Despite controversy and calls for the government to reconsider their plans, the changes to IR35 will be implemented in April 2020. But what exactly are the IR35 rules, and what can you do to prepare for these changes? This blog takes a look at the IR35 legislation and aims to answer some of your burning questions.
What is IR35?
Contractors who work through an intermediary, such as a personal service company, enjoy a certain level of tax efficiency. While they are not entitled to employee benefits such as holiday pay or sick pay, their tax status often enables them to take home more net pay than an employee in the same role. The benefit for an employer of hiring an individual in this way is that they don’t have to organise PAYE or contribute to National Insurance. Brought into law in April 2000, IR35 was designed to crackdown on the use of this corporate structure as a means of avoiding tax.
How does it work?
IR35 effectively determines whether an individual is a bona fide contractor or a ‘disguised employee’ for the purposes of paying tax. If it is concluded that an individual is a ‘disguised employee’, they will be deemed to be inside IR35 and will be subject to National Insurance and Income Tax. If it is concluded that an individual is actually a contractor, then they will be deemed to be outside IR35 and will not be caught by the rules.
Most of the questions that need to be answered in order to determine whether an arrangement will be caught by the IR35 legislation are relatively straightforward and are set out in the legislation itself. However, one of the key questions that needs to be answered is whether the worker would have been an employee of the client if they had been working directly for it, and this question is less straightforward. HMRC has provided guidance on the factors that it considers to be the most important in determining an individual’s employment status. These factors include whether there is personal service, mutuality of obligation, employee-type benefits and whether the individual provides his or her own equipment.
What are the IR35 changes?
Extension to private sector
In April 2020, IR35 will be extended to the private sector for large and medium-sized organisations. The 2020 changes will bring IR35 in the private sector into line with the public sector by shifting the liability for defining a worker as employed or self-employed from the individual to the organisation which engages them. The public sector, including major employers such as the NHS, have been responsible for this since April 2017. It will therefore be the private sector end user who will be the subject of any HMRC enquiry and of any demand for tax due.
Exemption for small companies
In the public sector, where the IR35 rules already apply, the size of an organisation is irrelevant. However, in the private sector, HMRC has confirmed that small companies will be excluded from the new rules. The government has estimated that, as a result of the exception, 95% of end users will not need to apply the reform. But what is classed as a small company?
In its latest guidance, HMRC has defined a small company as a limited company that meets at least two of the following criteria:
- An annual turnover of not more than £10.2 million;
- A Balance Sheet total of not more than £5.1 million; and/or
- Not more than 50 employees.
Where a private company satisfies these requirements, the individual will continue to ‘self-assess’ and account for Income Tax and National Insurance where it is concluded that the rules apply. Where a private company does not satisfy these requirements, they will be subject to IR35. Until the draft legislation is published, we cannot say for sure how this exception will be applied to unincorporated entities and limited liability partnerships.
What can you do to prepare?
The 2020 changes to IR35 are being introduced to make life easier for HMRC. Instead of pursuing thousands of individual workers, HMRC will pursue large employers, at a fraction of the recovery and administration costs.
Although the changes will not come into force until 2020, organisation is key. Large and medium-sized organisations should consider undertaking a review of their use of contractors, setting out who they are currently contracting with and on what basis. Organisations can also make use of an online tool called CEST, however this should be approached with caution. CEST has come under criticism in the past few months and should not be used as a substitute for a full and proper investigation.
As part of their review, large and medium-sized organisations should evaluate any contracts that they have in place with individual contractors. In order to limit the risk of IR35 applying, some of the following should be considered:
- Including a right of substitution clause within the contract. This clause should be drafted so that it is as wide-ranging as possible.
- Avoiding an obligation to provide and accept work. Including a notice period may point towards a conclusion that there is a mutuality of obligation, so this should be avoided.
- Structuring contracts, where possible, by reference to completion of a project or a piece of work, rather than by duration. Similarly, payment should be structured by reference to completion of a project, rather than time worked.
- If possible, requiring the individual to provide their own equipment, rather than providing equipment to them.
- Integrating the individual into the company no more than is absolutely necessary.
- Although not determinative, stating in the contract that the relationship is not intended to be one of employment.
Whilst it is important that contracts are drafted in such a way as to reduce the risk of IR35 applying, it is also important that the practical reality is in accordance with those terms. A carefully drafted contract will not avoid being caught by IR35, unless it also reflects the reality of the situation. IR35 is a complex area of law so speaking to a lawyer or tax specialist early on and before starting your review is recommended.
The cases brought against public sector employees have highlighted the fact sensitive nature of the legislation. Currently no easily applicable checklist exists making it difficult for big businesses to apply blanket procedures to ensure adherence to IR35 with multiple contractors. The government promised to improve the employment status tests in the Good Work Plan but is yet to do so. Unfortunately at this time employee status will be best analysed on a case by case basis.
The changes to IR35 will throw up all sorts of administrative challenges for large and medium-sized organisations. Those who start planning now will find themselves ahead of the game and ensure that the right level of resource is in place when needed. If you are a business and you think that IR35 may impact upon your operations then do get in touch.