The IR35 legislation has been one of the most complicated and controversial policies employers have had to contend with. This is especially true for employers operating in the STEM sector, which relies heavily on contractors.
In the mini-budget announced in September 2022, former Chancellor Kwasi Kwarteng stated that the controversial rules concerning off-payroll working introduced in 2017 and 2021 would be repealed. However, this decision was reversed by the now Chancellor, Jeremy Hunt, on 17 October 2022.
If you’re looking to hire contractors and wish to know how to approach the process or one of your contractors is unsure whether they're an employee or off-payroll, to help you, we’ve put together this helpful guide that covers all the key considerations.
Quickly jump to a section:
- What is IR35?
- How does IR35 apply?
- What does inside of IR35 mean?
- What does outside IR35 mean?
- What do I need to be aware of when conducting a status determination summary?
- What are the off-payroll rules?
- Will IR35 be scrapped?
- Does IR35 apply to international contractors?
Also known as the ‘off-payroll working rules’, IR35 is a piece of legislation that was brought in to try and ensure that contractors providing services through their own companies (or another intermediary) pay approximately the same amount of income tax and National Insurance (NI) as an employee. Contractors are sometimes known as ‘disguised employees’.
Since April 2021, ‘medium’ and ‘large’ businesses have been responsible for deciding whether the IR35 rules apply to their contractors on a case-by-case basis. They join public sector bodies, who have been similarly responsible since April 2017.
Suppose a contractor provides services to a business in the public or private sector. In that case, it's the responsibility of the contractor’s intermediary to decide their correct status and whether the rules apply to their situation.
What is an intermediary for IR35?
An intermediary will usually be the worker’s own personal service company, but could also be any of the following:
- A partnership
- A personal service company
- An individual
The client is the organisation who is or will be receiving the services of a contractor. They may also be known as the engager, hirer or end client.
What happens if the IR35 rules are deemed to apply?
If the rules are deemed to apply, then income tax and national insurance contributions must be deducted at source from the fees payable and paid over to HMRC (together with any applicable employer NI contributions) in much the same way as would be the case if the person was a standard employee on the payroll.
What qualifies as a ‘small’ business for IR35 purposes?
A business will be classified as ‘small’ if it trades in the private sector and satisfies two or more of the following criteria, which are taken from the Companies Act 2006:
- It has an annual turnover not exceeding £10.2m
- It has a balance sheet total of not more than £5.1m
- It had an average of no more than 50 employees for the company’s financial year
Unincorporated businesses and sole traders will only need to consider the turnover test.
A business may start as ‘small’. Still, if they break through the above threshold, the responsibility for determination will pass from the intermediary to the company directors or HR department.
How do I determine the worker status of an IT contractor?
As a result of the complexity of modern contracting, there can be no guarantee of correct worker status determination.
Ultimately, the only true arbiter of correct determination is HMRC. The HMRC’s Check Employment Status for Tax (CEST) tool sets out the factors that should be foremost in your thoughts when hiring IT workers.
- Will the worker be an office holder (i.e. board member, treasurer, trustee, company director or company secretary)?
- Will the worker have any management responsibilities?
- How will they introduce themselves to third parties, such as consumers and suppliers (working for you, working independently on your behalf, or working for their own business)?
- Does the contract have a substitution clause?
- Do you have the right to reject a substitute?
- Would the worker have to pay their substitute?
Control and supervision
- Do you have the right to move the worker from their original task, or would that require agreement or a new contract?
- Do you decide how the work is done? Or does the worker decide?
- Do you decide their working hours?
- Do you decide on the working location?
- Do you know which individual contractor will be carrying out the work?
Worker financial risk
- Does the worker have to buy equipment, fund any vehicle or other costs (including non-commuting travel, accommodation of external business premises, etc.) for this work before you pay them?
- Will the worker be paid on a time basis, a fixed project price, or a percentage commission split?
- Would the worker have to put the mistakes at their own cost?
- Will there be any paid-for corporate benefits such as gym memberships, health insurance or retail discounts, etc.?
- Does the contract stop the worker from doing similar work for other organisations?
- Is the worker required to ask permission to work for other organisations?
- Will the work take up most of the worker’s available working time?
- Has the worker done any self-employed work of a similar nature for other clients in the last 12 months?
Ongoing contracting arrangements
- Has the worker had a previous contract with your business?
- Does the current contract allow for it to be extended?
- Is the current contract the first in a series of agreed contracts with your business?
