Few contractors have not heard of IR35 – the tax avoidance legislation that in April 2021 affects many more businesses than before.
Yet a recent survey by IR35 Shield reported that the majority of in-work contractors (52%) have yet to be assessed for IR35. 86% of contractors have not been provided with vital documentation (a Key Information Document, or KID).
IR35 is tax anti-avoidance legislation originally introduced as part of the 1999 Budget. Its official title is Intermediaries Legislation although the phenomenon it identifies is also referred to as ‘off-payroll working’.
The goal is to legally define what a contractor is in terms of employment characteristics – and how it’s different from an actual employee. It ensures those who are for all intents and purposes are ’employees’ are taxed accordingly.
In this article, we examine the new IR35 requirements (initially due to come into play in April 2020 but delayed by the government). We look at what it means for businesses. This is followed by expert input providing guidance about how businesses can adapt, and also what contractors need to do.
What is IR35?
IR35 is designed to identify ‘disguised employees’, also referred to as ‘deemed employees’. These are contractors who work at a company in the same way that full-time employees do. They might have their own office desk, for example, and work the same Monday to Friday, 9am to 5pm hours.
However, the work for the business is defined by a contractual agreement and the contractor invoices for hours worked through a third-party intermediary. Most often this intermediary is a personal services company (PSC).
Other types of intermediaries are used too, but throughout this article, we refer only to a PSC.
The contractor is effectively paid for the work via a salary or dividends they take from the PSC.
There’s nothing fundamentally wrong with a contractor working through an intermediary such as a PSC – unless the contractor is a disguised employee. Working that way is considered a form of tax avoidance.
Although the contractor is indistinguishable from an actual employee, invoicing for hours via a PSC means both the contractor and employer avoid some tax and National Insurance contributions (NICs).
If IR35 applies, a contractor becomes required to pay a Deemed Employment Payment – essentially, ensuring the contractor pays the same amount of tax compared to a regular employee.
Often there’s a chain of organisations involved in employing the contractor. A company might use an agency to recruit and employ contractors, for example, in which case the agency makes payments to the PSC.
We discuss this later but, for the examples below, we assume a simple supply chain of just a single organisation paying the contractor’s PSC and benefiting from their services.
If a contractor is a disguised employee, it means they aren’t afforded benefits and rights given to actual employees, such as mandatory sick pay and holidays. This makes employing the contractor cheaper for the employer, compared to a “real” employee.
Notably, contractors who are sole traders and not invoicing via a company (that is, they invoice the employer or agency directly, on their own behalf,) aren’t affected by IR35.
This is because they pay tax and National Insurance on their earnings in the same way that an employee does, so there cannot be considered to be any tax avoidance.
Note that there has been significant discussion over recent months about an unintended consequence of new legislation included in the Finance Act 2020 that was intended to close a potential loophole relating to the new IR35 requirements.
An unintended consequence of this was that it meant umbrella companies, agencies and employers seconding employees to clients fall under the scope of IR35 (see below for definitions of these terms).
This was not the intention. HMRC is currently working to fix this error in the 2021 Finance Act.
What’s changed with the new IR35 requirements?
When introduced in 2000, the IR35 legislation said the PSC had to self-identify. In other words, it is down to the contractor themselves to examine their working conditions, determine their employment status and take action if they find they are disguised employees.
In 2017, the IR35 requirements were extended to employers for the first time, although only in the public sector.
The onus for performing the employee status determination falls to the employer rather than the contractor, meaning they need to figure out if the contractor is a disguised employee. If so, they have to pay them accordingly.
This means deducting employee tax and National Insurance contributions (NICs) at source, via PAYE, including the employer NICs too, as with any other employee.
This requirement to identify and correctly pay the relevant taxes on disguised employee contractors expands to medium/large-sized private businesses as of April 2021.
Many more contractors will be affected.
Some businesses will find themselves with a significant additional administrative burden in order to comply with IR35, not to mention a financial burden when contractors have to be transferred to their payroll and employer NICs added to the cost of hiring the contractor.
