IR35 and the Off-Payroll Working Rules
Introduction to IR35
For many years, the government and HMRC were concerned that people were using limited companies in order to unjustly reduce their tax liabilities where ‘normal’ employees were not able to.
Legislation was therefore introduced, around 20 years ago, so that the directors of (personal service) limited companies had to decide if the work that they performed for their customers was essentially that of an employee and employer relationship or on a self-employed basis.
If an employee- employer relationship existed then the directors of the company are required to put the money received from their customer through their own company payroll. The result was that both the director and the personal service company paid exactly the same amount of employment related income tax and National Insurance as if the payment had been paid directly by the company’s customer to the director-shareholder i.e. ignoring the personal service company. These rules are informally known as IR35.
IR35 firmly put the responsibility for determining employment status, dealing with the ‘paperwork’ and payroll compliance matters in the hands of the directors of the personal service company.
Before looking at IR35 and the new Off-Payroll Working Rules it would be useful to understand a little more about how employees and the self-employed are taxed.
Different types of taxes and National Insurance
The UK tax system favours self employment over employment when calculating the amount of tax and National Insurance due on an amount of earned income. If a worker is given the choice between working as an employee and being self-employed, with all other things being equal, they would favour self-employment as it would result in a lower tax bill and therefore greater net pay.
Employees and employers pay Class 1 National Insurance. This means that employees pay 12% of their earnings over £732per month, up to a limit of £50,000, and employers pay 13.8% of earnings, with no limit. This results in a combined National Insurance cost of 25.8%.
Individuals, whether employed, self-employed or directors of a limited company, pay 20% basic rate tax on their earnings up to £50,000 and then 40% thereafter (ignoring the higher rate band of 45% over £150,000). Therefore, the income tax payable it not affected by employment status, except for the ability for claim for a greater number of costs.
Limited companies pay 19% tax on profits which is very similar to the 20% basic rate tax paid by employees and the self-employed. There is actually a tax saving of 1% by trading through a limited company. From 1 April 2020, the rate of Corporation Tax falls to 17% therefore creating a 3% saving.
If a director-shareholder is a higher rate taxpayer and takes the profits from their company then they pay an additional 20% tax, having already paid 19% through the company. Therefore, an individual who is a higher rate taxpayer and who is employed, self-employed or a shareholder director would still pay around 40% total tax.
Most director-shareholders of their own limited company would take a salary of around £8,600 pa. This accrues various state pension and other social security benefits. Above this limit the same state benefits accrue but combined National Insurance of 25.8% is payable. This is why most director-shareholders take the largest proportion of their company profit through dividends.
Dividends, in excess of £2,000 pa, are taxed on an individual at 7.5%. As dividends have already been subject to 19% Corporation Tax then an effective rate of tax on dividends, based on pre-tax profit, of 6% arises. i.e. (100% - 19%) x 7.5% = 6%.
Summarising all of the above, an employee would pay 12% National Insurance on a salary whereas a director-shareholder would pay 6% tax on their dividends. In addition, the employer would also pay 13.8% National Insurance. As can be seen, being an employee is far more expensive, from a tax viewpoint, than being a director shareholder taking dividends from their own limited company.
Responsibility for determining employment status
It is for the employer to assess the employment status of their workers (whether they are employed or self-employed) before making a payment to them. Where the determined employment status is that of an employer and employee then it is for the employer to calculate the correct PAYE income tax and National Insurance and pay it over to H M Revenue & Customs each month.
If the employer incorrectly assesses the employment status, and believes that the individual is self-employed, then they would still be responsible for the underlying PAYE income tax and National Insurance. This is why it is so important that the business making the payment correctly determines the employment status of the recipient of the payment.