What is a status determination summary (SDS)?
The above factors help gauge whether the contract bears the hallmarks of a genuine self-employed, business-to-business relationship or is more akin to an employment relationship.
The more a worker is taking on financial risk, having autonomy on their working methods, hours, and location, not having guaranteed work or corporate benefits, servicing other clients, being paid fixed prices for fixed projects, and with the ability to substitute their services for those of another, then the greater likelihood they would be determined as self-employed, and therefore responsible for their tax and NI payments.
Likewise, if a worker is given personal roles with little autonomy, changing tasks under supervision, perhaps even with line management responsibilities, being paid an hourly rate or day rate, and with no financial risk, then it's likely that this would be determined as disguised employment. Therefore, the contract would be subject to deductions for tax and NI.
If the HMRC decides that a contractor is ‘inside IR35’ the person will be reclassified as an employee and must be paid through PAYE. However, the employee status only applies for tax purposes.
they're not entitled to any other employee protections, for example, those provided under the Employment Rights Act 1996.
Being classified as ‘outside IR35’ means the person is, in fact, a contractor and will pay their own tax either through self-assessment or, if they're a company, corporation tax.
SDS: Inside IR35 / Off-Payroll rules
If the SDS decides that the off-payroll rules apply, you should be prepared to deal with a disagreement from the contractor.
You have 45 days to respond to any challenge to an SDS. You should consider the reasons for the disagreement and decide whether your determination is right or not, providing reasons for this.
Suppose the determination remains that the off-payroll rules apply and your organisation engages directly with the worker’s personal service company (PSC). In that case, the contractor must be enrolled in your business payroll system, with appropriate tax and NICs deducted before the net payment is made to the contractor’s PSC.
Where an agency or another organisation is in the chain of engagement with the PSC, your organisation must still issue an SDS
Still, it's the last organisation in the chain before the PSC that has to deduct appropriate tax and NICs before the payment is made to the PSC
SDS: Outside IR35 / Off-Payroll rules
- If the decision in the SDS is that the off-payroll rules do not apply to the contractor, you (or the last organisation in the chain before the PSC) do not have to make deductions for tax and NICs and can continue to make gross payments to the PSC
- You should remember that if the working practices of the engagement change or you negotiate a new contract with the PSC, you should re-check the rules to see if this changes the SDS
In 2017 the government introduced new legislation to reform IR35 for the public sector, shifting the liability and risk for determining IR35 status to the public sector client.
These rules require public sector bodies who are the end client of the contractor’s services, to decide if any of their contractors, who provided services through a PSC, fall under the off-payroll rules.
If so, the public body has to advise all relevant parties and make payroll deductions before payment to the PSC.
Similar reforms around IR35 compliance were introduced for private sector companies on 6 April 2021.
If your organisation meets the criteria to implement the new rules, engages contractors through a PSC, and is the end client of the services, you must take the following action:
- Review each engagement with a contractor to determine whether the IR35 rules apply
- Using ‘reasonable care’, prepare a Status Determination Statement (SDS) for each contractor
- Issue the SDS to your contractor and their PSC
- If contracting the contractor through an agency, the SDS should be issued to the agency and other parties in the supply chain for the contractor
- Establish a disagreement process for a contractor to challenge an issued SDS
How do you manage your contractor relationships so they fall outside IR35 rules?
1. Defined provision of services – the contractor should know exactly what work is entailed in the contract with the client.
Each part of the service should be described in detail, with some expression of the desired outcome of the provision of the parts of the service and the service as a whole.
So if a contractor is handed a job description of a role detailing responsibilities, skills required, and outcomes looked for, which they will be expected to cover for a defined period.
They go in and perform the role described in the job description with no expectation of definite or indefinite extension beyond the term of the agreement. This could be seen as consistent with the definition of how services are to be provided.
2. Control – the contractor should not be told that they will be directed, supervised, or controlled by the customer or a customer representative.
To avoid IR35, the primary focus should, if possible, be on the ends and not the means.
This boils down to a question of terminology - every supplier of a business is directed by the customer's representative, and in every business-to-business relationship, one party 'controls' or is dominant in the relationship; this is most often the party which pays.
The party offering payment consideration is typically expected to give the payor what it wants.
3. Substitution – the contractor should be permitted to allow someone else to complete work or aspects of work in the contractor’s place as part of the contract.
