IR35 Introduction.

The text below has been prepared to help you to understand the basics of IR35. However the matter is complicated and the guide below is no means comprehensive and should not be used as a substitute for proper advice. If you would like more information please feel free to contact us on 01223 507080, alternatively there is a vast amount of helpful detail on the HMRC's (formerly the Inland Revenue) website.

Questions you may have are: Click on a link to find out more

What is IR35?

IR35 is the number of the Budget Press Release which announced the new regime which would apply to what are known as "personal service companies". It was designed to stop the tax advantages enjoyed by personal service companies and came into force from the 6 April 2000. Note that other entities such as partnerships can also be caught by the legislation but for simplicities sake this help text assumes a company is involved.

A personal service company is typically one where the only business of the company is to provide the expert services of its sole director and shareholder. Instead of the director working for the clients directly the client engages the limited company.

This obviously gave tax benefits - the director can set the company expenses against the income.The income can be taken out as salary or more beneficially as a dividend, corporation tax rates are generally lower than income tax rates, etc.

The IR35 legislation tries to stop this by ignoring any intermediaries (such as the personal service company) and looking at the reality of the contract. If it appears that the director of the personal service company was, to all intents and purposes, an employee of the client then the company has to pay tax like an employee.

The largest group caught by the legislation has been IT contractors but this has now been extended to domestic workers.

Is your contract caught?

The HMRC will normally examine the contract between the contractor and the client to see if it is caught by IR35.

There is no black and white answer whether a contract is caught or not. The HMRC will look for various indicators and weigh them up to decide. Not all the indicators are of equal importance.

Examples of indicators are:

Is the party carrying on a business on his own behalf not merely carrying on the business of his employer's.

The right to send a substitute or to be able to delegate work to others.

Significant financial risk and opportunity to profit from sound management. Can the party make significant profit by performing better or suffer financial losses by their performance. (e.g. If the party is paid hourly they are unlikely to be able to do either where as if the contract for a fixed sum and is to do a particular task and therefore the quicker or better they do it the less cost to them the more profit earnt.)

Provision of equipment. If all the equipment, office space etc. is provided for by the client then this indicates employment.

Control. Who has the control in the contract. If the client can control when and where the worker does his work this would indicate employment.

Length and number of engagements. The more numerous and shorter the engagements the less likely one is to be an employee.

Exclusivity. Where a worker provides services to only one employer and agrees not to provide his skills to anyone else this indicates an employee.

Though any written contract will be examined for the indicators there are not always written contracts to examine and the HMRC can also looked at implied terms. For example a contract could contain a right to send a substitute but if the reality is that this was never going to happen then the written clause would not be persuasive as an indicator.

What are the consequences if I am caught by IR35?
If you are caught by IR35 then the legislation stipulates how much money are to be treated as having received as salary. The company then pays tax and national insurance on this notional salary. This is included in the PAYE returns which the company must make.It is important to realise that the legislation applies on a contract basis. It is quite common for an IT contractor to be caught on his main contract but outside IT35 on software sales or small additional contracts.

The calculation
This calculation is reasonably complicated but below is the basic computation required with some explanation. The calculation is always performed for an entire tax year (6 April to 5 April).

Income from IR35 contracts (1) X
Less 5% deduction (2) (X)
Add any benefits/payments made to the worker
or his family that not received by the personal
service company (3) X
Income X

Less
Expenses allowable as an employee (4) X
Capital allowances allowable (5) X
Contributions to a pension scheme (6) X
Employer's Class 1 & 1A NIC paid (7) X
Employee's gross salary (8) X
Employee benefits (9) X
Less total deductions (X)
Amount subject to IR35 (10) X
Employers deemed NIC payment (11) (X)
Employee's deemed income (12) X

(1) Total income received by the personal service company in the tax year.

(2) A flat deduction of 5% of (1) is allowed to reduce the deemed income

(3) This catches any other income that may not have been paid in cash to the personal service company.

(4) Any expenses that allowed as an employee are deductible from the deemed income. Please see the separate section on expenses.

(5) Capital allowances are allowed on any plant or machinery purchased by the worker and used in the IR35 contracts. Since most workers use their client's equipment this does not arise often.

(6) Any contribution to the worker's pension scheme is allowable

(7,8,9) If the worker pays themselves a salary from the personal service company then any employer's NIC (National Insurance Contributions) on the salary paid, salary paid and benefits provided are deducted from the deemed income.

