Independent contractors and freelancers in the UK need to understand what IR35 means. This article covers everything you need to know about IR35, including how you can stay compliant while hiring contractors in the UK.
What is IR35?
In 2000, The UK government introduced IR35 (also known as the off-payroll working regulations) to combat tax avoidance by workers who offer their services via an intermediary, such as a limited company or a personal service company.
Before the introduction of IR35 rules, many individuals who would have been considered employees if they had worked directly for their clients could establish their own businesses and operate through them. This resulted in a substantial loss of tax revenue for the government.
The primary objective of IR35 is to ensure that individuals who work as employees pay roughly the same amount of tax and national insurance contributions as those their customers directly employ. This is accomplished by determining whether a contractor is an actual independent contractor or an employee.
Discover how to manage tax deductions for your independent contractors in 2023 here.
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Key aspects of IR35
The three criteria determining whether an independent contractor should be classified as an employee for tax purposes are the core of IR35 rules. These aspects are the control, substitution, and mutual obligation tests.
The control test determines whether the contractor can direct how the contractor performs or carries out the job. If the employer or organization can tell the contractor what to do, how to do it, and when, then it is likely that the contractor will be classified as an employee. This is due to the fact that the client's level of control over the contractor is comparable to an employer-employee relationship.
The substitution test checks whether the contractor can send someone else to carry out the task in their place. If the contractor can substitute themselves with someone else, they will likely be correctly classified as independent contractors. But suppose the client has every right to reject a replacement or requires the contractor to seek their permission before making a substitution. In that case, the contractor can be classified as an employee.
Mutual Obligation Evaluation
The mutuality of obligation test determines whether the client is obligated to propose work to the independent contractor and whether the contractor has the right to accept the proposed work. For instance, if the client is meant to offer the contractor a task and the contractor is required to accept it, then the relationship is likely an employer-employee relationship. However, if neither the employer nor the contractor is obligated to offer or accept work, the relationship is more likely that of an independent contractor.
Inside and Outside IR35
Inside IR35 refers to a work arrangement assumed as employment to report and file taxes. What this means is that the contractor makes the same tax and National Insurance Contributions (NICs) as a conventional employee in an organization.
On the other hand, Outside IR35 is a work arrangement considered self-employment for tax purposes. In this arrangement, the contractor is responsible for filing their taxes and NICs, often resulting in more beneficial tax treatment.
Off-payroll employment regulations
The Off-payroll working rules apply to independent contractors who provide services via an intermediary, usually a personal service company (PSC). It ensures that contractors pay the same tax and national insurance contributions (NICs) as employees when their working arrangement is like an employee's.
Off-payroll working regulations enable the government to prevent tax evasion by individuals and organizations that hire employees through intermediaries.
Tools to determine IR35 status
Determining IR35 status can be challenging. However, here are tools that assist organizations and independent contractors with the process:
- The Check Employment Status for Tax (CEST) tool from HMRC: CEST is an online questionnaire provided by HMRC to assist in determining a worker's employment status for tax purposes. Although it is not legally binding, it can help enterprises and independent contractors assess their IR35 status. Notably, the CEST instrument has been criticized for its accuracy and dependability, so it should not be relied upon only partially.
- Professional help from accountants or attorneys: If contractors need more clarification about their IR35 status or the consequences of the legislation, it is recommended that they consult a professional that is well-versed in IR35 tax, like an accountant or an attorney. These experts can assist in reviewing contracts and working arrangements to ensure full compliance with IR35 and reduce the risk of incurring penalties for noncompliance.
How does IR35 affect your business?
Understanding the effects of IR35 rules on both contractors and employers is crucial for ensuring compliance and an equitable workplace. Here are some of the most significant effects for businesses and contractors:
Impact on businesses
- Employment status classification: Contractors who fall within the scope of IR35 will be classified as employees for tax purposes, even if they are not deemed employees in other legal contexts. This classification may affect their tax obligations, National Insurance contributions, and overall working relationship with the organization.
