What is IR35?
IR35 - what even is it?
IR35 is a term that puts the fear of god into contractors who operate through their own limited company, often referred to as a working through a Personal Service Company (PSC). But where does this word come from and what does it actually mean? Its origin is traced back to a piece of tax legislation which is commonly known as the ‘Intermediaries Legislation’, with its aim to ensure that ‘disguised employees’ pay the same tax as if they were an employee - known as being caught or 'inside IR35'.If a company is business on its own right it is deemed to be ‘outside IR35' and not penalised.
Being caught inside IR35, when claiming to be outside IR35 (which is determination that HMRC make after formally opening and concluding an investigation into the tax affairs of the company) means that the business must pay over to HMRC the relevant back taxes, National Insurance Contribution (NIC) payments, interest and a potential penalty - a costly retrospective exercise in terms of not only money but also time and stress.
IR35 - What is its objective?
So what does IR35 attempt to achieve? Very simply, IR35 legislation allows HMRC to target and retrospectively tax, penalise and fine contractors who are disguised employees. Disguised employees are contractors, but those who are treated and act like employees at their end client(s), but whom claim the rights, including the more efficient tax breaks, that company owners are entitled to, .such as distributing company profits as dividends - which are not subject to NIC payments at the same rate as employees, claiming various expenses to lower profit, and through splitting ownership of the company with partners and/or family members, allowing them to each utilise their tax free allowance(s).
HMRC see disguised employees as contributors to the UK 'tax gap' - that being the lost revenue to the UK Treasury that should be collected in a perfect world. Many contractors provide their services via their own limited company, which is known as a Personal Service Company (PSC), whilst others choose to avoid IR35 entirely by operating via an umbrella company, who manage the payroll and deduct PAYE and NIC's etc - thereby paying the same tax as if they were an employee.
Operating on the wrong side of IR35 can lead to up to six years of back taxes, interest and penalties being applied by HMRC
The history behind IR35
On the 9th March 1999 IR35 was first announced as a term when the Inland Revenue 'IR', as HMRC were then known, bulletin number '35' was released, titled ‘IR35: Countering Avoidance in the Provision of Personal Services’. Following on from the bulletin 35 came the 'Intermediaries Legislation', which came in to force in the UK in April 2000 within the Finance Act.
But what actually caused the Intermediaries Legislation to be brought about? Well, as previously mentioned the issue stems from disguised employment. What tended to happen, in a crude example, is that employees would be working from a company as an employee up until the close of business on a Friday, leaving as usual that evening, then returning the following Monday and working for the employer as a contractor via their own PSC. The result was that the contractor saw their take home pay increase whilst the tax they paid reduced.
With contractors deemed to be posing as limited company’s, but doing nothing different to when they were employees, HMRC unsurprisingly cottoned on to the fact that they were seeing a reduction in the amount of tax being collected, which in turn lead to the commencement of a crackdown to tackle it.
IR35 was agreed to be useful and underpinned by sound principles, but within months there were serious flaws being raised by disgruntled contractors and their legal representation, some of whom were doing nothing wrong, when HMRC's investigations commenced. Hindsight is a wonderful gift, but the consensus was that IR35 had been introduced too quickly and without enough consultation with those affected. One of the more bizarre suggestions was that it was a panic solution brought about to tackle the then ever increasing number of contractors!
After a quiet period of 6-7 years containing little to no legislative change, the Managed Service Company (MSC) legislation was introduced in April 2007. The result was that contractors were only able to receive dividends if they operated and managed their own PSC rather than leaving that element to another entity, or a MSC. Any agency caught promoting the service of a MSC could be found liable for any underpaid tax and National Insurance Contributions (NIC's).
Further legislative change occurred in July 2010 when HM Treasury established the Office of Tax Simplification. A panel of officials and tax experts were assembled to review areas of tax complexity - which unsurprisingly contained IR35. Their task in regards to IR35 was to form an opinion as to if it should be revamped, suspended or discarded. The outcome as it turned out was that IR35 was not to be scrapped or suspended, but to be enhanced and modified - something that did not then take place until April 2017 when the 'Public Sector Off Payroll' legislation came into force, but more on that later...
Finally, in late 2010, a contractor deemed to be inside IR35 meant that they were also within the scope of the Agency Workers Regulations given the same tests applied to both.
IR35 gets is title from the name and number of the HMRC (then known as the Inland Revenue) bulletin the Intermediaries Legislation was announced in... IR35.
IR35 in the public sector
The public sector is effectively run by the government, so it comes as no surprise that it was the area HMRC sought to 'clean up' first given how much sway it holds. 2012 saw rules amended that so that contractors who provided services to the public sector, via their PSC, and where the contract was equal to or longer than six months and the day rate was equal to or greater than £200, had 20 days to from the commencement of the contract to evidence their IR35 status. Being unable to evidence their IR35 status would lead to the contract likely being terminated and details passed on to HMRC.
However, it was in 2016 when the big legislative change occurred, when in his Autumn Statement, the Chancellor confirmed that the public sector was to undergo a huge revamp in the April of the following year. With HMRC under the impression that there was £600m - £1.2bn in tax avoidance by contractors operating their PSC's, it introduced ‘off-payroll’ rules on April 6th 2017. This meant that the IR35 status of a contractor was no longer determined by themselves, but by the end client public sector organisation. Not only was the end client organisation to make the IR35 status decision (something they were not very well skilled in), but they were to be liable if deemed to have made the wrong decision - which unsurprisingly lead to a huge raft of risk adverse decisions being made, and many contractors being deemed inside IR35 when they had been working outside IR35 and they take home pay reduced by up to 25%! A further quirk was that where agency or other intermediary was in the chain and making payment to the PSC, at which point the tax liability passed to them!
HRMC attempted to assist organisations and contractors alike in determining IR35 status via an online tool they had created, known as Employment Status Service ‘ESS’, but it was derided as unfit for purpose and skewed by many of its users.
To compound the pain of a contractor now deemed inside IR35, whilst their tax status had changed to that of an employee, their employment status would not change - meaning they were unable to receive the rights and benefits that employees do, such as sick pay, maternity or paternity pay, holiday pay and unfair dismissal rights etc.
The future of IR35
Quite simply no one knows exactly that the future of IR35 holds or what it will look like. IR35 is such a controversial and emotional subject for many, meaning almost every review conducted and the subsequent recommendations are faced with a barrage of opposition. What is clear is that the UK tax system has not kept up to speed with the ever changing employment landscape - there are two ways of being taxed and three ways of being employed, leading to a complete mish-mash of taxation and employment rights into which contractors do not truly fit given the modern ways of working.
Current plans to roll out the April 2017 public sector legislation to the private sector is expected to be implemented in 2019, as having two sets of rules in what is an already complex environment just adds further fuel to the fire.
But between now and then a lot can change given the ongoing political turmoil in the UK, Brexit and a myriad of other issues to deal with. Where will IR35 be in 2020 - it takes a brave person to put a market down and confidently say what it will look like, they are either extremely gifted, going out on a limb or very very brave.
© 2017 Pete Willcocks