IR 35: the basics

This article is based on UK law. It was last updated in February 2008.

Tax provisions which place income tax and National Insurance liabilities on a service company for the worker it provides in the event that an employment relationship is found to exist between that worker and a client.

What is IR 35?

The legal position

"IR 35" is the term used to describe rules introduced in the Finance Act 2000. IR 35 was the number of the original Inland Revenue Press Release announcing the intention to bring in the new rules and therefore IR 35 is still used as shorthand for the rules. The provisions are now found in Chapter 8 of the Income Tax (Earnings and Pensions) Act 2003.

When does it apply?

The rules apply principally to what are generally called service companies or personal service companies. These are often one man or one woman companies which charge out services to a client. The fee for these services is paid by the client to the service company.

IR 35 applies where a worker provides services under a contract between a client and a service company. For example:

Client – agency (maybe) - service company – worker

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 IR 35 applicable. If the relationship between the client and worker is a self-employed / consultant relationship then the rules are not applicable.

Why do people use service companies?

Service companies have been around for many years but have become particularly prevalent in the IT sector.

Service companies have both fiscal advantages and commercial advantages.

Fiscal 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 lowest rate of corporation tax.
  Commercial advantages:
• 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.

Why did the Government bring in the rules?

The Government saw the use of service companies increasing and considered that they were being used by some individuals to avoid paying employment income tax and national insurance.

What is the effect of IR 35?

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.

Is IR 35 a concern for the client?

All the obligations under IR 35 fall on the service company - none fall on the client. This is an advantage over the old pre-IR 35 rules so far as clients are concerned.

The old rules:

Under the pre-IR 35 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 the Inland Revenue was unlikely to challenge the position and also generally the worker or service company would have indemnified the client against this potential liability.

The current rules:

IR 35 moves, with greater certainty, the potential liability from the client to the service company.

In practice this has resulted in some workers who are using service companies seeking to alter the contractual terms to attempt to avoid an employment relationship or to increase their fees to the client to allow for the changes in the tax paid.

What differences does IR 35 make to contractual relationships?

Employment relationship?

IR 35 only applies where there is (or would be, if the worker and client contracted directly) an employment relationship. The IR 35 rules use the same tests as already existed for distinguishing employment from self employment.

Many clients will, even prior to 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).

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.

Should the terms of the contract change?

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.

It is still advisable for the client to take an indemnity in respect of tax, although the risk of a tax liability has decreased under IR 35.

Resolving issues and strategies

IR 35 has created issues for the worker by raising the significance of any uncertainties concerning whether or not an employment relationship exists. Whereas IR 35 has not really changed the liability, by moving the risks more clearly from the client to the service company it has the consequence of causing the worker to question matters more than he or she did when they simply gave an indemnity. In examining the client – worker relationship:

• The first step is to consider if there is an employment relationship
• The second step is to review contractual terms to see if more weight can be given to showing a self-employed / consultant relationship.
• If after the first two steps there still appears to be an employment relationship then there is no reason why one cannot still contract with the service company (for all the reasons explained above tax is only one element) but it may be necessary to review the particular contract and discuss the position with the worker before entering into the contract.
• The alternative is to take the worker on as an employee – however this has wide implications for their employment rights and should be carefully considered.

Conclusion

• IR 35 puts the tax obligation on the service company – the main effect of which is to create more uncertainty for the worker (and possibly to require negotiations over the fees to be paid).
• If there would be no employment relationship (if the worker dealt directly with the client) the rules do not apply.
• Contractual terms are only one part of the test of "employment" but it is helpful to review them to see if any uncertainty can be removed.
• IR 35 may give more certainty to clients that they will not be exposed to tax liabilities as a result of the status of the worker but they may still want to take indemnities.