The IR35 legislation came into force in April 2000 and despite an overall lack of success, HMRC still pursue many cases each year under IR35 and as a contractor operating through your own company you ignore it at your own peril.

What is IR35

IR35 was introduced because the Government believed that some contractors were providing their services through a limited company or a partnership as a means of avoiding tax and national insurance contributions. The IR35 legislation effectively seeks to determine what the relationship would be if you were engaged directly by the end client; in short it asks the question - are you an employee “disguised” behind your limited company?”.

In order to understand how it works, we must consider the commonplace business relationships.

This relationship will be documented by two contracts: the one that the agency signs with the end client to find the resources which will allow the end client to complete the project; and the contract that the agency signs with the contractor’s limited company.  More will be said about these elsewhere later, but the first thing to notice is that there is no contract between you, the contractor, and the end client.

What, however, IR35 seeks to do, is create a hypothetical contract between you, the contractor, and the end client to establish what the relationship would be if you were engaged directly by the end client.

Would it be a Contract of Service i.e. employment (the master/servant relationship)
OR
Would it be deemed a Contract for Services i.e. self employment

IR35 - Determining Status

When HMRC look at an engagement to test its status, they will be looking for two things: contract wording which shows the engagement to be between two independent parties and working practices that demonstrate this independence. It is true that where neither the terms of the engagement, nor the working practices give a clear indicator of status, HMRC will look to other factors such as the financial risk being taken by the contractor and how their business is run (e.g. expenditure associated with running a business), but the overwhelming majority of cases are determined by the working practices and the contract terms.

There is some belief that it is sufficient to have a well written contract for a contract to be considered as “outside of” (”not caught by”) IR35, but the reality is that a well worded contract is not worth the paper it is written on unless the contract terms are supported by the working practices.

This raises an important point that the contract between the agency and the end client may not necessarily mirror the one that your company has signed with the agency (despite the best intentions of the agency to do so). Cases have been lost where the end client has denied the operation of clauses to which the contractor has signed up in good faith. This alone brings into sharp focus the importance of the engagement’s working practices.

Despite these comments, you are going to be on the back foot if the contract wording is unhelpful, so the issues to be addressed are as follows:

Control

It is important to establish whether the end client is controlling the work, or whether the contractor has reasonable autonomy in the performance of the services.  This will be determined by how, where, when and what is to be performed.  It is unlikely that either party will fully control all of these, but if the contractor wants to be seen as being independent, they will need to have a strong degree of influence over most of these.

Substitution

This area of an engagement is about determining whether it is your company that has been engaged to provide the service, or whether it is you personally. It is about the right of a company to send a substitute, not whether one has actually been provided.

Mutuality of Obligation

Here the issue is whether the end client (or the agency) is obliged to offer you more work and if it is offered whether you are obliged to accept it. If the answer to both of these is “No”, then there is no mutuality of obligation.

Compare this with an employment contract where your employer must continue to pay you even if there is no work, or make you redundant and compensate you.  Similarly, if you are asked to complete some work, you are obliged to do so.

Where an engagement with a particular end client is continually extended, then it becomes harder to argue that there is no mutuality, although it is impossible to define mutuality as commencing by reference to a particular passage of time.

Financial Risk / Being in Business on One’s Own Account

Many examples of financial risk stem from being in business on one’s own account and vice versa. Such as:

• Marketing and training expenditure bring with them no guarantee of future business and yet are clearly investment in the business;
• The payment of various business overheads such as insurances and accountancy fees;
• The purchase of equipment and stationery.

None of these in isolation will tip the balance in favour of employment or self employment, but one can understand that where such expenditure is largely missing from a business that HMRC might not consider that the individual was truly in business on their own account.

Calculations

If you are caught by the IR35 rules, you are treated as receiving a notional salary on the last day of the tax year (5 April) equal to the company’s gross income from relevant engagements less certain specified deductions. You will have to pay over PAYE and NICs on this notional salary by 19 April and include it on the year end return P35 by 19 May. It is evident that there is very little time to process the calculations, and HM Revenue & Customs have indicated that they will not penalise the use of provisional payments and calculations in order to meet the deadlines.

The deductions cover expenses that would normally be available to direct employees, contributions to registered pension schemes and the actual salary and employers NIC plus the employer’s NIC on the deemed salary. Also allowed is a 5% flat rate deduction to cover the company’s running costs.