Understanding IR35 and How It Affects Your Tax Liability

IR35 is a crucial piece of UK tax legislation that affects contractors, freelancers, and businesses that engage with them. Understanding IR35 is essential for ensuring compliance with HMRC regulations and avoiding potential tax liabilities. In this guide, we’ll explore what IR35 is, how it works, and its impact on your tax liability as a business owner or contractor.

What Is IR35?

IR35, also known as the off-payroll working rules, was introduced by HMRC in April 2000 to tackle tax avoidance. It aims to prevent disguised employment, where individuals provide services to clients through an intermediary (such as a limited company) but operate similarly to employees. By using a limited company, contractors can benefit from tax advantages such as lower National Insurance contributions (NICs) and dividend payments.

Under IR35, HMRC assesses whether a contractor is genuinely self-employed or should be classified as an employee for tax purposes. If a contractor falls inside IR35, they must pay income tax and NICs similar to an employee.

Who Does IR35 Affect?

IR35 impacts individuals who provide services through an intermediary, such as a personal service company (PSC), and businesses that hire contractors. The rules vary depending on whether the client is in the private or public sector:

• Public Sector: Since April 2017, the responsibility for determining IR35 status has been on the end client (the organisation hiring the contractor).

• Private Sector: Since April 2021, medium and large businesses have been responsible for determining a contractor’s IR35 status. Small businesses are exempt from these rules, meaning the contractor remains responsible for assessing their own status.

How Is IR35 Status Determined?

To establish whether a contractor falls inside or outside IR35, HMRC considers several factors, including:

1. Control: Does the client control how, when, and where the contractor works? A high level of control suggests employment status.

2. Substitution: Can the contractor send a substitute to complete the work? If not, this indicates employment.

3. Mutuality of Obligation (MOO): Is there an ongoing obligation for the client to provide work and for the contractor to accept it? If so, this implies an employment relationship.

   
   

Other factors, such as financial risk, provision of equipment, and the contractor’s level of integration within the company, also play a role in determining IR35 status.

How Does IR35 Affect Your Tax Liability?

If a contractor is found to be inside IR35, they must pay income tax and NICs as if they were an employee. However, they do not receive employment rights such as sick pay, holiday pay, or pensions. The financial impact includes:

• Higher tax deductions compared to an outside IR35 contractor.

• Employer’s National Insurance Contributions (13.8%) payable by the client in applicable cases.

• Reduced take-home pay due to PAYE taxation.

For businesses, failing to properly determine IR35 status can result in significant penalties from HMRC, including backdated tax and fines.

How to Ensure Compliance with IR35

To stay compliant with IR35 rules, businesses and contractors should:

• Conduct regular IR35 assessments using HMRC’s Check Employment Status for Tax (CEST) tool.

• Review contracts to ensure they reflect genuine self-employment arrangements.

• Seek professional advice from an accountant or tax specialist.

• Maintain detailed records to demonstrate compliance in case of an HMRC audit.

Final Thoughts

IR35 is a complex piece of legislation with significant tax implications for both contractors and businesses. Understanding and adhering to the rules is essential to avoid financial penalties and ensure fair tax treatment. If you’re unsure about your IR35 status, consulting an experienced accountant can help you navigate the regulations and optimise your tax position.

To find out more, and to receive expert advice on how to ensure your own tax efficiency, get in touch today.