is treated as pay on 5th April, and is liable to PAYE and Class1 NIC’s accordingly. This makes the extra tax and NIC payable on 19th April following the tax year concerned, which is a very short timescale so contractors need to be organised. Interest runs on underpayments from this date.
In arriving at the excess salary, certain expenses can be deducted from the income derived from IR35 contracts as follows…
- a flat rate allowance of 5% of the net of VAT income;
- expenses that would have been allowable as an employee – this includes travel from home to the client’s premises as long as the job is expected to and does not last more than 24 months;
- employer pension contributions;
- employer national insurance contributions;
- some capital allowances.
The excess amount is treated as being inclusive of employer’s Class 1 NIC, so these are deducted to arrive at the deemed salary on which tax and NIC is calculated.
The deemed payment and employers NIC payment thereon are then deductible expenses for the intermediary company, treated as if paid on 5th April.
If actual salaries are paid later of amounts that were included in the deemed salary calculation, they cannot be paid free of tax and NI as they only reduce the salary payment of the actual year in which they are paid. To avoid potential double taxation it is better to use dividends.
If caught by IR35, the method of extracting funds from the company once the deemed payment calculation has been applied needs to be considered. For example…
- A salary could be paid during the year to avoid a large tax and NIC payment on 19th April but it does mean you pay the tax earlier.
- It is possible to borrow from the company and then repay the borrowing out of a salary nearer the 5th April. There can be tax and NIC on the notional interest on the loan and it is possible a payment to HMRC of 25% of the loan will be required if the loan is not repaid in full within nine month of the company’s year end.
- Paying interim dividends in the tax year following the deemed payment and then claiming for the dividend not to be treated as a dividend for tax purposes relieved to avoid any double taxation – this is often the best way forward.
In determining whether the contract is caught by IR35 it is necessary to consider the existing tests developed over the years to determine whether an individual is employed or self-employed. These tests can be summarised in one question: Is the individual in business on his own account when offering services to the client? If the answer is not a definite ‘yes’ the following factors need to be considered…
Requirement to provide a personal service
- Must you complete the work personally?
- Can you send substitute to do the work?
Control and supervision of the worker by the client
- Can you work at times to suit you?
- Does the client control how you do the work?
Mutuality of obligation between the parties for the duration of the contract
- Do you have the option to turn down work offered and does the client have the option not to offer work?
- Is each side obliged to other work and accept work?
Financial risk of the worker
- Do you correct defective work in your own time, at your own cost?
- Are invoices raised by reference to the job rather than hours worked?
- Is public liability insurance in place?
- Is work carried out for more than just one or a very small number of clients?
Provision of equipment and materials by the worker
- Do you use your own equipment?
- Are materials supplied by you?
- Do you work from your own premises?
- Does your company have its own business stationery?
Trappings of employment
- Is holiday and sick pay paid to you by the client?
- Are any employment type benefits provided to you by the client?
- How long have you been working for the client?
- Is there a notice period to end the arrangement?
Intention of the parties
- What was the intention of the parties in forming the contract?
The first three factors are the most important. If one of these does not exist the contract does not have the attributes of an employment contract so must be another type of contract, such as a self-employment relationship. However to determine whether the worker is self-employed the other factors also need to be considered.
HRMC Business Status Tests
HMRC think they can generalise about what makes some companies fall within IR35 and other escape it. In May 2012 they have drawn-up a set of business entity tests, complete with a scoring system, to help you to judge whether your business would be at high, medium, or low risk of being investigated for falling under IR35. See HMRC guidance.
These business entity tests are not derived from the tax law. They merely represent the Taxman’s view of the risk of a business falling within IR35.
The scoring attached to the tests is controversial, as it penalises businesses that have no bad debts, never pay to advertise and operate from the owner’s home. These IR35 business entity tests do not change the IR35 law one bit, and will probably be ignored by the Tax Tribunal.
If you choose to use the IR35 business entity tests, you don’t have to declare your score to the Taxman, the tests are merely for your own guidance. However, if you are concerned that the business entity tests produce a high risk score for your businesses, we should discuss why this is the case. Are they any changes which can be made to the way your business operates which would make it less likely to be caught by IR35?
We can advise you on the correct tests for IR35, which would be recognised by the Tax Tribunal, so do ask if you would like some reassurance.
The Dragonfly Consulting tax case established that the Tax Inspector can question the relationship between the end client and the worker, and if he decides that it is really one of employee and employer, in spite of all the various contracts, agency and service company in place, the extra tax due will fall on the worker’s own company.
The case demonstrated how the contract between the agency and the final client can knock for six any clever contract drawn up between the worker’s company and the agency. HMRC have proved that the entire stream of contracts needs to be considered and compared to what actually happens on the ground.
For example, the agency may agree to include a substitution clause in the contract with the worker’s company, but if this clause is not reflected in the contract with the final client it is ineffective. Even if a substitution clause does exist in the agency/client contract it will be ignored if the client tells HMRC or the tax tribunal that it would never actually accept a substitute for the worker.
To ensure your working arrangement with your client will stand up to challenge by HMRC you need to see all the contracts in the chain, and be sure your client would agree to accepting a substitute if asked to.
It should be noted that in a recent case with judgement issued on 5 Jan 2011 (MBF Design Services Ltd) where a hypothetical contract was sought to be created to examine the relationship between the end client and the worker, the three key status tests of personal service, control and mutuality of obligations led to the decision in favour of the taxpayer. It was particularly noted that the ability to cancel the contract without notice and the fact that contractors were sent home without pay whilst employees had to remain on site meant there was a lack of mutuality of obligations.
Managed Service Companies
A Managed Service Company differs to a Personal Service Company in that there is normally a scheme provider that operates the company on behalf of the worker. Often these are known as “composite companies” with perhaps 10 to 20 workers being put through the same company or “managed personal service companies” with one for each worker but managed by the scheme provider on behalf of the worker.
From 2007/08 the Government has taken action to tackle Managed Service Company (MSC) schemes which are used to disguise arrangements that should be treated as employment arrangements for tax purposes and are used to avoid paying the employed levels of tax and national insurance.
Income that is received by workers through MSCs is now subject to employment levels of tax and NI. It is the responsibility of the MSC to operate PAYE and deduct the necessary tax and NI on the income.
In addition the rules for tax relief on travel expenses are the same as for other employed workers.
Whilst in many cases these companies should be caught by the IR35 legislation, they did not follow the legislation and when caught they simply liquidate as they have no assets, and start up another company the next day. To stop MSCs avoiding payment of these taxes, recovery of underpaid taxes and NICs will be possible from appropriate third parties, principally those behind the company operating such schemes including directors, shadow directors and connected or controlling parties.
These individuals will also be easier to catch as there will be no need to consider the specific relationship between each individual worker and the end client which was proving too labour intensive for HMRC.
The IR35 intermediaries legislation remains in place for personal service companies where the worker operates the company himself. The MSC rules are not targeted at these companies.
It has been reported in Accountancy Age that IR35 tax raised just £9.2 million between 2002/03 and 2007/08 financial years, a fraction of what was originally anticipated by the Government. The Professional Contractors Group obtained the figures from HMRC under the Freedom of Information Act.
How we can help you
We can assist you with…
- Contentious status disputes with the Revenue
- Advice on your contract and an opinion on whether is fails or passes IR35
- Assistance in improving your contract for the purposes of defeating IR35
- All aspects of the accountancy and tax affairs of your business.