If the business making the payment makes an error in their determination of employment status, and it is deemed that they are an employee, then the amount received by the worker is deemed as their net pay, rather than their gross pay. The worker would therefore have no further tax or National Insurance to pay on the amount received. However, the employer would need to gross up the net pay amount and then determine what the income tax and National Insurance contributions would have been to result in the net pay amount. This becomes an expensive matter for the employer. Not only must they pay the income tax and National Insurance of their employee but they must calculate the amount due based on a higher of gross pay.
For example, say a company [the employer] pays its customer (a personal service company) £700 for what it considered to be self-employed services. If it is determined that there was actually an employer-employee relationship then the £700 received would need to be grossed-up , say to £1,000. On the gross pay of £1,000 there may be income tax of £200 and employee’s National Insurance of £100 resulting in net pay of £700. In addition, there may be £138 of employer’s National Insurance.
The result is that on a payment of £700 the employer may have to pay additional tax and National Insurance of £438. Furthermore, the individual worker would have no self-employed income tax or National Insurance to pay on their £700 ‘gross pay’ as it would be deemed as their ‘net pay.’
Where an individual is genuinely self-employed it is for the individual worker to calculate their own tax and National Insurance and to pay it over to HMRC.
The self-employed are able to claim a larger number of a business costs against their business income in order to ascertain their taxable profits. An employee is rarely able to claim any costs against their gross salary when working out the PAYE due. The taxable profits of a limited company are calculated based on the same rules as the self-employed although a limited company pays less tax and National Insurance.
What is IR35?
IR35 colloquially refers to Budget Release 35 issued by the Inland Revenue (as it was then, but HMRC now) around 20 years ago.
A few years ago, HMRC recognised that often director-shareholders of limited companies, affected by the IR35 legislation, were not correctly applying the IR35 rules. This was either through ignorance of the law, misunderstanding their employment status or simply ignoring the law. The result was that money received by personal service companies was not subject to the higher employment taxes and possibly only to Corporation Tax and dividend taxes.
The original law, which is still referred to as IR35, and is still in existence, asks the directors of a business to consider the employment status of its workers. This can be a very complex matter to decide and which relies on case law (decided by judges over the centuries) rather than clearly laid down rules through legislation.
Even with the introduction of the new rules mentioned later in this article, the people applying the rules must still consider established case law and determine the employment status of their workers i.e. whether they are employed or self-employed; as there is no halfway house.
Payments to the self-employed are not normally put through a payroll system, as this is reserved for employees. These individuals are said to be paid ‘off-payroll’.
In April 2016 a new piece of legislation was introduced known as the ‘Off-Payroll Working Rule for public sector workers’. This legislation took the responsibility away from the director-shareholders, and their own personal service company, from deciding if they should be taxed as an employee and placed the responsibility on the public sector company paying them for their work. Public sector entities are essentially government agencies. The public sector entity therefore also became responsible for deducting and paying the PAYE deductions to HMRC. The public sector entity would also be liable for any taxes not correctly deducted and paid over to HMRC.
Unfortunately, many [self-employed] workers who worked in public sector entities have been re-categorised as employees. These workers are therefore receiving less net income, due to the extra National Insurance payable.
If you look at organisations like the NHS, that use the services of thousands of locum self-employed doctors and nurses, it becomes a logistical nightmare to review the employment status of each individual worker. As a result a considerable number of genuine self-employed individuals, who have historically operated through a personal service company, may have been incorrectly reclassified through a ‘blanket’ determination as an employee and therefore taxed as such despite correctly operating through their limited company and paying the correct amount of corporate taxation.
It is argued that higher paid contractors, where there will be fewer individuals, working in specialised industries may have more of a chance of persuading the company paying them that they are self-employed or at least have a greater chance of having their employment status reviewed in more detail rather than automatically deemed as an employee.
Similar legislation is to be introduced in April 2020, known as ‘Off-Payroll Working Rule for private sector workers’ that will ensure that all large and medium sized private sector organisations must perform the same review as public sector organisations and therefore decide if the money that they pay to personal service company workers is akin to paying a salary for employment related services. Private sector entities are commercial organisation i.e. any other type of organisation that pays workers other than public sector entities.
