This guide is based on UK law. It was last updated in December 2018.
The rules apply principally to PSCs. 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 PSC. However, the rules can apply to other intermediaries such as partnerships.
In April 2017 the rules changed for public sector engagers who became responsible for considering the status of their freelancers operating through PSCs. Public sector engagers must operate PAYE and pay employers' national insurance contributions if they consider that the individual would have been regarded as an employee of the business if a PSC had not been used.
The government announced in the budget in October 2018 that the public sector rules will be rolled out to the private sector from April 2020, but they will not apply to small businesses. In the case of small businesses engaging freelancers through PSCs, the PSC will remain liable for applying the IR35 rules.
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.
Advantages of PSCs
PSCs have been around for many years but have become particularly prevalent in the IT, media and construction sectors. They have both fiscal advantages and commercial advantages for the individual and for the engager.
- The individual 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 potentially pay less tax).
- More expenses can be tax deducted by the PSC than by the individual 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 corporation tax, payable at lower rates than income tax.
- Under current rules, the client will not have to account for employer NICs (13.8%)
Note that the tax benefit of receiving dividends has been reduced. Under the current system, from 6 April 2018 the first £2,000 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 protection for the individual 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, making freelancers a more flexible resource.
- It can be a useful way to protect intellectual property rights.
- It gives the individual 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 individual (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 private sector client and a PSC.
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 PSC, 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 / engager and individual 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 its Check Employment Status for Tax (CEST) Tool. Whilst the HMRC guidance and CEST are useful, it is important to bear in mind that they are not necessarily definitive and merely represent HMRC's view of the case law. Although HMRC says it will be bound by the answer CEST gives, provided all the questions have been answered properly.
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 PSC 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 PSC, calculated by reference to the actual payments made to the PSC 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 PSC 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?
In the past IR35 has not been a concern for clients who engage freelancers through PSCs as the obligation to work out the employment status of the individual and, if necessary, to apply PAYE, fell on the PSC and not the client.
That has already changed for public sector clients who are now responsible for applying IR35. It is also set to change for large and medium sized businesses in the private sector from April 2020.
Private sector businesses which engage large numbers of freelancers through PSCs need to be considering the implications of the proposed changes and how they will manage the transition to the new regime.