Are you a freelancer who keeps hearing the term IR35? Are different people telling you different things about the rules? Or, have you been burying your head in the sand hoping you aren’t affected? And, do you have the right contracts in place? All these questions are a confusing aspect of IR35 for freelancers so you’ve come to the right place to find out more! In this simple guide, I’ll give you an overview of IR35 for freelancers. So you can understand what it all means, I’ve included how it works and why it was set up over two decades ago. I’ll also show you how to determine whether you fall ‘inside the rules’ because you are what is known as a ‘disguised employee’.
This is quite a heavy-going article with lots of terms, definitions and links that will help you further. So, take your time reading it and bookmark it; you can come back to it later after you’ve had time to digest the information.
I am not an IR35 expert and the information in this guide is produced for a wider audience. As always, I aim to provide information to help you understand the rules of IR35 but care must be taken when applying them to your own situation. Always contact a professional, such as a contractor accountant or employment lawyer for help, specific to you.
Table of contents
- 1. What is IR35 for Freelancers?
- 2. Why was IR35 Introduced?
- 3. What Does Inside and Outside IR35 Mean?
- 4. Off Payroll Working
- 5. What Counts as a Medium and Large Sized Business?
- 6. What is a Disguised Employee?
- 7. Are You a Disguised Employee?
- 8. HMRC CEST Tool
- 9. What is a Deemed Employment Payment and How to Calculate It
- 10. Does IR35 Apply to Sole Traders?
- 11. How to Avoid IR35
- 12. Contacting HMRC
1. What is IR35 for Freelancers?
IR35 for freelancers is legislation, initially launched by HMRC back in the year 2000. It is designed to identify workers who operate through Limited Companies but are in effect employees just being paid via an invoice. The IR35 rules aim to identify individuals getting paid in this way. It also relates to taxing them in the same way an employee would be.
2. Why was IR35 Introduced?
Leading up the introduction of the IR35 rules, individuals were increasingly forming Limited Companies. This is what HMRC calls an ‘intermediary’ entity, to work for employers, in effect as an employee. However, they were giving them the ability to invoice for their services instead of being paid under PAYE rules.
If you have a Limited Company, then you probably know that getting paid in this way can be more tax efficient than being on payroll because you can:
- Deduct expenses;
- Pay corporation tax at 19%;
- Pay yourself a tax-efficient salary made up of dividends and PAYE salary.
Going back 20 years, running a Limited Company was even more tax-efficient than what it is today. This is because dividends were subject to a dividend 10% tax credit instead of the less generous dividend allowance that has replaced it today. That meant people were forming intermediary entities in their drones to take advantage of this tax loophole.
This behaviour wasn’t just popular with the freelancers, it was also encouraged by employers because it benefited them. Paying a Limited Company instead of a PAYE salary gave employers the ability to save money on things like:
- Employers National Insurance, currently 13.8% of gross salary;
- Pension contributions starting at 3% of gross salary;
- Holiday Pay;
- Sick Pay.
Those caught by IR35 have to pay National Insurance and income tax on the money they were paid through their Limited Company, as though they were on PAYE.
Initially, it was up to the freelancer to decide whether they were breaking the rules; meaning the client had limited responsibility when it came to checking whether the person working for them was truly a freelancer or a disguised employee. However, since April 2016, the rules of IR35 have evolved and are widely becoming known as off-payroll working. Where certain businesses have now been made responsible for deciding whether a freelancer is truly a business owner or an employee.
3. What Does Inside and Outside IR35 Mean?
Being inside IR35 means that you are an employee. If caught, you’ll face deductions from payments made to your Limited Company by your client. This can come into effect possibly annually, or added to their payroll and paid via PAYE.
If you are found to be outside IR35, then you can continue to freelance and invoice your client for work as normal. This is without any impact of IR35 or off-payroll working.
4. Off Payroll Working
Since 2000, the rules of IR35 have evolved in an attempt to catch more people to make the rules much tighter. With this evolution, the terminology being used has changed with a shift in how HMRC refers to IR35 and instead beginning to use the term ‘off-payroll working‘. Although the terms IR35 and off-payroll are used interchangeably, there is a subtle difference between the two legislations.
In April 2017, the rules of IR35 for freelancers were reformed to put the onus on the employers in the public sector to decide whether a freelancer is a true business owner or a disguised employee. Previously, it had been up to the freelancer to decide on their own tax status. However, this still left room for these disguised arrangements to continue. Plus, the employer is able to argue they were unaware that the freelancer had little or no other work.
From April 2021, this decision-making onus is going to be expanded to medium and large-sized businesses in the private sector. This has caused much uproar. In order for businesses to minimise their risks, they are taking the safe option and electing to either end their relationships with freelancers who are Limited Company owners. Alternatively, if they are happy to continue with their arrangement, they can choose to deduct income tax and National Insurance from payments made to freelancers. This was regardless of an invoice received, by calculating a deemed employment payment.
5. What Counts as a Medium and Large Sized Business?
HMRC has set out the following criteria for deciding which private companies count as a medium or large sized business. For IR35 purposes the rules will apply if 2 or more of the following conditions are met:
- they have an annual turnover of more than £10.2 million
- have a balance sheet total of more than £5.1 million
- they have more than 50 employees
Balance sheet total means the total amounts shown as assets in the company’s balance sheet before deducting any liabilities.
Private businesses who are affected are then responsible for approaching freelancers who work through an intermediary entity. They make a decision and communicate it to the freelancers using what is called a ‘Status Determination Statement’ (SDS).
A business must take care when making their determination. If not, they could be liable for the freelancer’s income tax and National Insurance in the event they are found to be inside IR35.