The three separate pieces of legislation (IR35, public sector Off-Payroll working and private sector Off-Payroll working) are normally, but incorrectly, referred to simply as IR35. There are, in fact, a number of differences between the original IR35 legislation and the new public and private sector Off-Payroll Working Rules.
Differences between IR35 and the Off-Payroll Working Rules
Any costs that an employee incurs must have been incurred wholly, exclusively and necessarily in the performance of their employment for them to be claimed for tax purposes i.e. to reduce their tax liability. Meeting the ‘incurred necessarily’ test is generally difficult. The cost must also be incurred ‘in the performance of the employment’. This would make it more difficult, if not impossible, to claim for work related travel. Employees generally have to pay to get themselves to work. There is no tax deduction for home to work travel as this is not ‘incurred in the performance’ of the employment, but instead ‘to put the employee in a position’ to perform their employment.
However, the self-employed are generally able to claim for travel to their temporary work places (i.e. their customer) though not if it is a permanent or regular workplace. General business administration costs will not have been incurred necessarily for the employment.
The self-employed only have to incur costs wholly and exclusively (not necessarily) for the purpose of their trade to be able to claim them as a tax deductible cost. Employees must pass the third, and much more difficult, test of ‘necessarily’ incurring the cost to claim for costs of running their business.
Under IR35, a worker is instead permitted to claim 5% of their gross income as a tax deductible cost of running the business. This reduces their Corporation Tax payable. There is no such deduction under the Off-Payroll Rules.
If a worker is categorised as an employee, and they have no other (non-‘IR35’) company income then they would pay income tax and National Insurance on their gross income from their customer but have no ability to save Corporation Tax on the general business costs. This is because if there is no surplus income, once their deemed employment income has been deducted, to cover the business costs then a corporate tax loss would result. A corporate tax loss cannot be deducted against the taxed employment income of the individual worker.
Under IR35, the deemed salary paid (rather than the dividend drawn) is put through the company’s own payroll.
Normal employees, and those taxed under the traditional IR35 rules, accrue state benefits e.g. one of their 35 qualifying years towards their state pension. They are also eligible for holiday pay, statutory sick pay, statutory maternity and paternity pay, redundancy pay and auto-enrolment pension scheme contributions etc. They also have far more protection under employment law. None of these benefits accrual to workers subject to the Off-Payroll Rules.
Under the Off-Payroll Rules a worker is subject to income tax and National Insurance as if they were an employee but receives none of the benefits of employment. The Off-Payroll Rules focus exclusively on taxing a worker as an employee, but from nearly every other perspective they are not an employee in law.
Employment v self employment
The terms employed and self-employed are not defined by law. It is therefore not possible to say that one type of work represents employment and another self employment. It has therefore fallen to the courts over the years to look at particular circumstances of a working relationship and to decide which ones help to define employment and self-employed.
Case law has established that deciding the employment status of an individual is not a mechanical exercise of running through items on a checklist. Instead, it requires a qualitative judgment of the overall position. In other words, all the facts of the situation must be considered in their entirety, though generally some elements of the relationship would carry more importance in determining status.
Whilst there are toolkits and planning checklists etc available, there is no often definitive easy way to ascertain whether a worker is an employee of self-employed (including through a limited company).
There are many famous celebrities and broadcasters on the BBC and ITV that are currently being brought to court by H M Revenue & Customs. They have provided their services to the BBC and ITV though personal service companies. In the opinion HMRC, they should be taxed on their earnings generated through their personal service company using the IR35 rules. In most recent cases, individuals are generally winning and HMRC are losing.
Many in the accountancy and tax profession state that HMRC do not fully understand the employment status rules themselves and therefore wrongly bring cases to court at great public cost.
It is often argued that HMRC take an overly narrow view of the employment status rules in order to collect more tax. Businesses must stand up for themselves but professional support is expensive.