Many, if not most, contractors work independently. They do not, therefore, have employees or agreements in place with other contractors to provide services in their place should they find themselves unable to proceed.
These contractors are generally required to accept the risk of not being able to meet this contractual obligation and therefore breach their agreement(s) specifically to avoid the applicability of IR35 regulation.
4. Mutuality of obligation – any further work in addition to previous work done for the client should be covered by a separate contract and agreement.
The contractor must not be obliged to do work for the client/agency, and the client/agency must not feel obliged to offer the contractor any more work than what was agreed in advance.
Contracts, which would otherwise fall outside IR35 regulations, run into issues here where a contractual engagement is extended, and so, consultants need to ensure that any extension is documented and signed by both parties as a new agreement on the terms of, or as amendments to the contract in place.
Consultants should never sign a contract which does not include a term or agree to a period which exceeds two years.
5. Contract termination – the contract should be for a defined project and should end when that project has been completed to the client’s satisfaction.
The contract covering the work should be based on a realistic, estimated timeframe in which the work can be completed.
Not all contracts are time-limited or have clearly defined outcomes.
Take 'agile' software development contracts, for example; milestones and outcomes are broadly defined at the outset.
Still, an agile process evolves as it progresses and can extend in time. This is true for service providers who are not contractors and is not a reasonable indicator that an individual is employed.
6. Financial risk – a contractor, should have professional indemnity insurance at the very minimum and agree to remedial work when needed and when caused by something the contractor has or hasn’t done or has done entirely wrong.
This is an accurate indicator of a contractor's independence and should be required by every client/recruitment business as an indicator of true independence.
Contractors, meanwhile, should be careful to limit their company's liability within or to the extent of the insurance on which they can rely.
7. Payment – the agreement on how the contractor is paid should look and feel like those that exist between companies and should not look and feel like a succession of paydays. Clients should be billed by the hour, by the day, or by the project.
If a contractor were to be paid on delivery of the services, then they would be asked to provide the entirety of the services OR deliverable milestones before being entitled to present an invoice in the same way that a web design / build business developing the services described as the contract on which 'Alan' might be engaged would.
'Alan', however, may bill monthly, which may appear to create a succession of paydays (particularly if, as many intermediaries indicate in their contracts, acceptable invoices will be paid, in arrears, on or before a specific date each month).
8. Exclusivity – the contracting organisation should in no way impede the contractor from working for other companies when they like, even if a client is a competitor of the contracting organisation. The obvious issue here is one of control, as indicated above.
Where the service provider is a company with staff, there might be a non-compete clause in the agreement.
As mentioned, the contractor is typically an individual working alone and can't be in two places simultaneously.
Suppose a client wants a certain number of hours/days a week to be spent on a contract/project. In that case, typically, a contractor will accept that obligation, and its relationships with other clients might suffer unless the individual is willing to work extended hours.
9. Equipment and premises – ideally, the contractor should provide the equipment used on a job.
The contractor should keep receipts for the equipment and demonstrate that they're in charge of upkeeping and maintaining their equipment. In many fields (e.g. legal, HR, IT, marketing), there aren't many contract roles which don't require a contractor to work whilst connected to their client's open server systems.
As indicated, few clients will provide access over a secure connection. So, for security and data protection reasons, most, if not all, require company equipment to be used, and in many circumstances, it's in the interests of consultants to comply.
Perhaps a more appropriate measure would be the extent to which a consultant might use client equipment for personal use (indicating treatment of the client's machine as 'theirs' and acting with it as might an employee) and the extent to which a contractor might need to modify their premises (home office) to accommodate the use of client equipment, etc. which is more often the case.
10. Intention – the contract should show that the contractor and the contracting organisations are separate and that there is no employer-employee relationship. There should be a clause to this effect in every contract for an arms-length, contractual engagement which is not subject to IR35 regulation.
The Chancellor of the Exchequer, Jeremy Hunt, has chosen to scrap the plans to repeal the Off-payroll IR35 Reforms, which Kwasi Kwarteng previously announced in his mini-budget on 23 September 2022.
For IR35 purposes, no UK employment taxes should be payable by a company in respect of non-UK tax resident contractors engaged through PSCs if all their work is undertaken overseas, and the contractor does not enter the UK for their role.
Get legal assistance from LawBite
If you’re in any doubt as to whether a contractor is inside IR35 or outside IR35, would like a contract for a contractor drafted, or are looking for general advice or support in this area, you can speak to one of our expert lawyers.
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