IR35 - Details You Should Know

Subjects covered: Introduction
IR35's purpose
Who does IR35 affect?
How IR35 works
The market reaction
The problems with IR35
IR35 and Atlantic
Finding the IR35 Rules
Introduction It seems that with the proposed MSC legislation looming, there has been has been a resurged interest by contractors in forming their own Limited Company.

Please be aware though that whilst the proposed legislation will almost certainly spell the end of Composites Companies, IR35 will certainly still be in place to regulate the employment status and therefore the tax efficiency of those that choose PSC’s.

Come April 2007, Composite Companies and other MSC's will be wiped out, leaving contractors with the option of using:
  • PAYE Umbrella Companies,
  • Agencies, or
  • Personal Service Companies (PSC's)
Unfortunately the PSC option is further jaded by the Intermediaries legislation known as IR35.
IR35's purpose The legislation is designed to increase the Tax and NIC Earnings from contractors who operate their own PSC.

In the old days, many freelancers' had discovered that it was more tax efficient to distribute the majority of income as dividends, rather than by salary.

Put another way, up until April 2000 many contractors used the 'wrapper' of incorporation as a way to gain the various beneficial Tax and National Insurance arrangements that were legitimately open to those working through their own Limited Company.

In a nutshell the IR35 rules sought to re-dress this "dividend remuneration discovery" by making the decision whether to work through a service company or as a direct employee broadly neutral in terms of the Tax and NIC's which is payable.
Who does IR35 affect? Much of the publicity surrounding IR35 has concentrated on its affect on the IT industry where a lot of contractual work is carried out.

The reality is that it covers all business sectors and has a bearing on any business arrangement where:
  • an individual (known as a worker) provides services to another person (client)
  • under arrangements involving an intermediary (such as a company or a partnership)
  • in circumstances such that if the contract had been made directly then the worker would have been an employee of the client
The range of professions where people work through service companies is wide. Examples include:
  • Medical staff
  • Chief executives of large PLC's
  • Legal and accountancy staff
  • Construction industry workers
  • Clerical workers
  • Press officers
  • To list but a few
It is important to understand that IR35 applies to anyone operating through an intermediary regardless of:
  • what their line of work is
  • what intermediary is being used: a Limited Company or a Partnership
How IR35 works The legislation aims to identify if the relationship between the worker and the client would have been one of employment had it not been for the existence of an intermediary.

Where the intermediary company provides its employee on terms, which would normally constitute employment with the client, this is called a 'Relevant engagement' and the IR35 rules apply.

It follows that the subject of 'employment status' requires consideration, which is not without complexity since there is no definition of employment to rely on in tax law. This requires the question to be considered in light of case law, which for this area involves non-tax cases. This detail of this is not considered here.

It is important to remember that this test of employment applies to the Worker and the End Client, not the Agency or the Intermediary.

Secondly, IR35 does not re-classify the worker as an employee of the client in the eyes of the law but merely dictates the tax treatment to be applied to the worker.

HMRC's approach to Employment Status has been to produce a manual, which provides guidance to contractors on the subject together with a list of factors indicating whether or not a worker will be deemed to be employed or not. Click here for IR35 status.

Where the worker is found to be a 'deemed employee', an IR35 salary calculator is used to establish what is to be taxed under PAYE and NI.

Except for a small list of deductions (5% for company running costs), the Intermediary will effectively be required to tax all the earnings of its employee (the contractor) as salary.

Remember that mileage and subsistence claims will not be allowed as expenses as the contractor will now be in deemed employment with the client.

It is in this way that HMRC removes the taxation advantage available through using an intermediary.
The market reaction The market reaction was the classic mix of outrage and disbelief and given that HMRC was closing what it saw as a loophole, the reaction from the market was nothing if not expected.

Over the years various representative bodies have gone to great lengths highlighting the conceptual errors and practical problems that IR35 brings with it. Example are given in the next section

As always the market responded, with the usual Contractor Management Companies concocting various models to deal with the 'menace' that is IR35.

Some of business models around:
The problems with IR35 A few of the practical and conceptual problems that IR35 creates are:
  • The law on employment status used to apply IR35 is not up to date with today's working practices.
  • Freelancers subject to IR35 suffer the worst of both worlds. They are classified as employees for tax purposes but have no employment rights
  • There is a feeling of discrimination against the smaller business because of the need to distinguish small intermediary companies from large ones so as to limit the application of IR35 to the intermediaries who are disguising employees.
  • Because of the expenses cap on the IR35 salary calculator, there is an argument that little margin for re-investment is left for the smaller intermediaries as a result of all monies being subjected to PAYE tax.
  • With the deemed salary system there is no distinction between earned and un-earned income as regards taxation unlike with dividends.
There is no doubt that whilst the legislation is not without its conceptual anomalies, it must however be appreciated that the government need the extra Tax Revenue that IR35 and the MSC legislation will be generating it.
IR35 and Atlantic Atlantic Umbrella has been compliant with IR35 since its inception and has never employed business models that circumvent or ignore it.

We are a PAYE umbrella company and as such we tax earnings at source. This has given our contractors that comfort in knowing that they operate 100% legally.

With the MSC legislation, we believe that our model is still 100% compliant and we will continue business as usual.
Finding the IR35 rules The detailed legislation for Income tax can be found in Section 60 of Schedule 12 of the Finance Act 2000.

The detailed legislation for NIC is contained in SI 2000 No 727, which was approved on 13th March 2000 and commenced on 6 April 2000.

In order to be able to introduce these anti-avoidance measures for both tax and NIC purposes, it was necessary to include at the same time, an enabling clause for the NIC's aspects of the measure in the Welfare Reform and Pensions Bill in 1999. This is because NIC's legislation cannot be included in Finance Bills.