In response to the IR35 expansion, some potentially affected businesses are simply refusing to hire contractors after April 2021. The contractor is required has to join the payroll as an employee, or take their services elsewhere.
Who do the new IR35 rules apply to?
They are complex and businesses should consult a qualified expert to make a determination.
In general, a limited company is considered medium or large if two or more of the following apply in a given financial period, and also applied for the prior period:
- Annual turnover is more than £10.2m
- Balance sheet total is more than £5.1m
- The average number of employees is more than 50.
If a business is unincorporated then only the turnover figure above is used to make the identification.
The existing IR35 rules applying to public sector employers continue as before the April 2021 IR35 rule changes come into force.
As mentioned earlier, close reading of the Finance Act 2020 might indicate that IR35 also applies to umbrella companies, agencies and employers seconding employees to clients.
HMRC has stated publicly that this is an error, and that this will not apply as of 6 April 2021 when the new IR35 rules begin.
When do the new IR35 rules apply?
For medium and large private sector entities, the new rules apply to work carried out on or after 6 April 2021.
If the contractor’s work with the company ceased before this time then it falls outside the new IR35 requirements.
If the payment is for work done before 6 April 2021, and the contractor continues to work for the company, then the new IR35 requirements apply to payment made after this date for work done before this date, and all future payments.
What does my business have to do to comply with the new IR35 rules?
Both public and medium and large private employers have the following obligations as of April 2021 (although preparatory work will need to take place by the company before this date to ensure full compliance in time):
- Determine the employment status of each contracted worker who works via an intermediary ensuring that they ‘take reasonable care’ in making the determination. HMRC’s Check Employment Status for Tax (CEST) tool can be used for this.
- Once the status has been determined, provide a status determination statement (SDS). They must share the statement and the reasons for that determination to the party with which they contract, and the off payroll worker.
- Keep detailed records of contractors and their SDSs, including the reasons for the determination and fees paid. This will involve creating a system to securely maintain these records.
- Have processes in place to deal with any disagreements that arise from their determinations. Such disagreements can be made by the contractor or the company paying the contractor (the agency recruiting and paying the contractor on behalf of the business, for example). There is no time limit for making such challenges.
- Establish if you are the ‘fee payer’– see “What are the new IR35 requirements if I use an agency to hire contractors?” below – because this directly impacts who has to run the payroll for the off-payroll contractor(s).
Small businesses don’t need to do anything here because they aren’t affected by the new IR35 requirements.
Contractors should continue to make their own determinations about the nature of the engagement with the company they work for.
Working for companies that aren’t covered by the IR35 changes, such as a small private entity, will require the contractor to self-determine if IR35 covers them.
How do I know if a contractor is a deemed employee under the new IR35 requirements?
HMRC provides an online tool called Check Employment Status for Tax (CEST). This can be used to determine a worker’s tax status by answering several questions.
This can be used by the party responsible for carrying out the employment status determination – this being either the contractor, or the business they are providing services too (the client).
The legislation says ‘reasonable care’ must be taken in making determinations. Some guidance has been provided by the government on what this means.
HMRC has told chartered accounting body ICAEW that using the CEST tool satisfies this requirement, providing the information entered is accurate and the tool is used in accordance with HMRC’s guidance.
According to the ICAEW, HMRC has also confirmed with it that an SDS accompanied by the PDF outputted by CEST satisfies the requirement to provide the reasons for the determination with the SDS.
What are the new IR35 requirements if I use an agency to hire contractors?
IR35 requirements placed on an employer become a little more complicated if they don’t directly pay the PSC (and therefore the contractor).
It’s very common within the IT or construction industries for an agency or even several agencies to be used to recruit a contractor and pay them via their PSC.
Should a contractor be identified as a deemed employee, IR35 legislation identifies a fee payer for the contract.
In the simplest situation, the fee payer is the same business contracting the individual, and for whom the contractor provides work.
