Extract: IR35 – A Guide for Contractors

The aim of this booklet is to explain, simply, the tax rule called IR35. IR35 was introduced by the government in the 1999 Budget. Its aim is to end perceived tax abuse by several hundred thousand self-employed contractors. The government holds the view that contractors have been using self-employment to dodge due tax and National Insurance contributions. At particular issue is the use of intermediary companies. Many contractors use an intermediary companies to handle their business, administrative and tax affairs.

The government regards intermediaries as little more than a form of sleight of hand. They confirm its worst fears about the shadier side of small businesses and their accountants. In its perception, here are people who should be paying the full amount of tax but who are avoiding it by using a tax dodge. The impression is confirmed by the fact that some contractors have worked solely for one client, often over an extended period of time.

The Treasury believes that these engagements are full time employment in everything but name. Both the engaging business and the contractor or intermediary company are avoiding paying the normal tax and NI contributions. Ministers and civil servants see the opportunity to bring evaders into line and also to earn huge sums in extra revenue. The government believes that it has the moral high ground.

Its principal target were the IT contractors – around 100,000 in number – who had left full time employment before the Millennium to seek lucrative freelance assignments. Many companies were fearful that their IT systems could be hit when the year 2000 dawned. As a result, they were prepared to pay large sums to consultants who could advise them on the integrity of their systems.

Many of these new IT consultants worked – on a self-employed basis – for one company only. The government was unimpressed. It assumed that these were tax evaders who should have been properly paying PAYE under Schedule E. The government never stated that IT contractors were its main target and it rapidly became clear that all self-employed people could fall under the remit of IR35. IR35 was the short hand for the initial press release which outlined the change to the tax rules.

Two years on, a limited consultation and judicial review later, IR35 is now operational with little manifest change from what the government intended. The rough edges have been smoothed and some of the more outstanding inequalities have been edited out. The judicial review gave greater flexibility in interpretation and forced clarity in the definition of contracts which are included in the scope of IR35. But IR35 is now on the statute.

The rules were announced by the Chancellor Gordon Brown in his 1999 Budget statement. The policy is perceived as political rather than fiscal and this has caused part of the problem. It is generally accepted among tax commentators that the IT consultants were the initial target of IR35. Many of them became consultants ahead of the Millennium. Large numbers of companies were prepared to pay considerable sums of money in fees to consultants to ensure that their systems were Millennium Bug proof. Vast numbers of IT employees left their secure jobs in such companies and struck out as freelancers to make hay while the sun shone. Many of them were engaged by one company only.

After making the move to self employment, most of these contractors stayed freelance. They did not seek to join another business as a full time employee. They attempted to build up their individual firms and to draw income from a variety of sources. The Inland Revenue, on its unusually helpful website, goes into great detail to explain its tests for determining whether or not a service company is a fully fledged business or merely device for tax avoidance.

However, the Inland Revenue and Paymaster General Dawn Primarolo have said that IR35 does not target IT specialists alone – it affects everyone who operates a service company. The rules embrace everyone using an intermediary to secure and maintain an assignment. This can – and often does – include project managers, research workers, writers, photographers, gardeners and designers. If the Revenue decides that an individual complies with IR35 then they are liable for tax and National Insurance Contributions. Although the taxpayer actually pays the tax, it is the status of the contract which determines which part of his/her income is eligible for IR35 payments. So an individual can have contracts which are covered by IR35 and others which are not.

Scope of the measure

When IR35 was first introduced, the Inland Revenue said it was designed to remove the opportunity for the avoidance of tax and Class 1 National Insurance contributions. Both the Revenue and the Government believe that IR35 is not only valid but warranted.

They say that contractors are depriving the Government of justifiable revenues which could be spent on equitable social and economic projects for the greater good. The Government has stated that it hopes to attract a further Pounds 300m -Pounds 900m a year in additional revenues from IR35.

But IR35 has united a range of disparate groups in protest at its perceived unfairness. It has attracted powerful criticism from individuals, trade associations, professional bodies, large advisory firms and lobbying groups. The weight of the protest has grown rather than abated. It is the single most live issue among finance professionals, many of whom regard IR35 as an attack on liberty.

Finance professionals object strongly to the double taxation which lies at the heart of the scheme. It goes against all tenets of fairness and equity in the taxation system, they say. Freelancers, who have always assumed that they were Schedule D with all the benefits and perils which that implies, are stunned and angered. The announcement of IR35 was more than two years ago but their anger has not diluted; it has intensified.

Judicial review

This found form in a judicial review sought by the Professional Contractors Group. On 02 April 2001, Mr Justice Burton confirmed, in the High Court, that IR35 was entirely legal and not in contraction of any statute – European or UK. The decision provided clarity after months of lobbying and ultimately a judicial review. The Inland Revenue and the Government were delighted. In spite of a few small changes to the definition of employment status, the ruling had gone wholly their way.

