What are the tax implications of being caught inside IR35?

It is, unfortunately, the case that IR35, Public and Private Sector off-payroll rules are something of a minefield.  It’s a complex area of tax law so it is not surprising that contractors and freelancers get confused and struggle to understand all the implications.

Although the Government announced a year’s delay to the introduction of the IR35 rule changes (due to COVID-19) on 17th March 2020, it’s still important to understand the implications and your options for when they do come into place. By planning ahead, you can ensure that you are compliant, save tax, and be ready for the changes well ahead of time. Many larger businesses are already changing the way they work with their contractors as they are concerned about backdated penalties and had already implemented changes ahead of April 2020 when the new off-payroll rules were originally due to come into effect. So, now is the time to get your house in order.

IR35 was first introduced in 2000 to ensure that contractors and freelancers, working through their limited companies, who are effectively deemed to be an employee, would pay broadly the same amount of tax as their PAYE colleagues.

Here are the tax implications of being caught inside IR35 as told by Jonathan Amponsah from The Tax Guys.

The basics

Despite the complexity of the IR35 rules, it is important to note that nearly all IR35 cases go back to the basic principles laid down in a 1968 tax case called ‘Ready Mix Concrete’. In the latest high-profile BBC cases, the Tribunal went through the three key principles of Mutuality of Obligations, Substitution and Control.

So the first thing to do before you throw in the towel and assume you are caught by IR35 is to test your working arrangements against these principles and ask yourself the following questions: Can I send in another person (substitute) to work on my behalf? Can I refuse to work and is my end client obliged to offer me work (mutuality of obligation) and what degree on control is exerted on how I do my work?

Release of a New Check Employment Status for Tax Tool

HMRC has released an enhanced version of the CEST (Check Employment Status for Tax) tool. It is understood that this tool has been rigorously tested against case law and settled cases by the taxman. HMRC promise to stand by the results produced by the tool provided the information entered is accurate.  However the test has also been widely criticised by contractors and other experts in the industry. So, if you’re still not sure about your status following the completion of this test, simply engage a specialist tax adviser or legal expert to provide you with formal advice on your situation.

Tax implications

If you’re found to be inside IR35, then the general tax implication is that you are responsible for paying income tax and National Insurance contributions on an amount called deemed payment.

You will need to calculate this deemed payment on your limited company income for the year.

This means that you deduct your Pay As You Earn (PAYE) salary, a 5% expenses allowance, plus any pension contributions.

What’s left is then treated as if it were the gross cost to the employer (deemed payment). So, let’s say if you have £100,000 income, you pay £10,000 as salaries and pay £10,000 into pensions. And let’s say you’re eligible for the 5% expenses deduction. So, the deemed payment which you will need to apply income tax and NI on will be £75,000.

In practice, if you are certain your contract is caught by IR35, then the simplest solution is to pay out all of your limited company’s income less legitimate expenses and pension contributions as a PAYE salary.

Public sector

Originally, the responsibility for determining IR35 status was placed on the contractor and not the end client. But in 2017, the rules changed for those working with public sector clients (HMRC, NHS, the MOD and the like). Here the responsibility to prove self-employment status shifted from the contractors to the public sector client. Under this rule, where a contractor is caught by IR35, they will be taxed and pay NI as an employee. There is no 5% deduction for expenses under the general IR35 deemed payment tax calculation.

Private sector

For big private organisations, the new IR35 rules set to come into place in April 2021 include something called “off-payroll working”.  Again this shifts the burden of determining the employment status of contractors or workers to the private organisation. For example, the private sector client will need to carry out an assessment of the employment status of the worker and provide a “Status Determination Statement” (SDS).

Under the new rules, if the contractor is inside IR35 then the fees paid to them, called the “direct deemed payment”, are to be treated as employment income. This means PAYE and employees National Insurance is deducted from that direct deemed payment. Then the entity paying the contractor, which could be the agency or hirer, has to pay their employment taxes on top.

Exemptions

It is important to first note that the new rules do not apply to all private sector end clients. Those clients qualifying as “small” will fall outside the scope of the new rules. The companies act definition of a small company will be used for this purpose. Therefore where the private sector client does not have a turnover of more than £10.2m, balance sheet value of more than £5.1m and employees of more than 50 (remember any two of the three tests will suffice) then it does not have to assess the employment status of its workers.

So, for contractors who are worried about the new IR35 rules, finding out a bit more about your end client might prove a worthwhile exercise.

Options under the new private sector IR35 rules

As stated above, some companies are exempt from the new rules so there is always the option of working with these companies and not with the big banks and PLCs. A second option would be simply to accept employment contract(s) with your end client(s). Alternatively, you could choose to work under an umbrella company where they deduct your taxes and pay over to HMRC.

HMRC will enquire only if it “suspects” fraud 

With the private sector IR35 changes, HMRC has recently announced that it will only use the information it gathers from the new rules to open an enquiry into earlier years if there is reason to suspect fraud or criminal activity. Whilst this will be welcome news for many contractors who are worried that a change in their status stipulated by their private sector client will lead to a costly investigation, it is worth bearing in mind that the offence of fraud (or cheating the public revenue) is wide-ranging and can catch behaviours including withholding PAYE/NI, and failing to disclose income. Greater clarification re IR35 will be needed from HMRC though it is hoped that a pragmatic approach will be taken.

If you have to close your limited company

Looking ahead, the new rules may sadly mean the end of their limited company for many contractors. If this is the situation you find yourself in, and there is cash in your company, you need to look at the tax-efficient way of closing the company down. It is possible that you can pay only 10% tax on the funds left in the company rather than high-income tax rates. HMRC may take the position that the existence of excess cash in your company means that the 10% tax may not apply. Make sure you get tax advice as you may be able to resist this argument. 

More on calculating the cost of IR35 and busting IR35 myths.