But often it’s an agency. Sometimes there are several agencies.
This matters because the fee payer has legal requirements when it comes to payroll – see “How do I pay a contractor who turns out to be a deemed employee under the new IR35 requirements?” below.
The business for which the contractor provides work should pass the SDS they create on to the agency, as well as to the worker.
Should there be more than one agency then the SDS should continue to be passed on down the chain until it reaches the party that pays the PSC. This is the fee-payer.
But there are some very important notes:
- The liability for deducting tax and NICs sits with the business until they pass on the SDS to the next party in the chain.
- If any party in the chain receives an SDS but fails to pass it on, they become the fee payer. A party is not liable for deducting tax and NI until they receive the SDS.
- If no other party in the supply chain meets the above conditions, the client becomes responsible.
How do I pay a contractor who turns out to be a deemed employee under the new IR35 requirements?
If a contractor is identified as a deemed employee then the fee payer – see “What are the new IR35 requirements if I use an agency to hire contractors?” above – has some specific requirements when it comes to processing the payment.
- The fee payer is responsible for calculating the PAYE, employee and employer NICs (and the apprenticeship levy, if applicable).
- The fee payer must report any payments to the PSC, or to the agency the contract is with. A Full Payment Submission (FPS) must be made through the Real Time Information (RTI) system listing the taxes and National Insurance contributions deducted. A payslip can be issued to the deemed employee, or this tax and NIC information can be listed on a remittance notice.
- The fee payer is responsible for issuing an end of year taxable summary form (P60) or end of employment taxable summary form (P45).
- The fee payer must not deduct student loan repayments, or auto-enrol the worker, or make statutory payments (SSP, SMP, etc). The PSC should do this as required.
- It’s good practice to always provide a payslip and inform the PSC how much tax has been deducted so they can reconcile, but these aren’t currently demanded by HMRC.
RTI has a new off-payroll worker flag – OPW (off payroll worker) – that must be used for deemed employees. Payroll software may need to be updated in order to offer this feature.
If you use cloud payroll software then it will be automatically updated in time for April 2021.
Fee payers can use the same payroll as for other employees, and simply deploy the OPW flag as required, or run a separate payroll where all employees have the OPW flag set.
There’s no requirement to add deemed employees to your existing payroll, unless this works best for your business.
However, you will have to create a new payroll if the payments are not otherwise reported under your existing PAYE scheme.
The tax code to use will probably be BR, because the deemed employee is considered to have a primary employment with their own intermediary.
You may need to issue a new starter checklist to the deemed employee to gather the required information.
What happens if the contractor disagrees with my IR35 classification?
You may find that a contractor or agency disagrees with your findings via CEST, and therefore your classification of them as a deemed employee.
Under the proposed client-led status disagreement process, proposed by the government, the contractor can contact you with their reasons for disagreeing.
You must then respond within 45 days, during which time you should continue to apply the rules in line with your original determination.
You might respond restating your identification of the contractor if you continue to believe that’s the case, or the new information provided by them might mean they are not a deemed employee.
You should definitely communicate with them to discuss the situation and try to uncover all the pertinent information, and continue to abide by the findings of the CEST tool in any event.
If you decide the contractor is not a deemed employee then you should communicate that to them and to the fee payer if an agency or other third party is used to pay them.
How does IR35 affect construction workers?
Sub-contractors could be affected by IR35 if they operate as an incorporated business. IR35 takes precedence over the Construction Industry Scheme (CIS) requirements, although both seek to withhold tax and National Insurance at source.
In other words, medium or large construction contractors falling within the new IR35 requirements should always consider incorporated sub-contractors as deemed employees if the IR35 rules outlined above apply.
They should therefore not apply the CIS.
Guidance for businesses adopting the new IR35 requirements
Jill Smith is Policy Operations Manager at The Chartered Institute of Payroll Professionals (CIPP) and provides the following five pieces of advice for businesses finding themselves having to adapt to the new IR35 requirements. The CIPP offers an IR35 webinar.