IR35, which was so vehemently attacked, had now to be calculated and paid. The reaction of many contractors was that they would seek work outside the UK where they said that the tax regime was more favorable. In practice many of the hundreds of thousands of contractors who are affected by IR35 may find ways around the legislation. For example, IR35 does not affect individuals who own less than five per cent of their service company. Some of the loudest antagonists among the consulting community have proposed forming service companies with 21 directors. Others may seek to ensure that their contracts come from a variety of sources.

Their contention – still strongly held – is that IR35 is a measure which restricts their human rights. It effectively stops them from earning a living as they see fit. When the first proposals were issued, the critics were relieved in a way because they thought that they were so manifestly unjust that they would have to be scrapped. But the government and the Revenue made few concessions on points of principle. The burden of responsibility for complying with the new law was shifted from the employing company to the intermediary. However, the army of antagonists had not managed to move the Treasury or the taxman one inch on the basic idea that freelancers are not tax dodgers by nature.

As the measure is now law, tested by a High Court judicial review, the debates in the future will focus on case law and particularly on the interpretation of what work is covered by IR35.

IR35 came into effect on 06 April 2000 and so at 05 April 2001 the first payments under the scheme became due. Regardless of legal action by the Professional Contractors Group to end IR35, individuals and intermediaries who come under the scope of IR35 are obliged to make a return and pay any tax due.

Deemed employment

All self employed people – potentially – come under the scope of the new rules. Individual contractors and the directors of intermediary companies need to determine whether a specific contract is relevant for IR35. The Inland Revenue has set out in some detail which factors need to be considered.

For Inland Revenue purposes, every contract must be assessed to determine whether it is deemed employment. Deemed employment is a key area where interpretation comes into the picture. There are tests but there are no hard and fast rules. And an assessment made by the directors of an intermediary can be challenged by the Revenue’s inspectors.

In short, the directors need to decide whether or not a specific contract falls under the scope of IR35. The key factors which need to be considered are:

  • The nature of the signed contracts between all parties in an engagement
  • The scope of the working relationship between the intermediary and the client.

Much of the later argument in the IR35 saga has revolved around the definition of employment. The law does not include a clear and precise definition of employment. Instead what constitutes employment or self-employment is the subject of case law. IR35 looks like it will certainly be a field day for accountants and lawyers.

In establishing what is employment (and therefore what is self employment) hinges on the following test:

Is the contract at issue for service or services?

Service means employment and services freelance fee-based work. To decide which applies a further series of tests is applied. These are grouped into major, intermediary and minor factors.

Major factors cover:

  • the issue of control
  • the financial risk
  • the basis of the payment
  • any concurrent contracts
  • who provides the equipment and premises
  • who determines who does the day to day work.

Intermediary issues embrace:

  • whether the worker is part of the client organisation
  • the nature of contract notice periods
  • the length of the contract
  • any access to corporate employee benefits.

Minor factors can be more general in scope. These could be described as cultural – the way in which the worker conducts his or her business:

  • Is there, generally, a systematic approach to gaining work from a range of employers?
  • Is there investment in the business?
  • Is there a package of normal business expenses such as office rental, equipment hire and administration costs?
  • The Revenue will consider the intention of the contract and the relationship with the engaging company.

Since these are described as minor factors, presumably they will only have a real bearing if a case is borderline or becomes contentious.

For IR35 purposes, these factors and issues will decide whether a company needs to comply with the rules or is exempt.

What you need to do

  • Go through each of your contracts
  • Determine whether each is a service or services contract
  • This should be fairly obvious
  • Where there is doubt examine the list of major, intermediary and minor issues above
  • Draw up a list of contracts which fall under IR35 and one for those which do not
  • If you are convinced that your contracts do not fall under the scope of IR35 you must be prepared to argue this out with the Inland Revenue.

As we discovered in the previous chapter, virtually any freelance is covered by IR35. But being covered does not – necessarily – equate with a payment. We saw earlier in that there is a series of tests which determine whether a contract seems either to be included in or excluded from the scope of IR35.

It is essential to establish at the outset whether any contract is likely to be considered relevant for IR35. Most contractors should consider themselves for all practical purposes potentially within the reach of IR35. Then each contract must be assessed separately to determine whether on not its falls under the terms on the new rules.
It is perfectly possible that a proportion of a contractor’s work during the year will be rated for IR35 and the remainder will not be. Equally, other contractors may have no IR35 work in a given financial year and for others, all their work may come under the scope of IR35.

What needs to be done

1. A list of assignments should be created for the a particular financial year
2. The relevance of each assignment for IR35 must be recorded
3. A tally should be completed of the value in fees in the IR35 assignments and the non-IR35 assignments
4. The amount owing to the Revenue needs to be computed IMMEDIATELY
5. Contractors paying taxes related to IR35 have very little time after the end of the financial year to work out what is owing and to pay the appropriate amount.

It is a useful tip to keep an ongoing tally running during the year. Once you are certain that you have commenced all your contracts for the financial year, you have a fair idea of how much you will earn. It is a simple computation. The proportion which is IR35 earnings will be taxed on the basis of employed income and you – or your accountant – will need to get a cheque off to the Inland Revenue within a fortnight of the financial year end. The remainder will be taxced as self-employed income.