Determining your employment status
To consider your employment status in greater detail you may wish to review two articles on our website on Employed or self-employed - Why all the fuss? and Employed or self-employed? - that is the question.
HMRC’s guidance notes mention two particular scenarios.
The Off-Payroll rules are likely to apply where the worker is:
• required to work at the end client site
• supplied with equipment by the end client
• directed in their work by a manager or other officer of the public sector body
• leading a team
A worker is not likely to be caught by the Off-Payroll rules where they:
• works mainly from her own office
• provides her own equipment
• employs her own staff
• meets her own costs and expenses
If you consider yourself a self-employed worker then you should have little to fear regarding the new ‘IR35’ Off-Payroll working rules for the public and private sectors. It is possible that your customer may take a different view to you as to your employment status. As it is for your customer to make the decision, you may find that you are taxed as an employee rather than a self-employed worker engaged through your own company. We would therefore suggest that if your customer fundamentally disagrees with you as to your employment status that you contact them to explain why you consider yourself to be self-employed.
Owners of personal service companies should therefore considered their employment status now and if in doubt communicate with their customer. It may be possible to change the contractual terms, or agree different terms, with your customer to help demonstrate that your employment status is one of self-employment.
HMRC have created an online tool to assist employers and contractors etc to help establish employment status. HMRC will stand by the result if you answer the questions correctly, though you are not obliged to accept it if it goes the ‘wrong way’. Please see the ‘Check Employment Status for Tax’ (CEST) tool. We would suggest that you run through the sequence of questions and attempt to answer them truthfully. That should then give you an indication of your employment status.
It is widely acknowledged in the tax profession that the current CEST tool has some fundamental flaws. The tool has recently been updated by HMRC with the new rules for private sector businesses having to determine the status of their contractors before 6 April 2021.
The CEST tool is useful. However, you do not have to accept the result it gives. HMRC acknowledges that in many cases the CEST tool fails to provide an answer one way or the other. HMRC say that based on usage between November 2019 and November 2020, the tool determined that 52% (505,598) of cases were outside IR35, 29% (281,099) were within IR35, and for 19% (188,719) of cases CEST could not provide a definitive answer.
Where the CEST tool does not provide a clear answer then HMRC says you should check its Employment Status Manual. There are no prizes for guessing which side of the IR35 fence a borderline case is going to fall. Remember that CEST is just a tool. It is not compulsory to use. The courts are there to ultimately decide on the law and not HMRC.
One of the advantage of using CEST is that HMRC will stand by the result it produces as long as the data you provide is correct and entered accurately.
The consequences of being re-categorised as an employee by your customer
Being re-categorised as a deemed employee would result in paying 12% employees National Insurance and 13.8% employers National Insurance and also deducting income tax a source. All amounts should be put through a company PAYE payroll scheme.
There would be little difference in the income tax / Corporation Tax position as 19% Corporation Tax would already be payable. It is the 25.8% National Insurance cost that would be noticed the most.
From April 2016, if you work for a public sector organisation, and from April 2021, if you work for a (non-small) private sector organisation, then rather than you making the assessment about your employment status it will be at the discretion of your customer.
You can challenge the customer’s assessment. It then has 45 days to explain how it arrived at its decision.
Small companies are defined by the Companies Act 2006. A small company must meet two of the following qualifying conditions:
an annual turnover not more than £10.2m
a balance sheet total not more than £5.1m
no more than 50 employees.
If these are not met in two consecutive years the company will cease to be small.
Under the original and on-going IR35 rules it has been and will continue to be the responsibility of the directors of a personal service company to review their employment status and if necessary apply employment taxes to amounts received from their customers.
Just to be clear, if a personal service company receives money from a ‘small’ customer, as opposed to a medium-sized or large customer then the new ‘Off-Payroll Working Rule for private sector workers’ would not apply. The directors of the personal service company would therefore have to follow the original IR35 rules.