Typically, contractors have found it more tax efficient to distribute their company income as dividends, usually subject to the payment of a small salary. The IR35 legislation is designed to increase the revenue from National Insurance contributions (NIC) by introducing the concept of "deemed salary" which will be taxed and subject to NIC as if it has been paid as a salary.
The Government’s concern is that small limited companies are being used to disguise employment. In order to retain some logic to treatment of small companies under this legislation, they have had to lay down certain ground rules.
When a company provides an employee or service to a client under terms which, without the intermediary, would normally constitute employment, this is called a relevant engagement and the IR35 rules apply.
Tricky, because it’s really about considering whether the client has technically employed the services of that person. Even if the individual isn’t directly employed by the client, the "relevant engagement" rules will still apply.
You’ll be taxed according to IR35 rules on any income you get from work arising from a relevant engagement with a client. Clearly, therefore, you need to apply the correct classification to the method by which you did business with a client, so that the legislation is only enforced when appropriate.
Deemed employment or self-employment
As deemed employment will trigger the IR35 rules, it is vitally important to consider what the Inland Revenue views as being employed.
The entire IR35 site is available at the Inland Revenue.
It wouldn’t be the wisest of ideas to put complete faith in an off-the-shelf contract that describes self-employment. The parties involved need to make sure their business dealings and working relationship adhere to what’s outlined in their contract.
Internal Inland Revenue guidance on contracts states that: "The terms of a contract can be written, oral or implied, or a combination of all three."
To establish the terms of engagement the enquiring officers will need to see copies of any contract in existence, before reviewing the following for additional evidence:
• Other documentation, such as handbooks, procedures manuals and franchise agreements. These may give more information about the terms of the engagement and may also identify the conditions under which the worker is expected to operate.
• Evidence to support oral and implied terms, which might contradict the written contract. SE541 warns that the written contract may not have been implemented and that the true contract is made by oral or implied terms. These are identified from verbal agreements at the beginning of the contract, and also from working practices on a day to day basis. Guidance highlights "the prevailing practices or conventions of the particular trade or organisation."
So, in a nutshell, if you have a contract with a client, but the way in which you engage and work with that client differs from the terms in that contract, the court could regard this as a variation in the terms of the contract, and therefore view the case based upon the working relationship, rather than on a contract that bears little resemblance to reality.
Expenses available for deduction
During the calculation of the "deemed salary", certain expenses will be deducted from the income you get from relevant engagements. The most important of these is the deduction for travelling expenses.
To be clear, the following expenses are mentioned by the Inland Revenue in various consultations and FAQ publications:
• Travelling and other expenses deductible under Section 198 of the Income and Corporation Taxes Act 1988;
• Employer contributions to approved pension schemes that attract tax relief in the normal way;
• Gross salary paid plus any employer NIC on both the salary paid and any deemed payments;
• 5% of the gross income from relevant engagements to cover running costs;
• Any other expenses which don’t fall within S198 TA, but have another statutory route for deduction, such as payment of professional indemnity insurance.
So how much will it cost me if I fail IR35?
It really depends on how much your contract rate is. Generally speaking the cost to you will be the additional National Insurance contributions that are payable on the deemed salary. To calculate exactly how this would affect you, use the IR35 calculator.
How do I know whether I pass or fail IR35?
This is dependent on your contract and working practices. The easiest way to find out is to ask an expert provider for an opinion on your contract. Fees range from around £125+ VAT for a review of your contract.
Where can I find out more?
Our IR35 resources section goes into more detail, together with expert articles, a summary and the latest developments in the law.
- Setting up your company
- Contractor insurance
- Contractor finance
- Inland Revenue
Disclaimer: the information on these pages is provided for your information and reference only. Before making any important decisions regarding your employment or any legal matter, you should consult a qualified professional adviser who can provide specific advice based on your individual position.