Business regulations exist to ensure fairness across the board, and IR35 is one such regulation. It concerns itself with “off-payroll working” rules, ensuring individuals supplying services via intermediary companies pay the same tax (income tax and national insurance contributions) as those with a standard employment status.
But what are these rules, and how do you ensure you abide by them? In this article, RealBusiness will outline the methods by which you can do this, as well as how to determine employment status, status determination statements and more.
How do I ensure I am IR35 compliant?
IR35 rules were introduced in the year 2000, originating from Inland Revenue press release number 35 in the 1999 budget. It was made to close the various tax avoidance loopholes that exist with employees who are off the payroll.
Step 1 – Find out who’s responsible for making the determination
Who determines the employment status of the contractor depends on the end client’s business sector and size:
- Public sector clients – This means public sector organisations, such as central government departments, NHS bodies, etc. Regardless, the public sector itself must run status tests on each contractor to decide if they’re effectively an employee for tax purposes.
- Medium and large companies in the private sector – Private sector companies exceeding two of the following thresholds in their last financial year: £10.2 million turnover, £5.1 million balance sheet total and/or 50 employees. Since April 2021, organisations of these sizes must determine IR35 status and document their reasoning in a status determination statement, and pass it to the contractor and any downstream fee-payer.
- Small private sector clients – Organisations that do not fall within two of the three categories (£10.2 million turnover, £5.1 million balance sheet total and/or 50 employees) are considered small businesses, and are exempt from the off-payroll working rules. HMRC takes on the responsibility of the administrative burden of retaining alignment of tax treatment for disguised employees.
Step 2 – Determine employment status
The engaging business, meaning the end client, must issue a written status determination statement (SDS) to the fee-payer (the “employer”) to set out the grounds for whether the engagement is inside or outside IR35. If the employee falls outside IR35, then the contractor’s intermediary is entirely responsible, and your obligations as per IR35 rules end there.
Testing whether the employee in question is within IR35 is a matter of weighing probabilities across the following five principles:
- Control – Control refers to the extent to which the engaging business directs the mode of work, such as:
- How – Is the business done through the provision of mandatory equipment, or do they use their own tools/software?
- When – Is the contractor bound by fixed hours, or do they choose their own?
- Where – Does the contractor choose where to work, or are they free to dictate their own location?
- Substitution – Does the contractor have the unfettered right to send a suitably qualified substituteto perform the services in question? If this is the case, there’s a strong argument for considering the contractor self-employed.
- Mutuality of Obligation (MoO) – Is there an ongoing obligation to offer and accept further work from you? If so, this creates a continuous relationship that is reminiscent of employment.
- Financial risks and rewards – This means the allocation of commercial risk or opportunity for profit. A contractor who has liability for poor performance, such as recouping the cost of poor work, is indicative of self-employment.
- Other factors – There is a multitude of other factors that go into the fifth principle, including:
- Integration – How closely do they work as part of the engager’s organisation?
- Right of termination – Notice periods and ability for either party to terminate the contract without penalty.
- Provision of benefits – Access (or lack thereof) to holiday, sick pay or pension schemes.
- Contractual vs actual practice – Courts and HMRC focus on working practices over contractual wording—substitution clauses never used in practice, or extensive managerial oversight contrary to contract terms, will be disregarded.
Step 3 – Understand what inside or outside of IR35 rules means
IR35 rules change depending on this determination:
- Inside IR35 – To be inside IR35 means you are the deemed employer. All fees, then, are processed through PAYE, which will deduct income tax and employee NICs. Deemed employers must also pay employer NICs (13.8%), as well as an apprenticeship levy if applicable. Bear in mind that contractors have no entitlement to employee benefits such as holiday or sick pay.
- Outside IR35 – To be outside IR35 means that the contractor is “self-employed on own account”, meaning the contractor’s intermediary company invoices net fees, retaining discretion over profit extraction. Profits withdrawn as dividends incur corporation tax and personal tax, which may give a tax-efficient structure and wider access to the business tax regime.
Step 4 – Make deductions
The contractor’s intermediary must be paid as if they were a salaried employee if they fall within IR35. Practical steps are:
- Maintain and cascade the status determination statement (SDS) – Produce a written SDS that states clearly whether the engagement is inside IR35, and why. You can explain why by using HMRC’s guidelines and maintaining a clear audit trail for transparency. Send this SDS to the fee-payer.
- Operate PAYE on all deemed payments – Deduct income tax and employee national insurance contributions on every payment to the contractor’s personal service company (or umbrella company). Ensure that you remit employer national insurance contributions and apprenticeship levies where applicable.
- Restrict expense claims to “employee-style” allowable – Contractors may only claim expenses allowable for a PAYE employee, such as travel and subsistence, exclusively (and necessarily) incurred in the course of duties. It’s best to outline this clearly in your company’s expense policy, and tell the contractor to submit expenses through he same portal and documentation as staff.
- Maintain comprehensive records for HMRC audits – Keep all relevant documents to reinforce your decisions. These include SDS documents, contracts, records of working practices, CEST/advisor reports, payroll runs and RTI submissions for at least six years. Keep them stored in a centralised compliance repository indexed by contractor and contract period. HMRC reserve the right to investigate status decisions dating back to April 2017 for public sectors, and April 2021 for private sector businesses.
- Embed IR35 into contracting and procurement processes – Train your hiring managers on IR35 principles, and incorporate IR35-friendly clauses (substitution, control, mutuality) into all contractor agreements. Automate status-assessment triggers in the talent-management system.
- Manage disputes and appeals – Provide contractors up to 45 days to dispute an SDS. In cases where disputes occur, document the appeals process, record outcomes, and re-issue an SDS if the status changes.
- Review and update continuously – Regularly assess your existing contracts, particularly where scope or working practices have changed. You can do this by scheduling annual or trigger-based IR35 reviews.
Why is it important to comply with IR35?
Not complying with the IR35 legislation could leave you with expensive costs when defending yourself against an enquiry from HMRC, which quickly add up if you don’t have an insurance policy. Also, you will have the possible burden of paying the cost of any unpaid taxes if you are caught by the legislation, which could be substantial. Anyone can be investigated by HMRC if you are found to be inside IR35, but have paid tax as an outside IR35 contractor, you will need to pay back the tax, interest, and any penalties as a result of this.
For more information about the IR35 legislation, have a read of our ‘What is IR35?‘ guide, which will give you all the details you need.
