IR35 is a tax legislation in the UK designed to combat tax avoidance by workers, typically contractors or freelancers, who supply their services to clients via an intermediary (usually a personal service company, or PSC) but who would otherwise be classified as employees if the intermediary were not used. The goal of IR35 is to ensure that such individuals pay the same level of tax and National Insurance Contributions (NICs) as employees.
What is IR35?
IR35 is also known as the "off-payroll working rules", and it applies when a worker provides services through an intermediary (like a limited company or PSC) but the nature of the work and the relationship with the client means that the worker is essentially operating like an employee, rather than as a self-employed individual.
If a contract falls within IR35, the worker is considered to be "inside IR35," and they must pay income tax and NICs as though they were an employee of the client, even though they are technically a contractor.
Key Elements of IR35:
Inside IR35:
- If your contract is deemed to fall inside IR35, this means HMRC (the UK tax authority) considers you to be effectively an employee for tax purposes.
- You must pay the same taxes (Income Tax and NICs) as employees would, and you can no longer benefit from tax efficiencies typically associated with operating as a contractor or freelancer, such as taking dividends from your limited company.
Outside IR35:
- If your contract is deemed outside IR35, you are considered to be genuinely self-employed, and you can continue to operate under the tax advantages of a limited company or PSC, such as taking a combination of salary and dividends.
Does IR35 Apply Only to Contract Jobs?
IR35 applies specifically to contractors, freelancers, and individuals working through intermediaries such as personal service companies (PSCs). These are typically people who work on a contractor basis rather than as permanent employees. However, it does not apply to employees directly hired by a company because employees already pay the appropriate Income Tax and NICs under the PAYE (Pay As You Earn) system.
Here’s a breakdown of who it applies to:
Contractors/Freelancers: IR35 is most commonly associated with contractors who provide services to clients via an intermediary, such as a personal service company (PSC). The law is meant to ensure that people who are working in a manner similar to employees pay appropriate taxes.
Private Sector and Public Sector: IR35 applies to both sectors, but the rules were tightened in recent years. Since April 2021, medium and large private-sector companies (following similar rules introduced for the public sector in 2017) are responsible for determining a contractor's IR35 status, rather than leaving it to the contractor.
- Public Sector: Since 2017, public-sector organisations have been responsible for determining the IR35 status of contractors they hire.
- Private Sector: Since April 2021, medium and large private companies are responsible for determining whether a contractor falls inside or outside IR35. Small businesses, however, are exempt, and contractors working for small businesses can continue to determine their own IR35 status.
Small Business Exemption: If the client is a small business (in terms of size, turnover, and number of employees), then the contractor remains responsible for determining their own IR35 status.
How to Determine IR35 Status:
Several factors help determine whether a contractor falls inside or outside IR35. HMRC looks at the "employment status test", which considers aspects of the working relationship. Key factors include:
Control:
- Does the client have control over how, when, and where the contractor carries out their work? If the client exerts significant control, this points towards being inside IR35.
Substitution:
- Can the contractor send someone else to do the work, or is it required that the contractor personally does the job? If substitution is allowed and the contractor can hire someone else to do the work, it indicates that they are outside IR35.
Mutuality of Obligation:
- Is the client obligated to offer work and is the contractor obliged to accept it? If so, this is more like an employee-employer relationship, indicating IR35 might apply. If the contractor has no obligation to accept work (i.e., they can turn it down), they are likely outside IR35.
Provision of Equipment:
- If the contractor uses their own equipment and tools, it indicates self-employment (outside IR35). If the client provides all the equipment, it suggests they may be inside IR35.
Financial Risk:
- True contractors or self-employed individuals typically take on some level of financial risk, such as not being paid for incomplete work or making an upfront investment in tools or equipment. If the contractor does not bear any risk, they may be inside IR35.
Part of the Organisation:
- If a contractor is treated like part of the organisation (e.g., has a company email, attends staff meetings), this suggests an employee-like relationship, indicating they are inside IR35.
How IR35 Affects Taxation:
Inside IR35: If your contract is inside IR35, the fee payer (either the client or the recruitment agency) is responsible for deducting Income Tax and National Insurance from your pay, just like a regular employee. You don’t get to take your earnings as dividends, which is a key tax benefit for contractors operating via a PSC.
Outside IR35: If you’re outside IR35, you can continue to take advantage of the tax efficiencies that come with running a limited company, such as drawing income via salary and dividends, which often results in a lower overall tax bill compared to being paid as an employee.
Recent Changes to IR35:
- Public Sector (2017): The government introduced IR35 reforms in 2017 for public sector bodies, making the client responsible for determining IR35 status.
- Private Sector (April 2021): These same rules were extended to medium and large private sector businesses in April 2021. Contractors working with small private companies can still determine their own IR35 status.
IR35 and Buy-to-Let Properties:
IR35 applies only to work-related income and does not affect income from investments like buy-to-let properties. If you own a buy-to-let property, the rental income is considered investment income and is subject to property tax rules, not IR35. Therefore, IR35 does not apply to rental income or property ownership structures.
Conclusion:
IR35 is a tax rule in the UK designed to ensure that contractors or freelancers working through intermediaries, like personal service companies (PSCs), pay the appropriate taxes if they are effectively acting as employees. It applies to contract jobs, particularly where the contractor is hired by a business but operates through a limited company. IR35 does not apply to full-time employees or income from investments such as rental properties. If your contract is inside IR35, you'll be taxed similarly to an employee, but if you're outside IR35, you can continue to benefit from the tax advantages of operating as a contractor.