IR35: What is IR35 Tax?

If you work as a contractor or freelancer, you’ll need to be aware of the IR35 legislation, which expanded its qualifying criteria as of April 6th 2021.

IR35 is a piece of tax legislation designed to stop companies from employing contractors as “disguised employees.” While IR35 had previously been present within the public sector, it’s now been rolled out across private organisations, impacting roughly 60,000 businesses, 20,000 agencies and 500,000 contractors across the UK.

Under the new legislation, companies must determine whether contractors work regularly enough to fall within the scope. The ‘hirers’ (business taking on the contractor) are now responsible for deciding whether contractors fall within or outside the scope of IR35, which impacts the amount of tax the contractor must pay.

Keep reading to learn more about:

• What is IR35 tax
• Why is IR35 happening?
• How does IR35 work?
• What tax do contractors need to pay?
• The financial impact of IR35

IR35 essentially looks to better define the difference between an employee and a contractor.

• Employee. Individuals are employed by a business, most-likely report to a manager, receive a salary regardless of performance and qualify for employee benefits.
• Contractor. Contractors are paid for the level of work they carry out, which can last months to a few years, but they may be assigned for a fixed period and only carry out a specific project. 

Previously, some companies had used this as a ‘loophole’ to avoid paying tax, provide employee benefits and keep control of a short-term, easy-to-let-go workforce. Contractors can prove to be more affordable to companies as they do not need to pay employers National Insurance, pension contributions or provide paid holidays or sick leave.

IR35 has come into effect in an attempt to claw back some of the lost tax contributions from off-payroll contractors or “disguised employees.” Research from HMRC suggests that this change could result in an additional £1.3 billion in taxes for the UK government.

Under IR35 legislation, businesses will need to determine whether an individual is working ‘inside’ or ‘outside’ IR35 using a set of clear guidelines. Companies should take an individual approach to assess each contractor based on the following criteria:

How much control does the company have over a contractor’s day-to-day responsibilities? The more control, the more likely the individual is working inside IR35.

Can the contractor send another individual in their place? The harder this becomes, the more likely the individual is working inside IR35.

Working as a contractor comes with a degree of financial risk, especially as contractors are typically expected to correct any errors in their own time.

Is the company obligated to provide work, and is the individual bound to accept? The more this mutual agreement exists, the more likely the individual is working inside IR35.

Does the individual receive the same benefits as permanent employees like gym memberships, company cars, etc.? The more benefits the individual receives, the more likely they are to be inside IR35.

If you’re unsure if you call inside or outside IR35, you can use HMRC’s online tool to check your employment status. 

IR35 aims to make sure contractors and employees pay the right amount of tax. Businesses are primarily responsible for determining whether someone is inside or outside IR35, but HMRC can appoint an investigator if a contractor exhibits suspicious behaviour.

Individuals that fall within IR35 are treated as employees for tax purposes and must pay income tax, National Insurance and pension contributions through PAYE operated by their company.

Contractors trading via a limited company inside IR35 must pay the following in tax:

• Employers National Insurance of 12% for all gross earnings
• Employees National Insurance of 11% on all income within the lower bracket
• Employers National Insurance of 1% on all income within the upper bracket
• Income tax at a variable rate depending on the level of income

Contractors must complete a deemed salary/Schedule E calculation each tax year for the income they receive. Within this deemed salary, contractors can claim an expense allowance of 5% of the income received to cover administrative costs like premise costs, accountancy, stationary, training costs, etc. You can also claim direct expenses like travel, computer costs, subsistence, etc.

Contractors inside IR35 can also still take advantage of the Flat Rate VAT scheme. However, overall the taxes applied are closer to that of an employee and, as such, give less favourable terms for reducing your end of the year tax bill.

Contractors that fall outside IR35 won’t receive employee benefits, but they can manage their own taxes, deduct expenses and charge VAT. By operating outside of IR35, you can pay yourself a salary, take dividends, claim all costs and manage your taxes as usual.

While your tax bill will be largely reduced, you’ll still need to pay corporation tax of 19% on all profits after accounting for trade expenses. Find out more about the taxes businesses must pay here.

With IR35, the difference in take-home pay between a contractor inside and outside IR35 is quite significant. The below table shows the change in tax liabilities for contractors within IR35.

(image source)

Suppose you’re legitimately working as a contractor and believe you should fall outside IR35. In that case, there are some actions you can take to challenge an incorrect decision or, at least, ease the financial impact.

You may want to consider getting legal advice and having your contract reviewed by an IR35 expert. Legal experts can also help you create an agreement with the best chance of falling outside IR35.

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