Start the process now
Start the preparation. You’re going to need good communication skills across the team, or your organisation. It’s got to be a team effort.
Who’s going to manage the changes required within your business and ensure the right people from the areas across the business are involved and committed? Look at budget constraints.
What impact is this going to have on your company?
What does your current workforce look like?
Your organisation needs to review current contractor engagements. Ensure any intermediaries such as PSCs are identified. Safeguard the business from risk by undertaking due diligence on your labour supply chain.
Were the workers sourced through a third party such as an agency? That’s really important.
How are you going to assess the employment status of each worker that you’ve got, to have a clear and consistent methodology in the company?
Decide how the status determinations will be made
Some companies, such as Lloyds Bank, are taking a blanket approach. The CIPP suggests avoiding a blanket approach to determinations.
Make sure each status determination statement you do is separate for each individual and each engagement because it could be very different.
You need to consider a process to assess whether the status of workers may have changed or it may change over a period of time.
Communicate with the contractors
At the CIPP, we suggest that if you are going to use the CEST tool to make your assessment you consider doing it together with the contractor.
Have a process within the company when you’re asking the questions required for CEST – ensure you’ve gone through the CEST tool and know what’s going to be asked, so you can gather in advance all the information you will need to answer each question.
There are some questions it asks around whether yours is the worker’s only employment.
If you haven’t got good communications with the worker, you might not know the answer but if you complete the CEST tool together you will have all the information you need.
Train your staff
Who’s going to be responsible for the changes within the organisation, and do they understand the rules?
Factor in staff training requirements, consider the need to outsource any specialist knowledge and advice.
Ensure anybody you outsource to is reputable.
Guidance for contractors about the new IR35 requirements
Dave Chaplin is founder and CEO of ContractorCalculator.co.uk, which has been advising contractors about IR35 since its introduction. His website IR35shield.co.uk offers several IR35 tools to help determine employment status.
Here, he offers some advice to any contractor concerned about the new IR35 requirements.
Chaplin says: “There’s a misconception. Contractors are saying, ‘Oh, now I need to learn about IR35…’ Well, you should’ve known about IR35 20 years ago. IR35 has always applied to you.
“What’s changed is that the determination on the status has moved to the client and there is a different tax calculation. It’s new legislation. But the concept of a deemed employee has been around for 20 years.
“Contractors need to be informing their clients and encouraging them to start looking at this as soon as they possibly can.
“The danger is that, if the client runs out of time, they’ll introduce a blanket policy that says we won’t hire anyone who’s working through a limited company. That’s what banks have done. There’s nothing to stop other firms doing it.
“The risk to the client is that their contractors will go and work somewhere else, or they will have to pay them considerably more. So, if the client is sensitive to the commercial fallout, then they need to be alerted by the contractor as soon as possible.
“Clients and contractors need to avoid the cliff-edge scenario.
“Agencies and firms need to work together too and, particularly, contractors need to encourage the agency to work closely with the client to make sure that the agency themselves are going to be happy with the determinations.
“The contractor needs to have the SDS paperwork to give themselves comfort. If they don’t have the paperwork then they might want to consider working somewhere else, where they can get the evidence that shows that they are outside of IR35.”
IR35: What now?
This article has provided guidance about IR35 but there remain a significant number of unknowns around the legislation and its implementation.
It’s been reported that the government is reviewing IR35 in light of this lack of understanding.
If nothing else, the accounting impact for medium and large businesses is going to be significant – those paying the contractor will have to examine their double-entry and accounting processes.
There are now specific insurance products for contractors to protect them from the consequences of IR35.
The insurance attempts to protect the contractor from the cost of an HMRC investigation and any resulting back tax, interest and penalties (depending on the level of insurance taken out).
Might we also expect similar insurance products for business/fee-payers? Only time will tell but this certainly should be considered by businesses.
Editor’s note: This article was first published in March 2020 and has been updated for relevance.