Understanding IR35

Ever since IR35 came sauntering onto the private sector scene, complete with its shiny new updates, many companies have lurched in fear of the risk it now poses to employers and their companies.

This blog answers

What is IR35 UK?

Which companies do the Off Pay-Roll IR35 rules apply to?

How do you know if you are using a disguised employee?

“I have contractors! Could they be a disguised employee? Am I in trouble? Will I be audited and fined?”

We see in the news that even the Home Office have been given an HMRC whopping bill of £29.5 million for tax and national insurance not paid. Interest accrues too on the outstanding amount. There was a further £4 million penalty for being “careless” in identifying disguised employees. 90 out of 216 off-payroll workers on the Home Office’s books had their status changed after the HMRC reviewed the assessments.

The Department of Work and Pensions (DWP) got a shock when they received a bill for an eye watering £87.9 million after they too failed to spot disguised employees and make the right tax and NI payments. What’s more, the DWP claimed to have relied on HMRC’s Check Employment Status for Tax (CEST) tool, the recommended tool for employers to check a worker’s employment status.

Using the CEST tool correctly

One of the take-aways from this is organisations still need to ensure they are answering the questions correctly if they use the CEST tool otherwise the result CEST provides (of “off-payroll rules do not apply/apply”) might be based on inaccurate responses. The HMRC will not stand by the result it gives if that is the case.

Even the UK Courts can’t even make up their minds if a football referee is a disguised employee of Professional Game Match Officials Ltd and whether tax and NI should have been deducted or not from sums paid to them for their services! This case has been bouncing its way around the courts for some time and a final decision is awaited.

Public sector bodies such as the Home Office and DWP have needed to assess off-payroll workers since April 2017 if they are the end hirer of a contractor through a Personal Service Company. However private sector organisations (who are medium or large – see below) have only had the same assessment obligations since April 2021.

All this uncertainty, all this confusion, and all this hype is not welcome! Many organisations have chosen to move away from using contractors. Some organisations may have erred on the side of caution when it comes to contractors, determining them to be an employee and resulting in them paying tax and national insurance contributions where perhaps they don’t have to.

So, let’s see if we can set straight, for our own sanity, some of the questions around IR35.

What is IR35 UK?

History Time!
In the past, a contractor could set up a limited liability company in their name with themselves as the only individual providing services through that company (a Personal Services Company (PSC)). A client of the contractor would pay the PSC (rather than the contractor). From there, the PSC could pay themselves (i.e. the individual) a salary which could be below the minimum threshold for National Insurance Contributions (NIC) and tax. If the contractor wanted more money released to him, they could pay themselves dividends as a shareholder and/or director of the PSC. These are NIC-free and tax free up to £2000. Are you married? Got a kid? - All the better! The contractor could make them shareholders and pay them (effectively themselves) further dividends. The contractor could also offset payments (such as household bills) against tax. This led to HMRC missing out on millions of pounds worth of tax revenue! Roll up a peeved, grumpy HMRC with a plan to address this…

IR35 is a piece of legislation designed to close this loophole. HMRC believes an estimated £700 million p.a. of revenue is being lost due to contractors working through PSCs as “disguised employees” of end-hirers and not paying the right tax and NICs.

Before it was up to the contractor offering their services through a PSC to decide if they were an employee of a medium/large end-hirer or genuinely self-employed (and “off-payroll”). Often it appears a contractor might be attracted to the option that meant paying less tax and NI. Ultimately the consequences principally sat with them for that decision.

Under the new IR35 process from April 2021 for medium and large end-hirers this has changed as it is the responsibility of that end-hirer to: 1) ascertain if the contractor is really a disguised employee, 2) make the correct tax and NI deductions if they think the end contractor might be a disguised employee and, 3) take on the liability for any unpaid tax if those contractors are not off-payroll.

This means that if a business was to identify a contractor as NOT being an employee, but HMRC find they ARE, the business is liable for the contractor’s unpaid tax and NICs, plus interest and potentially hefty fine!

Which companies do the Off Pay-Roll IR35 rules apply to?

For these Off-Payroll IR35 rules to apply to an end hirer they must meet the criteria of a “medium to large” company. A company must meet two of these criteria:

• The company must have an annual turnover of more than £10.2 million
• Their balance sheets (including fixed and current assets before deducting liabilities and deferred tax provisions) must be over £5.1 million
• They must employ more than 50 people.

If you don’t meet at least two of these criteria, then for now you can relax a little – it is down to the PSC to assess their contractor and make the right deductions for tax and NI! If your company does meet these criteria however and you use contractors through PSCs the Off-Payroll IR35 rules for the private sector apply to you!

How do you know if you are using a disguised employee?

Okay so you’ve ticked the boxes for a medium to large company and you work with contractors whose services are being provided through PSCs, how do you distinguish the legitimate contractors from the ones who you now must pay tax for as a result of the introduction of the Off-Payroll IR35 rules in April 2021?

When assessing a person’s employment status HMRC will look at a range of information including these factors: 

• Does the contractor have other clients?

  
  If a contractor works exclusively for you, whether because they are too busy to work for another client or because a contract forbids this, then it is an indicator they might be your employee (in disguise).
  
  

• Who has control? – Does the contractor determine what hours they work?

  
  Do they determine what the work entails and how it is done? Where it takes place? Lots of this may fall under a grey area when the contract was negotiated, but the more control that the contractor has the less likely they will have the status of an employee in the eyes of HMRC.
  
  

• Can the contractor be substituted?

  
  Can the contractor be easily swapped with another person without your agreement? If they are the only person who can do that job and no substitutes are acceptable, then this could be taken as an indication of employment.
  
  

• Does the contractor carry any risk?

  
  In the contract between contractor and company, who is bears financial risk? Employees rarely take financial risk for a company, but contractors are different; often taking on the costs equipment, vehicles and materials etc. Are there any indemnities in the contract, or is there mention of liquidated damages for any delays for example? Does work that is not right have to be put right at the expense of the contractor? Does the contractor provide their own licenses and insurance?
  
  

• Are they an integrated member of the team?

  
  HMRC will assess whether the contractor has become part of the fabric of your company. Do they have a company email, attend socials, or have equipment provided for by the company? If so, this is an indicator that they may fall into the category of an employee.

The Government, courts and businesses are still finding their feet when it comes to IR35. As such, uncertainty may continue for a while as to how the rules will be interpreted and enforced. As some cases start trickling through in respect of the public sector organisations where these rules have been in place for some years, the position might become a little clearer for private organisations facing the same rules.

In the meantime, businesses should continue to regularly take stock of their contractors and off payroll workers to make sure they aren’t disguised employees or have started to move into the employee category over time.

If you need any advice please do not hesitate to get in touch.

Further reading 

• 7 FAQs about IR35 and Off Payroll | Law 365
• IR35 Explained - Interview with Megan O'Hara and Kim Simmonds
• Law 365 explains IR35 - What you need to know (slideshare.net)
• Home Office Annual Reports and Accounts 2020-2021 
• Department for Work and Pensions – Annual Report and Accounts 2020-21