What is IR35 and off-payroll working? Everything you need to know

To prevent tax avoidance, IR35 aims to pinpoint whether the work contractors perform for businesses is as an employee, or that of a self-employed contractor, and has huge implications for your payroll.

The legislation, introduced in 2000, is complex to follow compliantly. If you work with contractors, it’s important to understand which contracts fall under IR35 and which don’t, so you can competently manage your payroll administration and avoid penalties from HMRC.

Below you will learn what IR35 is, why off-payroll working rules were introduced, and when the rules apply and their impact.

What is IR35?

IR35, or off-payroll working rules, are designed to ensure a contractor pays roughly the same Tax and National Insurance (NI) as an employee if the work they do would usually be done by an employee.

The legislation is an anti-tax avoidance measure to stop people who work for one company, essentially as employees, from avoiding tax by classifying themselves as self-employed, and setting up their own limited liability companies because they are more tax efficient.

Who do the rules apply to?

An off-payroll worker who mainly works for one client is usually deemed to be inside IR35 and would be paid as an employee. A genuine contractor who works various short-term contracts for separate clients is usually outside of IR35. In this case, the worker may get assignments from an agency, who they invoice and who pays them.

IR35 or off-payroll working rules apply to employers as well as workers. HMRC wants to stop employers avoiding paying employer’s NI, and ensure they give contractors employment rights.

IR35 applies to workers who provide services through an intermediary, such as a partnership or a limited company, often known as a personal service company (PSC). It also applies to the clients that receive these services, and the intermediary suppliers that represent the link between workers and clients.

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When do the rules apply?

Off-payroll rules apply when a worker supplies their services via their own intermediary, usually a limited company or a PSC. If not working behind this structure, the worker would be deemed as being employed by the client company.

IR35 rules are decided on a contract-by-contract basis. A worker may have some contracts deemed to be inside IR35 and others outside of IR35 rules.

It can be difficult for both workers and client companies to decide whether a specific contract should be inside IR35 rules. The two overriding considerations are the wording of the contract and the way the work in the contract is undertaken.

The contract wording should indicate whether the work being performed is ongoing in nature and able to be completed by a separate employee, and whether the worker received similar benefits to that of an employee or not.

HMRC operates tests to decide employment status, including:

• Control – Who decides where you work, what you do and what hours you work?
• Background – Will the contractor be doing work previously done by an employee?
• Substitution – Can the contractor send a substitute that a client cannot refuse to do the same job, except in special circumstances?
• Previous experience – Has the client previously been investigated for using contractors in roles within IR35?
• Mutuality of obligation – Is the client obligated to provide the worker with work, and is the worker contractually bound to accept it? This can apply if the same contract agreement is renewed each time it expires.
• The nature of the client relationship – IR35 rules usually apply if the client supplies the worker with equipment, the client is the worker’s only client, or the worker is deemed to be embedded within the organisation.

To ascertain whether the nature of the work suggests the contract should be inside IR35 rules, the contract should outline how the work is being performed. It should indicate whether the contractor can consult on problems with an employee or whether they are expected to solve problems themselves, where the contractor is expected to work, and whether other activities linked to being an employee apply, such as breaks and working hours.

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Who decides whether IR35 applies?

Normally the client decides if IR35 rules apply for the worker, but it depends if the client is part of the public or private sector, and the size of their business. New rules introduced for public sector employers in 2017 and private companies in 2021 regarding IR35 have made the issue more complicated.

In April 2017, the government issued new off-payroll working rules for the public sector. After April 2017, the public sector body must decide if the worker is inside or outside of IR35, not the worker, as was previously the case. If they are inside, whoever pays the worker must deduct tax and NI and report the details to HMRC.

If a worker provides services to a smaller private sector client, the worker’s intermediary – usually themselves via their limited company or PSC – is responsible for deciding whether IR35 rules apply.

Following the updated legislation in April 2021, businesses classified as medium or large must decide the workers’ employment status.

You can check if IR35 applies by using Gov.UK’s check employment status for tax (CEST) tool.

What happens if IR35 applies?

If the worker is classed as an employee for tax purposes, the employer or client must use their payroll software to deduct tax and NI from payments to the worker’s intermediary.

If IR35 applies, the worker will usually pay more tax under a less tax efficient payment structure. If either the worker or client is responsible for assessing a worker’s IR35 status and they get it wrong, they could be fined by HMRC.

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How to ensure compliance

To minimise the risk of making the wrong decision on what is a complicated issue, contractors can take out IR35 investigations cover, which covers costs linked to an HMRC investigation.

The most important action for a small business to take is to talk to the contractor or intermediary about the nature of the work being performed within the contract, and about the worker’s status. It is in both parties’ interest to get the IR35 classification correct.

A small business should record the details of each contract being offered and the work to be performed by the contractor to gather evidence to back up whether each contract is outside or inside of IR35. Small businesses should keep copies of the contracts and other arrangements linked to how the contractor they are using will work.

If a small business wants to employ a worker outside of IR35 and believes the contract should be on this basis, they should analyse the contract carefully and suggest amendments that comply with the rules, but support the IR35 status a business wants the contract to come under.

What are the penalties for non-compliance?

The severity of penalties depends on the degree to which a contractor or client knew whether their IR35 status was incorrect. Both parties can potentially be penalised, although the 2017 and 2021 reforms shifted the burden of deciding which status should apply to the client engaging a contractor’s services, if the client is deemed to be of the appropriate size.

Employers that are “wilfully deceptive” can be taken to a tribunal by HMRC and could be liable for any NI they have avoided paying.

Contractors or workers who did not realise they should be inside IR35, i.e. they are deemed an employee not a contractor for tax purposes, can be liable for 30% of their unpaid tax if the mistake is due to negligence or carelessness.

Contractors who know they should be within IR35 but continue to operate as if they were self-employed can be liable for 70% of their unpaid tax bill. Contractors that try to hide their real IR35 status are liable for 100% of their unpaid tax bill. All of these penalties are in addition to paying the correct amount of tax.

How to get more help

To comply with IR35 off-payroll working rules and avoid an investigation and potential penalties, consider getting specialist help from an independent financial advisor or accountant. For smaller employers, they can advise on the correct treatment of contractors used for contract work. Similarly, for contractors they can help judge if the work you perform is inside or outside of IR35 rules.

HMRC has many resources available on Gov.UK to help workers and employers make the correct choices, including a guide to complying with the reformed off-payroll working rules (IR35).

Conclusion

IR35 or off-payroll working rules can be complex to navigate and remain compliant with. Normally, if work performed under a contract is the work that an employee would do for one company, the worker is likely to be deemed as working within IR35, and pay and tax should be taken by the intermediary company who pays the worker, and receives payment from the client who hires the worker.

HMRC has various tests it can apply to decide whether a contract is inside or outside of IR35. Both workers and employers should carefully consider the contract status to ensure they follow the correct rules and pay the right amount of tax and NI to match the type of work undertaken within a contract.

Read more: Employing contractors: essential UK laws & responsibilities to get it right