IR35

The IR35 rules have caused controversy throughout the contractor landscape since their inception in 1999 as part of the Finance Act. Have more questions? Talk to the team at Umbrella Supermarket today.

What is IR35?

The IR35 rules have caused controversy throughout the contractor landscape since their inception in 1999 as part of the Finance Act.
Under the IR35 rules, anyone caught by IR35 should process the proceeds of their contract through PAYE effectively wiping out any tax advantage to being a contractor.

Contrary to today’s popular opinion, the IR35 rules were originally designed to stop a genuine tax avoidance problem, rather than to penalise all hard working contractors.

IR35 was introduced to tackle a perceived surge in “false self-employment”, which gave a tax advantage to both the contractor and the end client, while in turn damaging tax revenues.

Originally designed to prevent employees leaving their jobs on a Friday and returning to work as a contractor on Monday on similar terms (but with both parties paying less tax), IR35 has become controversial in recent years as its remit has expanded from saving falling tax revenues to generating new revenue altogether.

While in 1999, IR35 was implemented to prevent a “Friday to Monday” phenomenon and save tax revenues, by 2017 IR35 had morphed into a full income tax based set of rules designed to dictate how contractors paid tax.

Prior to 2017, IR35 had focused on the written contract between the client and contractor. Contracts were evaluated for evidence that they were in effect employment contracts. Post April 2017, for those in the public sector only, IR35 shifted to focus on the actual working practices of the contractor, placing the emphasis for deciding IR35 compliance onto end clients.

With financial penalties in place (and a new dedicated IR35 compliance team), public sector bodies en masse deemed contractors inside IR35. As a result, thousands of contractors that had paid lower tax bills through utilising their own Limited Companies were forced to switch to PAYE and accept higher tax payments.

The second phase of the IR35 roll out will begin for private sector contractors in April 2020.

Is using a Limited Company tax avoidance?

Working through a Limited Company presents contractors with a significant tax advantage over employees who pay their taxes through the PAYE tax system.

This advantage stems from a contractors ability to utilise the dividend mechanism to extract company profits alongside taking a minimal salary.

In the 2019/2020 tax year, contractors looking to extract profits through dividends can access the first £14,500 of their income tax free by:

  • Taking a £12,500 salary (equalling the tax free allowance on income).
  • Taking £2,000 in dividends (the first £2,000 of dividends are tax free).

After taking their £14,500, contractors using dividends must pay tax on any amount they receive, however the taxes they pay are lower than if they were earning this money as a salary:

  • Basic Rate – 7.5% (From £2,000 to £37,500)
  • Higher Rate – 32.5% (Earning from £37,501 to £150,000)
  • Additional Rate – 38.1% (Earning above £150,000)

Comparatively, an employee would pay tax on income earned over £12,500, paying income tax according to the following thresholds:

  • Basic Rate – 20% (From £1 to £37,500)
  • Higher Rate – 40% (Earning from £37,501 to £150,000)
  • Additional Rate – 45% (Earning above £150,000)

As a result of paying lower taxes through the dividend mechanism, contractors using a Limited Company are financially better off than their employed counterparts.

It could therefore be said that by choosing to use a Limited Company, contractors are “avoiding” paying the same level of tax as employees, however in reality contractors are not the only people to use the Limited Company structure.

Limited Companies are used the world over to control assets and invest in enterprising ideas. In the UK lower taxes on dividends are generally accepted to be an incentive for those wishing to take the risk of investing capital into a business in the hope of a reward.

It’s well documented that contracting is riskier than being an employee and comes with no employment rights. In return for taking that riskier route to finding work, it’s only right that contractors should be able to reap the rewards of the dividend mechanism.

However this is not a view shared by HMRC. HMRC’s position is that all contractors are in effect “falsely self-employed” and despite the fact that they get no employment benefits like holiday pay, sick pay or security of a role, are taking no more risk than an average employee.

This position has caused considerable controversy not least because despite forcing contractors to abandon the Limited Company model, HMRC have made no moves to ensure contractors caught by IR35 have remedial access to employment rights.

Are contractors worse off under IR35 than as an employee?

Under IR35 you’ll need to process your entire contract, less 5% for expenses and any pension contributions, through PAYE. This in itself will not make you worse off than an employee but it does make using a Limited Company relatively pointless and as such many contractors will utilise an Umbrella Company.

