Dealing with tax is a pet hate for many self-employed professionals. The annual self assessment brings with it an almost audible collective groan from across the country. However, self assessment has some potential advantages; if you are not paying tax via PAYE, there is scope for a mitigation of your tax liability through the exploitation of various reliefs and loopholes. Frequently, however, these loopholes are closed with little warning. IR35 is a case in point.
The legislation that has come to be known as IR35 (in reference to the press release in which it was first described) has produced widespread criticism amongst freelance contractors. IR35 is an anti-avoidance measure; prior to the introduction of the legislation, it was possible for some freelance contractors and other self employed individuals to 'disguise' their income through the use of intermediary companies.
This is best explained by way of an example. Imagine that Client A requires a service, and that they wish to contract with Freelancer B for the provision of this service. Before IR35, Freelancer B could have an arrangement with Intermediary X, whereby the client contracts with the intermediary rather than contracting directly with the freelancer. The freelancer would then take their fee in the form of a dividend payment from the intermediary, rather than a standard payment from the client. Dividends are not subject to National Insurance Contributions (NICs), and the freelancer's tax liability was therefore significantly reduced.
In the initial briefings, the aim of IR35 was said to be to prevent self employed contractors setting up limited companies through which they could provide services that they were otherwise providing on a freelance basis. This was in part motivated by the tax advantages enjoyed by 'consultants' who were effectively employees, but who set up limited companies and worked as contractors instead. However, the consequences for freelancers have been severe.
Applications
IR35 applies in a broad range of cases. In essence, three criteria must be fulfilled: the freelancer must personally perform the relevant work; an intermediary company must be used, rather than the freelancer contracting directly with the client; and the terms of the arrangement must be such that the freelancer would have been treated as an employee of the client for NIC purposes, were they to have contracted directly. If all of these conditions apply, HMRC is able to draw up a 'hypothetical contract' between the freelancer and the client. If this contract would otherwise be treated as one of employment under the current Employment Status rules, any fees paid by the client to the freelancer will be treated as employment income for Income Tax and NIC purposes. This results in a reduction in take-home pay of around 20% for many freelancers.
However, the implications of IR35 for self employed individuals are more severe even than this. Under IR35 rules, expenses claims on the part of the contractor are limited to 5%. Furthermore, the costs of sickness, holiday pay, training and so on are not allowable under IR35. Herein lies the principle point of contention: if the contractor were truly an employee, they would be entitled to a set of standard employee benefits. Under IR35, however, the contractor bears the tax burden but is not entitled to the advantages of employment.
Finding the right solution
Ensuring that your contracts fall outside the remit of IR35 is a difficult and potentially time consuming process. As such, you should consider whether or not it is worth the effort to get yourself out of IR35. Clearly, long-term freelancers will certainly wish to 'IR35-proof' their contracts in order to avoid the reduction in earnings. However, this may be less worthwhile for those who freelance on a 'casual' or short-term basis.
In these cases, you may be better off falling within IR35, but taking pre-emptive action to ensure that you would not fall foul of any investigation. This means either establishing a limited company, or making use of a PAYE umbrella company. These organisations deal with the payroll aspect of your employment, which can be very time consuming. You may well choose to sacrifice a small percentage of your income in order to avoid having to administer your own payroll scheme - and, indeed, in order to avoid the very real possibility of a PAYE Audit.
Alternatively, you may try to avoid IR35 altogether. There is no catch-all method for this; some companies offer standard 'IR35-proof' contracts, but in reality your contracts will have to be tweaked for each and every job or project. In essence, however, the contract should highlight your status as a self employed professional. Among the most important factors to consider here is the concept of 'Mutuality of Obligation', which underpins an employment contract. Under this type of contract, it is deemed that the employer has an obligation to give the employee work, and the employee has an obligation to accept it. If you wish to avoid IR35, you should therefore ensure that any contracts you sign contain a clause explicitly stating that the client has no obligation to offer more work, and you have no obligation to take it.
Finally, it is important that your working practices are in line with your self employed status. For example, you should have control over when you start and finish work each day. This may also have an effect on your payment terms; a regular monthly payment is often used by HMRC as evidence of employment. As such, you should ensure that your contract allows for payment on production of an invoice or completion of a project.
IR35 is a hugely complex piece of legislation with significant repercussions for all self employed professionals, therefore the most important first step is to find out whether you currently are bound by the legislation or not. If you are, you may be liable for unpaid tax.
If you do fall under this legislation, it can take time and effort to get out of it. As such, you must weigh up the actual financial costs of falling within IR35, and then decide whether adjusting your contracts is warranted.
