Last updated on September 5th, 2010 at 06:07 pm

What is IR35?

Back in April 2000, schedule 12 of the Finance Act 2000, IR35, was enacted into law. IR35, a controversial piece of tax legislation, was introduced by the government to tax ‘disguised employment’.

Prior to the passage of IR35, contractors who declared themselves self-employed could offer their clients personal contracted services through their own intermediary, personal service company or limited company. Contractors were able to establish an employment contract with clients that could be classified as an ‘employer-employee’ dependent relationship, while maintaining the tax privileges of their independent status. The contractor was previously able to reduce the amount of taxes and Class 1 NIC contributions that other ‘normal employees’ would be required to make. IR35 was instituted to expose these ‘disguised employees’ and close the tax loophole.

Despite governmental discussions on abolishing the ill-defined legislation, IR35 still remains in effect and has repercussions for anyone planning to start a company.

The Implications for the Self-Employed

“Getting caught” or falling within IR35 legislation can have a devastating effect on freelancers, contractors and the self-employed. The HMRC can audit accounts for up to six years in arrears and force a contractor to pay any unpaid taxes in as little as three to six months. Tax obligations under the IR35 schedule can also increase by 25% or more, forcing contractors to increase their rates to compensate for the income shortfall.

Self-Employment Check

IR35 legislation is complicated enough that a specialist contract accountant should be hired to review any contract to determine if it is subject to IR35.

The HMRC, which is responsible for investigating and auditing contracts between contractors and clients, uses a complex scheme to determine the precise relationship between the parties specified in individual contracts. For IR35 rules to apply, an individual would have to perform the service personally for the client, but not directly. The contractual arrangements would involve services rendered through the intermediary, normally the contractor’s personal service or limited company. The contractual arrangement would have to be organised in such a way that if the contractor had provided the services directly to the client, an ‘employer-employee’ relationship would exist between the two.

IR35 rules do not apply directly to a person, intermediary or limited company, but rather to individual contracts. Therefore, some contracts may include IR35 taxable income and others may not. What’s more, IR35 does not define ‘self-employment’ status. The entitlement to a 5% expense provision is not reduced even if a contract is deemed IR35 taxable.

Self-employed individuals should diversify clients and consider the following to determine if they actually pass the ‘IR35 self-employment’ test:

• Do I incur risks if the service is performed poorly?
• Does the contract allow me autonomy over work performed?
• Is there an actual physical business?
• Are there other employees?

Umbrella Companies: Why Use Them?

Despite its fee structure, using an umbrella company may be a good idea, especially as a short-term option and for contractors who are reluctant to set-up their own limited company. For starters, the contractor would essentially become a PAYE (Pay As You Earn) employee of an umbrella company, thereby making their employment status completely transparent, which is important for IR35 regulation compliance. Provided that you are not treated as a permanent employee of the umbrella company you can still remain outside the scope of IR35. An added advantage is that the umbrella company completes your expense and tax reports, freeing you from this often time consuming obligation.

However, working for an umbrella company also significantly reduces the contractor’s autonomy and representation. When considering starting an independent business, contractors should speak to a tax specialist and legal consultant, or an IR35 Accountant to determine if joining a PAYE umbrella company would be beneficial or not.