When an individual provides services to a client through an intermediary, such as a personal service company, income tax and national insurance liabilities can fall on the intermediary for the individual it provides. The rules, which are known as 'IR35', apply if the individual would have been regarded as an employee of the client, had the individual not contracted through the intermediary.
IR35 was the number of the original press release announcing the intention to bring in the new rules and therefore 'IR35' is still used as shorthand for the rules.
The rules apply principally to service companies or personal service companies. These are often one man or one woman companies which supply an individual's services to a client. The fee for these services is paid by the client to the service company. However, the rules can apply to other intermediaries such as partnerships.
Service companies have been around for many years but have become particularly prevalent in the IT sector. They have both fiscal advantages and commercial advantages.
- The worker can decide how much salary to draw from his service company and when (and so defer the tax payable). He can also decide to take a dividend payment instead of salary (and so pay less tax).
- More expenses can be tax deducted by the worker's service company than by the worker himself as an employee.
- A salary could be paid to a spouse (for example for secretarial services). If that spouse is a shareholder, he or she could receive dividends.
- Any retained profits would generally only be subject to the corporation tax – which is payable at lower rates than income tax.
Note that the tax benefits of receiving dividends will be removed for some from 6 April 2016 when the tax credit on dividends is abolished. After that time the first £5,000 of dividends will be exempt and dividends in excess of this will be taxable at 7.5%, 32.5% and 38.1% for basic rate, higher rate and additional rate taxpayers respectively.
The tax treatment of travel expenses paid to temporary workers is also changing from April 2016.
- The protection for the worker of limited liability as a company.
- Many agencies and clients prefer to work this way as it removes from them the need to take on employment responsibilities.
- It can be a useful way to protect intellectual property rights.
- It gives the worker more control.
When does IR35 apply?
IR35 will only apply if the managed service company rules do not apply. A 'managed service company' is an intermediary company that is promoted by and provided to workers by a scheme provider. The worker (although a shareholder) does not exercise control over the company. More details can be found about the managed service company rules on HM Revenue & Customs' (HMRC's) website.
Assuming the managed service company rules do not apply, IR35 applies where a worker provides services under a contract between a client and a service company.
There is, however, an important further requirement. The rules only apply where the relationship between the worker and the client, if it had been made by a contract directly between them, would be considered to be an employment relationship. In other words one has to ignore the existence of the service company, and then test whether there is an employment relationship (as opposed to a self-employed / consultant relationship).
Only if this "employment" test is met is IR35 applicable. If the relationship between the client and worker is a self-employed / consultant relationship then the rules are not applicable.
The test of whether or not an individual is an employee is laid down in case law. However HMRC has guidance on when it considers an employment relationship to exist, including an Employment Status Tool. Whilst the HMRC guidance is useful, it is important to bear in mind that this is not necessarily definitive and merely represents HMRC's view of the case law.
From April 2013 IR35 also applies where an individual is engaged through a service company and the worker would be regarded as the holder of an office with the client if the contract was directly with the client or the worker is an office-holder with the client and the services relate to the office. This would catch a service company providing the services of an individual as a director of the client, including a non-executive director.
What is the effect of IR35?
If the rules apply, because there would be an employment relationship if the worker had contracted directly with the client, then a deemed employment income tax charge is charged on the service company, calculated by reference to the actual payments made to the service company by the client.
The rules are applied to each engagement, contract or project separately and only apply to any which fall within the employment relationship test. The deemed tax charge arises once a year at the end of the tax year. HMRC guidance sets out how to calculate the deemed payment.
Income tax and national insurance contributions are payable by the service company in the normal way in respect of any salary paid by it to the worker and any taxable benefits it provides to the worker. This is taken into account in the calculation of the deemed tax charge.
Is IR35 a concern for the client?
All the obligations under IR35 fall on the service company - none fall on the client. This is an advantage over the old pre-IR35 rules so far as clients are concerned. Although note that the government is considering whether to change this.
Under the pre-IR35 rules if there was shown to be an employment relationship between the client and the worker then the client could have been required to account for income tax and national insurance and potentially have suffered interest and/or penalties for incorrect operation of PAYE.
However, in practice, if a service company was involved HMRC was unlikely to challenge the position and also generally the worker or service company would have indemnified the client against this potential liability.
IR35 moves, with greater certainty, the potential liability from the client to the service company.
What differences does IR35 make to contractual relationships?
IR35 only applies where there is (or would be, if the worker and client contracted directly) an employment relationship. The IR35 rules use the same tests as already existed for distinguishing employment from self employment.
Many clients will, even prior to the introduction of IR35 in 2000, have sought to check whether there was an employment relationship and have taken indemnities if it was possible that an employment relationship applied. It is still advisable to consider this approach.
There is, however, no reason to stop contracting with a service company even if there is an employment relationship - it may still be the best way to proceed for both the client and worker. There are still commercial advantages for both parties (as explained above) and, for the worker, some financial advantages (tax is still only paid at the end of the year). Although, as mentioned below, the Government is clamping down on the use of service companies in the public sector and some of the tax advantages of service companies will be removed by the changes to the taxation of dividends.
In addition, for the client the tax test of an employment relationship does not necessarily mean that a worker goes on to gain other employment rights.
The terms of the contract are one of the factors in determining if there is an employment relationship. Therefore it will be useful to review the contract to see if its terms reflect an employment or a self-employed relationship, and whether any changes are required.
In 2011 a review of IR35 was carried out by the Office of Tax Simplification (OTS). The OTS considered that IR35 needed to be reformed and suggested various possible reforms, including suspension with a view to permanent abolition.
The government decided against abolition but instead agreed to some simplification measures. These included establishing an IR35 forum to discuss the operation of the rules with business representatives.
In May 2012 HMRC published guidance on its risk-based approach to checking taxpayer compliance with IR35. The guidance confirmed that if taxpayers could show they were outside IR35 or in the low risk category, HMRC would close any IR35 review and would not undertake a further review in the next three years. In order to establish the risk rating, the guidance set out 12 business entity tests and allocated points for each test.
Subsequently research by the IR35 Forum showed that the business tests were not often used and HMRC withdrew them with effect from 5 April 2015,
In July 2015 the government published a consultation document asking for views on options for reform. That document estimated that non compliance with the IR35 legislation would cost £430m in tax and NICs receipts in 2015. One of the options for reform considered in that document is to shift the obligation to account for the tax onto the client engaging a worker through a personal service company.