What is IR35?

IR35 Calculator

What is IR35?

If you are a Limited Company contractor or you plan to become one, it is highly unlikely to have not come across the term IR35. Many new contractors are curious to know about IR35 and how it affect them when working on different contracts.
In this article, we provide a storyboard example of Tim, a fictitious individual who goes from being a full time employee (FTE) to a contractor.
The guide then moves from story board to IR35, looking in detail at how each aspect is related to Tim, his situation and his contract. The end result is an IR35 Study case that you can use as an example and compare to specific contract work.

Background of IR35

Let's try and understand the background of IR35 through a story.

In the 90's, Tim was a full-time employee with an IT company. Tim had all the security of full-time employment, including fixed monthly pay, fixed working hours, and all kinds of holidays. Tim was very happy as a full-time employee. The only thing that made him unhappy was the high taxes on his salary. While he made use of all the legal benefits available, he wanted to get more cash in hand.

Tim started to look at new ways to reduce the money he had to pay on tax. During his research, he found that if he became a Limited Company contractor, he can get a lot of tax savings. However, soon he realized that being a contractor had too many risks — there was no guarantee of income, plus he will have to take full responsibility of the business including marketing and invoicing. Tim was not too keen on taking these risks.

However, the tax benefits of being a Limited Company contractor were too good to resist. So Tim thought of a middle way. He checked with his employer to see if he could work as an independent contractor instead of a full-time employee. Tim proposed to retain all the benefits such as fixed pay and holidays. The only change requested by Tim was a new legal arrangement between him and his employer. Tim was a highly valuable employee for his employer, so the employer accepted Tim's suggestion because this change wasn't affecting his company in any way. So, Tim resigned from his full-time position, set up his own Limited Company, and joined his employer again – only this time as a Limited Company contractor. Tim could now deduct all his expenses from his income, and pay only 20% corporation tax on his profits. He could remove his profits as dividends and take advantage of dividend tax credits. Tim didn't even have to pay National Insurance on his income. This arrangement continued to work perfectly, Tim was very pleased that he paid a lot less tax.. Seeing Tim's success, his colleagues decided that contracting could also work for them, they also told their friends about Tims' new car and big house that he had bought by paying less tax. Before long, a lot of people had adopted Tims' excellent strategy for saving money on tax.

All the contractors and freelancers were happy with there increased take home pay and all was going well... until one day when the Government noticed that the treasury funds seemed a lot lower than usual and realized it's losing out a lot of tax revenues because of this legal loophole. HMRC were a little cross about this own goal that saw people paying less tax and rushed out a solution which they thought would bring back the tax revenues. The rushed tax solution appeared in 1999, when the government introduced IR35 or Intermediaries Legislation 35.

What is IR35?

IR35 is a series of rules that aim to check arrangements of 'disguised employment' where employees dodged taxes by working as Limited Company contractors. While the aim of the rule was to check tax evaders, it was poorly written and started to affect genuine self-employed contractors. The government viewed all contracts and contractors through the lens of IR35, and this added to the stress of genuine contractors.

To continue with our story, thanks to IR35, Tim was caught by the government, and he could no longer evade taxes. Why was Tim evading taxes? Tim was evading tax as he had not changed his role, only changed his approach with his employer to circumvent tax law. Technically, Tim was still doing the same job with the same terms, conditions and benefits as though he were still a Full Time Employee (FTE).

Let's introduce John. John is a self employed contractor who had been working this way for several years. John regularly works for different clients filling different contract / work requirements. The introduction of IR35 also changed a lot of things for John, who was a genuine self-employed contractor. John had all the risks associated with being a freelance contractor and he had to run the entire business on his own. He was liable for his errors and sometimes had to rectify his mistakes without any extra pay. While there were many risks, John was happy with the tax benefits available as a Limited Company contractor. However, because of Tim's mischief, the government started looking at John and other contractors like him with suspicion. The government wanted to make sure that nobody became a contractor as they don't like contractors as they incorrectly see them as tax dodgers. The government likes simple process where everyone is an employee and pays the same tax. Sadly that's not good for the economy, job creation or business flexibility but the government often like to learn the hard way. And so, post 1999, even genuine contractors have to make sure that their contracts are nowhere close to being 'inside IR35'.

We will examine how IR35 affects you in our next IR35 Path of Knowledge guide: How does IR35 affect me?

How do I know if I am inside or outside IR35?

There are several factors that determine whether a contract is inside or outside of IR35. One of the key determining factors is 'control', i.e. how much control does the client have over the contractor.

Normally, contractors are independent, and their responsibility towards their client is restricted to the terms of the contract. The client cannot control the contractor's entry or exit timings, or the number of days the contractor works on the client's project. Similarly, the contractor is free to take up work from other clients.

Similar to control, there are many other factors that determine whether a contract is inside or outside IR35. Some of these are listed below.

Using this and several other parameters, HM Revenue and Customs (HMRC) determines the IR35 status of a contract.

We cover this in more detail in the 3rd IR35 Path of Knowledge guide: Are you contracting Inside or Outside of IR35 Legislation?

What happens if a contractor is caught inside IR35?

If you are caught 'inside IR35,' you will have to pay income tax and National Insurance on all such income that you've saved by being a contractor.
In some cases, you will end up paying a higher amount of tax that you would as a full-time employee.
So, for all the effort and risk of being a contractor, being caught as 'inside IR35' can prove to be very costly.
Although the HMRC will phase out the Business Entity Test as of April 2015, they will still use a similar system to guage how a freelancer is working and how their contract is written. For this reason we suggest that you still use the IR35 Business Entity Test to help you gauge your contract and whether you fall inside or outside of IR35 legislation

Summary

IR35 is a very important piece of legislation for any independent contractor. To avoid any trouble, you should make sure your contract is free of any anti-IR35 clauses. Check out our IR35 business entity test to see if you are inside or outside of IR35.

IR35 Calculator Trivia: The Intermediaries Legislation is named as IR35 because it was the 35th press release issued by the Inland Revenue in that specific year (1999).

IR35 Path of Knowledge

Next in our series of IR35 Path of knowledge articles: How does IR35 affect me?

The IR35 calculator is designed for illustration purposes only. Whilst we aim to deliver high accuracy, we make no guarantees on the accuracy of the financial calculations made.

© IR35 Calculator 2013 - 2019