However those contractors caught by IR35 will not have the security or statutory benefits that come with being employed and therefore will be worse off overall.

Yet benefits are not the only major disadvantage that contractors caught under IR35 will need to deal with.

In fact there is a hidden disadvantage that contractors face that severely impacts a contractors take home; Employers National Insurance (ENI).

ENI is an additional tax paid by employers over and above the Employee National Insurance contributions paid from a salary.

Unless a contractor can secure a day rate high enough to cover the ENI, the ENI deductions of 13.8% will need to be paid by the contractor.

This means that a contractor on £65,000 per annum will need to find £7,739.04 in ENI in addition to their £65,000, which represents a significant financial disadvantage over an employee.

If the contractor is unable to secure the additional £7,739.04 from the client (making a billable amount of £72,739.04) then they will need to foot the bill themselves.

When processing their billable income through PAYE, contractors will actually depress their income slightly to afford the ENI. As a result the contractor would effectively pay themselves £58,200 through PAYE, with £6,800 being paid to HMRC in the form of ENI (£65,000 in total).

Alternatively some end clients will pay the £7,739.04 directly to HMRC on the contractors’ behalf when sending their funds to the contractor and provide them with an ENI credit, although this practice is rare.

Is there an IR35 test?

In short yes. There is a “CEST” tool provided by HMRC that allows contractors to check their employment status for tax however this has been widely criticised for being too closed minded in scope.

It’s therefore important to not only take that test but review your working practices yourself.

As a general rule, IR35 looks at three main pillars of your working practices:

Control – What level of control does your client have over what, how and when you do your work. For example, does your end client require you to work in a team, manage or be managed, book in your holidays or wear a uniform? In reality a contractor should be free to operate as they wish, but if your client requires you to act like an employee then the chances are you’ll be caught by IR35.

Substitution – A key focus for IR35 is the ability to send anyone to fulfil a contract. As an employee you can’t ask someone else to go into work for you, but as a contractor you should be able to send any qualified person to do your role if you can’t make it.

Mutuality of Obligation – As an employee your employer is obliged to find work for you to do and for you to accept it. As a contractor, your client shouldn’t have to find work for you to do if there isn’t any.

The most common industry for contractors to fall foul of IR35 is in the NHS because it is tightly controlled, substitution is rare and mutuality of obligation is clear. As an example:

A nurse in the NHS will book holidays, work according to a rota, wear a uniform, fall under a line manager, be unable to send someone else to do their job and have to treat the patients put before them.

In reality then, contracted nurses in the NHS will fall foul of IR35 as they are defacto employees.

In contrast an IT Consultant for a bank:

Will work whenever they want, can work from home, will often wear their own clothes, can choose from several projects and can hire in extra consultants to fulfil parts of their contract they are unable to do.

A contractor with a role as described above should fall outside of IR35.

How to find an IR35 compliant Umbrella Company

It’s a great title but there is no such thing as an IR35 compliant Umbrella Company. The term “IR35 Compliant” is a marketing ruse used by Umbrella Companies that prey on people unsure around their own IR35 compliance.

The fact is from April 2020, your end client will tell you whether you’re IR35 compliant or not, and if you’re not then you will need to process your payroll through PAYE. Your accountant can do this for you through your Limited Company however it is much less hassle to use an Umbrella Company.

Umbrella Companies are intermediaries that employ you to fulfil your contract with your client. They invoice for your time, collect the funds and process your payroll through PAYE less their administration fee.

Often Umbrella Companies compete on price, but a new breed of Umbrellas are now offering employee benefits like cinema tickets, gym memberships and M&S discount cards to entice contractors onto their books.

Umbrellasupermarket.co.uk was establish just before the April 2017 IR35 reforms to help contractors find and compare the best Umbrella Companies in the UK. Our free to use innovative platform quickly became the market leader in online Umbrella Company comparisons.

When comparing Umbrella Companies it’s important to consider not just the impact of their fee on your take home but also:

  • If the benefits they offer actually give you a financial boost and as such outweigh the increase in fee.
  • If the Umbrella Company will help you access government tax breaks such as childcare payments. Not all Umbrellas provide this service and as such you can be £100’s worse off by going with one Umbrella over another.

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