IR35: What is it? Your complete guide to off-payroll working

IR35 is designed to crack down on tax avoidance among contractors and the companies they work for.

However, following the implementation of the new IR35 rules in the private sector, there is confusion among contractors and commissioners.

Here's everything you need to know about the IR35 off-payroll working legislation rules, including what it is, its history, and how to avoid any IR35 penalties.

What is IR35? 

IR35 is the official name for off-payroll working rules and refers to a set of tax laws that came into force in April 2000 as part of the Finance Act. 

Its successor, the off-payroll tax, was introduced in April 2017, as the original legislation became complex and hard to enforce.  On paper, IR35 and off-payroll tax sound relatively simple, as you may think the distinction between an employee and a contractor is clear. 

However, the legislation is nuanced and subjective, meaning even the most well-meaning, law-abiding companies and contractors can end up in HMRC's bad books.   

The IR35 off-payroll rules were adjusted on 6 April 2024, addressing the long-standing issue of double taxation.

Before the amendment was implemented, double taxation would occur when HMRC deemed a contractor had been incorrectly placed outside of IR35 by an end-user organisation.

In these cases, HMRC did not offset the contractor’s already paid taxes when issuing businesses with tax penalties for non compliance, and instead collected more tax than it was owed.

The new rule ensures businesses can benefit from HMRC’s tax offsets already paid by contractors against PAYE liabilities.

As of April 2024, HMRC now uses a combination of ‘best judgement and assumptions’ to estimate the tax values already paid by contractors.

Deductions now include Class 2 and 4 national insurance (NI) contributions, tax on dividend payments, corporation tax, income tax, and employee NI contributions paid to contractors through intermediaries.   

Why was IR35 introduced? 

IR35 was implemented as part of HMRC's efforts to stop companies and contractors from working together as employers and employees so they could avoid certain taxes. 

Employers could save money by avoiding NI contributions and bypassing any legal obligation to honour employment rights or offer benefits. 

And in return, employees posing as contractors could pay less tax on their income.

What is a 'personal service company'? 

Many freelance workers or contractors operate as a limited company. It can add prestige to your services, separate your personal finances from those related to your business and allows you to pay yourself in a more tax-efficient way. 

For example, company directors can draw income from a combination of salary and dividends, which are taxed at a lower rate than salaries, to reduce their tax bill. This option is legal but becomes more confusing in the case of 'personal service companies' (PSC).  

A PSC is a company that has just one person as the sole shareholder and company director.

Most self-employed individuals who operate under a PSC are doing so for legitimate reasons, such as allowing them to work with clients who will only award contracts to limited companies. 

However, IR35 was implemented to weed out those who operate under a PSC for tax evasion purposes.  

Inside IR35 vs outside IR35: what’s the difference? 

The difference between an off-payroll employee (inside IR35) and someone operating as a genuine contractor (outside IR35) is how they work in the eyes of HMRC. 

For example, a contractor could rack up 40 hours per week working for just one client, working directly with them rather than via a third party. 

In this case, the only 'intermediary' is the self-employed worker's company, which is a PSC. Without it, they would be employees, meaning the person would likely be considered an off-payroll employee.  

A genuine contractor, meanwhile, would typically provide work via an external intermediary. For example, a freelance designer could work with an agency that delivers the client's creative work.

The freelancer would invoice the agency and receive payment from them, even though the work is being completed for the agency's clients.

They may occasionally work directly for the agency (creating images for their website, for example), but this will typically fall short of the hours an employee would put in or have a fixed end date. 

If you're confused, the Check Employment Status for Tax (CEST)' online tool at gov.uk is a great place to start. 

This interactive tool can help companies and individuals understand whether their relationship can be classed as employer-employee or contractor-client for tax purposes. However, it's certainly not a substitute for bespoke professional guidance.  

Who is responsible for working out employment status? 

This question doesn't have a straight answer, as it depends on both the client and the contractor.

In the public sector, the party doing the hiring (the client) is responsible for working out whether their contractor is inside or outside of IR35. If inside, whoever pays the contractor will need to make sure they deduct tax and NI contributions and appropriately report them to HMRC.  

In the private sector, an April 2021 legislation reform means that businesses classed as 'medium' or 'large' are now responsible for working out their contractors' employment status.

They'll need to inform the contractor of their decision in a 'status determination statement.' Contractors who work with small businesses will still be responsible for their employment status.    

What are the penalties for being caught inside IR35? 

The consequences of being inside IR35 (you're not really considered a contractor) are severe for both contractors and clients.  

• Contractors who were careless about their employment status but didn't know it was inaccurate can be liable for 30% of their unpaid tax bill 
• Contractors who are deceptive and know they are within IR35, but still operate as if they are self-employed, can be liable for 70% of their unpaid tax bill
• If found to be wilfully deceptive, employers will be taken to a tribunal by HMRC, where they may be asked to foot the bill for any NICs they have avoided 

Top 10 ways to fail IR35 tests 

It can be complicated to work out whether you, or any freelancers you work with, fall foul of IR35 rules. Here are the top 10 factors that indicate a freelancer or contractor are in 'disguised employment'.  

• Background: Will the contractor be doing work that an employee previously covered? 
• Previous investigations: Has your business, or the business you'll be working with, previously been reprimanded for installing contractors into roles that are within IR35? 
• Contracts: A contract that hasn't been drawn up or checked by a professional is usually in breach of IR35.
• Control: The contractor is told by the client how to complete the tasks on their contract and where and when they need to do it. Start and finish times, lunch break times and specific days of working are massive red flags.
• Substitution: If the contractor cannot be substituted or replaced by someone else to carry out their obligations, their role fails IR35. 
• Mutuality of Obligation (MOO): The contractor expects to be given work by the client, and the client expects it to subsequently be completed, meaning both parties have a mutual, often exclusive, obligation to each other.  
• Invoicing structure: True freelancers will typically invoice clients at set milestones, such as completing a project or at the end of every month, detailing the hours or number of deliverables they've completed over a set period. If a contractor has a set weekly or monthly income that resembles a salary, this could fall within IR35.  
• Equipment: If a contractor is required to use their client's equipment, there must be a legitimate reason, such as safety or security. Otherwise, the relationship risks straying into the employee-employer territory. 
• Integration into the business: While it's possible to establish long term relationships with genuine contractors and have them work alongside employees, it's easy to fail IR35 if they become too at home. For example, having their name appear on telephone lists or appointing them as a fire warden are both absolute no-nos.  
• Intentions: Explicitly stating in a contract that your relationship is a client-contractor one, not employee-employer, will help you stay outside of IR35.   

Should I speak to a professional about IR35? 

Falling foul of IR35 rules come with hefty financial penalties. However, it's not always black and white as to whether you're breaking them, no matter how diligent an employer or contractor is. 

An accountant or a financial adviser will offer impartial, practical advice on whether you're within or outside of IR35 rules.

It's always best to seek advice before proceeding rather than risk a severe financial penalty.

Get expert financial advice

IR35 is designed to stop businesses and contractors from working together as employees and employers in order to avoid taxation.

While the legislation has recently been amended to correct HMRC’s previous issues with double taxation, it can still be confusing for employers and contractors and may require expert guidance to navigate. 

If you're looking for an adviser you can trust, let us connect you with an expert financial adviser who can provide ongoing assistance with IR35 compliance.