(10) This is the gross amount subject to the IR35 legislation

(11) The gross amount at (10) includes any employer NIC that would be due on the deemed income. This has to be calculated and paid to the HMRC.

(12) The deemed income due to the worker. Normal employee's NIC and income tax has to be calculated on this and paid to the HMRC. The payment is deemed to have taken place at the end of the tax year.

Any tax and NIC on the deemed payment has to be paid by the 19th April after the end of the tax year.

Another important point is that expenses of the company are not allowable against the deemed income calculation, yet this deemed income is allowable against the corporation tax calculation. Therefore personal service companies where all the income is caught by IR35 general show a loss for corporation tax purposes.

Expenses
Any expenses met by the personal service company that would have been allowable expense for an employee to claim against his earnings can be used to reduce the deemed income. Note the expense has to be met by the personal service company and therefore the worker must reclaim any expenses paid for personally from the company. The employee can claim the expenses on his personal tax return if not reimbursed by the personal service company but this less tax efficient as there is no National insurance saving then.

Expenses that are allowable for an employee have to be "wholly, exclusively and necessarily incurred in the performance of the duties of the employment". This term has been defined in numerous tax cases.

Since expenses allowable for employees are minimal below are details of expenses that can be claimed.

Subscriptions
Subscriptions to professional bodies. A list of approved organisations can be obtained from the HMRC. Invoices and receipts should be retained as proof of the expense.

Training
Training paid for by the worker is not allowable, however if the employer or agency can pay for the training and it is work related no charge arises (You may need to negotiate with the employer or agency to pay for the training but pays you less for the period).

Insurances
Professional indemnity insurance is allowable but public liability insurance and employers' liability insurance are not. Death in service costs are also allowable but are also not taxed as benefits on the employee. Other insurances such as dental or BUPA whilst allowable deduction for the deemed income calculation are also taxable on the employee as a benefit so no tax saving is made. Invoices and receipts should be retained as proof of the expense.

Travel
Travel expenses necessarily expended on travelling in the performance of the duties of employment are allowable as long as they are not ordinary commuting or private travel. These would include a mileage rate and parking costs. Ordinary commuting is a journey between home and a permanent workplace.

A temporary workplace is one that can meet either of the following criteria:

Where duties are not performed to a significant extent at that place (significant extent is generally interpreted as no more than 40%)

The engagement is expected to, and actually does, last for two years or less. This does not apply when the engagement comprises all or almost all of the period the employee is likely to hold the employment. In other words if it is your main employment. However since contractors are employed by their own companies this does not have any effect on the contracts.

Since most contractors caught by IR35 have only one contract at a time the second point is the most pertinent but there are some further points to clarify the situation for this criteria:

If a contract is given for greater than two years then no travelling expenses can be claimed even if the contract ceases earlier than two years.

If renewal contracts are given the travelling expenses are allowable until the renewal takes the worker over the two year limit. Example - Jane has an 18 month contract to work in Dorset therefore travelling expenses are allowable, however 2 months before the end of the 18 month contract she is asked to renew for a further 12 months. At this point if the renewal is accepted then no further travelling expenses may be claimed.

Where there is no substantial effect on the employee's journey, or expenses of travelling then the two or more different contracts will count towards the two year limit. Example - Lucy works for a bank in Kings Cross for 12 months and commutes from Cambridge. Her next contract is next door for a different bank for 6 months. After this contract she is offered a 12 month contract in Liverpool Street for a third bank. As the cost of commuting to each location is not substantially different and in the case of the first two not a substantially different journey no travelling expenses can be claimed from the commencement of the third contract as this will take her over the two year limit.

Invoices, receipts and/or mileage logs should be retained as proof of the expense.

Accommodation and Subsistence
If business travel is allowable then any associated cost for accommodation and subsistence is allowable. However if your workplace is situated near to your home then any accommodation and subsistence expenses are not likely to be allowable even if the travelling test has been satisfied.

Invoices and receipts should be retained as proof of the expense.

Note that personal items such as phone calls, newspapers and laundry are not allowable, but there is a flat rate allowance of £5 (£10 outside the UK) that can be claimed per night away on business to cover such expenses.

Companies can apply for a dispensation which allows them to apply a scale rate for expenses to their employees. The scale charge can be then used to repay employees a flat rate (depending on their position or salary) for subsistence costs.

Dispensations are examined by the HMRC on a case by case basis so no guarantee can be made that one will be accepted.