All Limited Company contractors in the UK are worried about IR35. Being inside IR35 can completely negate the tax benefits associated with being an independent contractor. If a contractor is caught inside IR35, it would mean similar, or sometimes more, payments in taxes and National Insurance Contributions (NICs) in comparison to a full-time employee with similar income.
In spite of knowing the tax risks of being inside IR35, many contractors are not fully aware of the key differences between being inside and outside IR35. In this article, we try and understand the main factors that impact the IR35 status of contractors. We continue with the story of Tim, a fictitious contractor who once became a Limited Company contractor to save taxes. Tim is a full-time contractor now, but like all genuine contractors, he is at the risk of being classified as inside IR35.
Let’s look at each of the factors that will play a role in determining Tim’s IR35 status.
Full-time employees always operate out of their client’s office address. Their business address is their employer’s address.
Tim is not an employee, and as such he is supposed to have his own business address. Even though he may be operating out of the client’s site, if he has a registered business address, it will be helpful from an IR35 point of view.
Note that simply stating a fictitious business address won’t serve Tim’s purpose. If there’s an IR35 enquiry, Her Majesty’s Revenue and Customs (HMRC) would like to see Tim’s lease or contract for the office address, his home address, and the address of his clients.
Contractors like Tim are responsible for their own mistakes.
The business risk taken by a contractor is one key reason why the government charges less taxes to contractors.
To determine whether he is inside or outside IR35, the HMRC would like to assess how much risk is borne by Tim. Professional Indemnity Insurance (PII) is a good indicator for demonstrating Tim’s professional liabilities.
If caught under an IR35 investigation, HMRC would like to see Tim’s PII policy document, premium note, and a detailed explanation of why he took a PII.
Being a Limited Company contractor, Tim is the sole owner of all the profits generated by his business. So, as compared to a full-time employee, there’s a bigger incentive for him to work harder or smarter and maximise his profits. Also, he can quote different fees for different contracts to earn maximum profits. Sometimes he may add additional staff to complete a project faster or at a higher profit. Full-time employees don’t have any such options. In most cases, their earnings are fixed with some annual pay increases or bonuses.
If there’s an HMRC enquiry, Tim has to show proof of his activities to increase his profits. For example, HMRC will see Tim’s contracts and check if there are clauses that reward him for timely completion of projects, or whether he has the freedom to determine the work process so that he can maximize his profits. HMRC will also see at Tim’s costing for different proposals, copies of proposals submitted, and the proof of acceptance from clients.
As a contractor, Tim can hire other members who can generate additional revenue for his company.
Let’s say Tim is earning 70,000 a year, and he adds another assistant who brings an additional revenue of £45,000 a year. Such assistance is one clear sign that Tim is an independent contractor because full-time employees don’t have the advantage of adding assistants to their projects.
As evidence for employing assistants, HMRC will want to see Tim’s account books to check any payments made towards assistance. It will also want to know the details of the work assigned to the assistant, the name of the assistant, and also the payment mode adopted to make the payment.
Typically, if at least 25% of a contractor’s annual revenues are generated by another worker, it is a good indicator of being outside IR35.
Like all contractors, Tim is responsible for the growth of his business, and no business can grow without advertising and marketing.
If caught under an HMRC investigation, Tim should have enough proof to show the amount spent on advertising in the previous tax year.
As part of evidence, HMRC would like to see copies of advertisements, and copies of invoices received from the advertisement agency.
To be entirely safe from being inside IR35, it will help if Tim’s business has more than £12,000 of advertising expenses in one year.
Tim was earlier a full-time employee and changed his status to a contractor only to save tax. Of course, he’s a genuine contractor now and is no longer dodging taxes.
But the real reason behind IR35 was to catch non-genuine contractors who continued to work for their previous employer, and simply changed their employment status to save taxes. The previous PAYE test is a good way to flag off any such arrangements.
HMRC will check if Tim has engaged on PAYE terms with any of his clients on for at least 12 months before he became a contractor, without any changes in his working terms. As evidence, HMRC can check Tim’s and his client’s employment records.
Contractors need to have a solid business plan, which should include the forecast for their future revenues, expenses, and cash flows. A business plan is very dynamic and has to change regularly to reflect changes in the internal and external environment of a business.
In an IR35 investigation, HMRC will want to see copies of Tim’s business plan and the history of changes made to the original plan.
Also, it is important for Limited Company contractors to have a separate business account. As evidence, HMRC will want to check Tim’s business bank account statements.
If full-time employees make a costly mistake, under no circumstances will they be made to pay for the mistakes from their salary. Depending on the mistake, they may be warned or may even be dismissed, but they are highly unlikely to pay any financial penalties.
On the other hand, Tim is responsible for bearing the cost of correcting any mistakes made by him. For example, if he makes any mistakes, he may have to work extra without pay to correct the mistake. In some cases, he may even have to compensate from his own pocket for any losses caused to his clients.
HMRC uses this as a criteria to determine the IR35 status of contractors. It will want to see Tim’s contract for any clauses around mistakes and the conditions for rectification. It would also like to know the things that can possibly go wrong, the possible corrective actions, and how much will it cost to undertake the corrective action.
Being a Limited Company contractor, Tim faces the risk of non-recovery of dues, or getting less money as compared to the originally agreed amount in a contract.
This could be either because the client has gone bankrupt or is not happy with Tim’s work.
Any non-recoveries from clients is a good indicator of Tim being outside IR35.
As evidence, HMRC will see the accounting records that show writing off of debts, copies of interaction with the client regarding recovery of dues, and any copies related to intended or actual legal action for recovery of payment.
One of the key responsibilities of independent contractors is deciding their payment terms and sending an invoice to the client upon completion of the work.
Tim will have to provide enough evidence to HMRC about his billing activities.
For example, the HMRC would like to see documents like invoice copies, and copies of any billing-related correspondence with the client.
If the HMRC is convinced about billing, there are better chances of Tim being classified as outside IR35.
Contractors don’t have to do all the work themselves and have the right to send a substitute. For example, if Tim is busy on other projects, he can always send another equally-skilled contractor as a substitute to his client. Full-time or permanent employees never have this kind of flexibility.
If investigated by the HMRC, Tim will have to produce evidence for substitution such as any clauses in the contract which indicate permission for substitution.
For example, there could be clauses stating Tim’s responsibilities for sending a substitute if he’s unable to visit a client, or the responsibilities for a substitute’s performance and payroll.
Finally, HMRC would like to see whether Tim has used any actual substitutes or subcontractors for any of his contracts.
As part of evidence, the HMRC would like to know the details of the clients for whom subcontractors have been used, and the details of any such subcontractors.
HMRC will also ask for details of payments made to the subcontractors, the role of the subcontractors, and any employment contracts with the subcontractors, etc.
If there’s enough evidence of actual substitution or subcontracting, this will be a big advantage for Tim in an IR35 investigation.
The above-mentioned criteria are part of the business entity tests created by HMRC to determine the difference between being inside and outside of IR35. As you can see, contractors need to have detailed evidence to back each of these criteria, and simple verbal assurance won’t be sufficient to convince the HMRC.
To determine your IR35 status, you can use our business entity tests tool. The tool has all the questions listed above. At the end of the test, you can see your IR35 risk score in an easy-to-understand, graphical format.