- Tax reporting consequences: The contractor will be subject to Pay As You Earn (PAYE) tax and National Insurance contributions if IR35 considers them employees. This classification can result in increased tax expenses for contractors not part of the IR35 jurisdiction and paid taxes as a sole proprietor or through a limited liability company.
- Changes to take-home pay: Due to the increased tax liability, contractors under the jurisdiction of IR35 may see a reduction in their take-home pay. This can impact their financial planning and may influence their decision to continue working as independent contractors or pursue permanent employment.
Impact on employers
- Since the implementation of the off-payroll regulations in the private sector, it has been the responsibility of enterprises to determine the IR35 status of their contractors. This includes evaluating their working practices and contractual terms to ensure they accurately reflect the contractor's employment status for tax purposes.
- Tax liabilities and penalties for noncompliance: Employers who incorrectly determine a contractor's IR35 status or fail to deduct and pay the appropriate taxes and National Insurance contributions may be subject to significant financial penalties from HMRC. Additionally, if businesses are found to be non-compliant, they may be liable for unpaid taxes, interest, and fines.
- Potential changes in hiring practices: To mitigate the risks associated with IR35, some businesses may opt to hire more permanent employees or work with umbrella companies rather than engage directly with contractors. This can affect the flexibility and adaptability of a company's personnel, as well as the availability of qualified contractors on the market.
How to navigate IR35
It can be challenging to navigate the complexities of IR35, but with the right approach, organizations and contractors can effectively manage the legislation and its effects. Here are some suggestions for navigating IR35:
Ensure contract clarity and accuracy
A contract that is well-written and free of ambiguity is essential for determining IR35 status. Businesses must ensure that their contracts with independent contractors accurately depict the working relationship, including control, supervision, direction, substitution, and mutual obligation details. The risk of violating IR35 can be mitigated by routinely evaluating and revising contracts in accordance with contemporary work practices.
Regularly examine contracts and operating procedures
IR35 status is subject to change as working relationships evolve. Businesses and independent contractors should periodically evaluate their contracts and working methods to ensure continued IR35 compliance. This includes assessing the level of control, supervision, and direction exercised over the contractor, as well as ensuring that there is a genuine right of substitution and no ongoing mutuality of obligation.
Consult a professional if you are uncertain of your IR35 status.
If businesses or independent contractors are apprehensive about their IR35 status or the implications of the legislation, it is strongly advised that they seek professional guidance. Accountants, attorneys, and IR35 specialists can assist with reviewing contracts, evaluating working practices, and minimizing the risk of penalties for noncompliance.
Partner with an Employer of Record
An Employer of Record (EOR) platform is a reliable and certain way to navigate IR35 efficiently. Typically, EOR platforms enable organizations to hire independent contractors anywhere in the world while handling the entire employment process and requirements on behalf of the organization or employer. By partnering with an EOR, organizations can efficiently reduce compliance risks with IR35, thereby ensuring effective management of the contractor’s tax and employment status.
Learn why an EOR is the best way to pay independent contractors in the UK.
How Skuad can help
Skuad is a global employment and payroll platform that helps organizations hire full-time employees and contractors in over 160 countries without setting up subsidiaries or legal entities. Skuad’s platform also enables organizations to onboard talent, manage payroll, and ensure compliance with country-specific employment laws and tax regulations.
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What does it mean if I'm inside IR35?
If you are inside IR35, the HM Revenue and Customs (HMRC) considers you an employee, not an independent contractor. This means that you are responsible for paying income taxes and contributions just like an employee.
Is IR35 just for the UK?
Yes, the IR35 tax legislation only applies to contractors in the UK
Is there IR35 in the USA?
No, IR35 does not exist in the United States, and there is no equivalent jurisdiction in the US. However, the IRS in the US provides guidelines that determine if a worker is an independent contractor or an employee.