Compliance with the rules

Responsibility for compliance with the rules lies with the contractor. Initially, presumably in order to ensure that the scheme was properly applied, employing companies were responsible. But as one of the few concessions after limited consultation, the burden was shifted to the contractor. This is undoubtedly fairer even if the whole scheme is questionable.

According to the Inland Revenue’s IR35 web site

‘Anyone supplying their services through an intermediary such as a service company or partnership will need to think about the new rules.

‘But only those contracts which would have been contracts of employment with the client if the worker had worked directly to them instead of through an intermediary will be affected.

‘The most usual sorts of intermediary are service companies or partnerships which are normally under the control of the worker. The worker can then take the money out of the service company in the form of dividends instead of salary. Dividends are not liable to NICs so the worker will pay less in NICs than either a conventional employee or a self employed person.

‘If there is more than one intermediary between the client and the worker, any intermediary which makes payments direct to the worker may be affected. However, the intermediary with the direct link with the worker will normally be the intermediary responsible for complying with the legislation.

‘Individuals not in business and contracting with an intermediary on a personal basis (eg a householder engaging a plumber to fix the kitchen sink) will be specifically excluded from these new rules.

The Revenue’s web site is extremely clear and written in a coherent and logical fashion. It is a useful first point of reference but it cannot substitute for good professional advice. It should also be remembered that the Revenue welcomes IR35 and most intermediaries and contractors regard it as pernicious. This may colour any dialogue between taxman and taxpayer.

The Inland Revenue has deliberately not defined service companies precisely in order to capture the widest spread of operations. Point five of its FAQs – General on its IR35 site says ‘The legislation may affect any kind of intermediary so no particular intermediary will be defined.’ In drafting the rules, it has aimed not create any further loophole.

Again the Inland Revenue’s web site is straightforward on who applies to people working in the IT sector. This is not correct. The legislation is not targeted at any particular occupation or business sector. It can apply in any business sector where:

  • An individual (known as a worker) provides services to another person (known as the client);
  • Under arrangements involving an intermediary (such as a company or a partnership);
  • in circumstances such that if the contract had been made directly then the worker would have been an employee of the client.

‘Anyone who structures their working arrangements in this way could be affected by the legislation. Examples of occupations where people work through service companies run right across the board, including medical staff, chief executives of large plcs, legal and accountancy staff, construction industry workers, clerical workers, press officers, night club bouncers and many others.

‘Advisers need to be aware that IR35 can apply to anyone working through an intermediary, regardless of occupation. If they are giving advice to those working in this way they need to decide whether their clients are affected by the legislation and find out what action they need to take over the coming months.

‘The intermediary is normally a limited company, commonly referred to as a service company. However, a partnership could also be an intermediary. The vast majority of intermediaries are companies so this article is aimed principally at how the legislation applies to companies. There are, however, some differences in the treatment of partnerships and further guidance on these aspects can be found in the Inland Revenue’s Employment Status Manual at ESM3000 onwards.’

During the consultation process, the IR35 original proposals were softened and key changes were made to make them fairer. Its guide to the changes Ernst & Young commented: ‘Under the IR35 proposals the client company had responsibility for determining whether the engagement was caught, and thus whether PAYE/NIC should be deducted. If the client got it wrong, penalties and interest were payable. The new proposals shift responsibility onto the intermediary. This is a big improvement.

In order to make it easier for clients to know whether to apply PAYE/NIC to an engagement, a certification scheme was proposed. This would have been immensely burdensome, and has now been abandoned. From the outset, IR35 was reviled. Personal services companies saw it as an attack on their liberty and resented the attempt to tax them twice for the same piece of work. The double taxation element of the proposal angered the accountancy firms and bodies. In its guidance to the taxpayer, the Revenue says that the new rules affect all freelancers.

The Inland Revenue’s web site explains ‘The purpose of the new rules is to remove opportunities for the avoidance of tax and Class 1 National Insurance Contributions (NICs) by the use of intermediaries, such as service companies or partnerships, in circumstances where an individual worker would otherwise be an employee of the client or the income from an office’

In short, if you are self employed and you work on contract for one employer, the Revenue assumes that you are really employed by that company. The huge demand for IT freelancers in the wake of the new millennium alerted the Government and the Revenue to what they saw as the widespread abuse of the system. Although it was a happy time for IT freelancers, the burst of well rewarded work in pursuit of the Millenium Bug was by no means normal fare. Like all other self-employed people, during the usual round they have to compete for work with the best.


In a nutshell, all self employed people are potentially covered by IR35. The determination of whether you need to make IR35 will be decided by the status of the contract which you hold in a given financial year. You – and any advisers -will need to determine if these contracts are eligible for IR35 or not. You will need to be confident that your assessments are watertight and not to be found wanting in any way for any potential Revenue investigation.

Copies of the booklet are available from 0800 479 3082, which is a toll free number, with a credit card or by writing to First Stop Publishing at 248 Eden Park Avenue, Beckenham, Kent BR3 3JH with a cheque. The price is £12.49 which includes postage and package.

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