6. What is a Disguised Employee?
Before the rules of IR35 were introduced, it was becoming increasingly commonplace for people to quit their job on a Friday and re-start under a contract through their Limited Company on the following Monday. Essentially, doing the same job but just getting paid differently. This is what is known as a ‘disguised employee’.
A disguised employee is a freelancer who is in effect an employee but is invoicing through a Limited Company. It isn’t necessarily someone who works five days a week; it can be a freelancer who works part-time.
7. Are You a Disguised Employee?
There are a number of checks that you can do to establish whether you are a disguised employee. HMRC starts by asking three questions to test an arrangement between a freelancer and their client:
- Is there Mutuality of Obligation (MOO)? And, is the client obligated to provide the freelancer with work and does the freelancer expect to be given work?
- Is there Control? Does the client tell the freelancer where to do the work and how the work should be completed instead of leaving the freelancer to decide how they deliver the output?
- Can there be Substitution? Can the freelancer send a replacement to complete the agreed work or will the client reject any such changes?
These three tests are not the only questions they will use to understand the true working relationship between a client and freelancer. They will dive deep into the nature of an arrangement, regardless of any contracts in place, asking questions such as:
- Has the freelancer paid another person a significant amount of money to do the work?
- Can the freelancer be moved around to do other tasks, instead of the one originally agreed to, without their consent?
- Does the client have the right to decide how the work is done?
- Does the client decide the freelancer’s working hours?
- Should the client decide where the freelancer works?
- Does the freelancer have to fund upfront costs for equipment or travel before their client pays them?
- Should the client take up the majority of the freelancers time?
- Does the freelancer introduce themselves to clients as being their own boss or working for the business?
This list of questions is by no means exhaustive. However, they are designed to assess the true nature of an engagement regardless of any contracts in place. IR35/off-payroll working is now about looking at how freelancers are engaged to work to get to the heart of an arrangement.
Even if you have multiple contracts with multiple clients, you could find yourself a disguised employee for one client only. Or, if the contract is ongoing, you could find a shift in any arrangements between you and your client could mean part of your arrangement renders you as a disguised employee.
8. HMRC CEST Tool
If you’re contracted to work for someone and have concerns about your employment status, then the first place to check whether you are inside IR35 as a disguised employee is to go over to the HMRC website. They have an online CEST tool, which stands for ‘check employment status for tax‘. Here, you’ll be asked a series of questions regarding your relationship with your client to assess your status. At the end, you’ll be given a probable determination for your working arrangement. You can print this and then use it to investigate further.
9. What is a Deemed Employment Payment and How to Calculate It
If you are found to be inside IR35, then your client will need to deduct income tax and National Insurance from payments made to you. Conseqently, you pay the same amount of tax as someone who is on PAYE. This is what is known as a ‘deemed employment payment’.
Your client will be responsible for calculating this deduction and paying it to HMRC on your behalf. This is part of their normal payroll obligations. You’ll then receive the net amount, just like if you were receiving a payslip.
This deduction can be calculated annually or on a more regular basis. Allowances will be made for any expenses you pay for as well as a 5% blanket deduction to reflect the running costs of your Limited Company.
The deemed employment payment should be reported by the employer as part of their normal payroll duties on a Full Payment Submission on or before 5 April each year. In addition, a P60 form should be issued to the freelancers so they can include details of these deductions in the employment section of their tax return.
The fees you charge for providing services will be subject to VAT, even if the engagement is within the off-payroll working rules. This is because it’s still you that is contracting to provide service to a client, and as such the supply remains within the VAT regime.
This does mean that if you are impacted by a deemed employment payment, you’ll suffer the tax but have none of the benefits offered by a PAYE employment status like pension contributions, holiday pay or sick pay.
10. Does IR35 Apply to Sole Traders?
The rules of off-payroll working relate to Limited Companies only. However, the rules of IR35/off-payroll working relate to all workers, whether you are a sole trader or have a Limited Company.
If you are a sole trader working for a small private company, then the onus remains on you to decide on your employment status. However, you should be mindful that IR35 regulations do still apply and if you are discovered to be freelancing as a disguised employee, you will be found liable for unpaid income tax and National Insurance. Your employer, however, may not be found liable for unpaid employer’s National Insurance and pensions because it is up to you to decide on your employment status not them.
11. How to Avoid IR35
When it comes to avoiding IR35, you must make sure you keep on the right side of the law because tax evasion is illegal. You should also remember that including clauses in your contract won’t necessarily mean you avoid IR35 because HMRC have expanded the rules as part of off-payroll working. This means they will look at the true nature of any arrangement regardless of a contract in place.
First things first, you must remember if you are truly in business then you won’t be affected by IR35/off-payroll working. This is because you are not an employee who is controlled by an employer. That said, the nature of freelancing can mean it’s easy to become ‘part of the furniture. This is especially true if you end up working from a clients premises, whether it’s your choice on not.
When starting out with a client, having a contract in place that sets the expectations of your client will help avoid you falling inside IR35 or suffering, rightly or wrongly, any deemed employment payments. To that end, always make it clear that the contract is not with you personally. Rather, it is with your business (hint: don’t mention your name in the contract). Furthermore, ensure your client is aware that you could send someone else to do the work instead of you; that way you won’t fail the substitution test. You should also make it clear that you have the power to reject work so you won’t fail the Mutuality of Obligation test. Keeping timesheets is also a really easy way to prove how many hours you are working and who for, in the event HMRC investigate you.
12. Contacting HMRC
If you are unsure of your employment status, HMRC has set up a dedicated IR35 team who you can reach by email at email@example.com or phone on 0300 123 2326.