Inside vs outside IR35: Decoding your contractor status and tax implications
As a contractor, knowing your IR35 status could mean the difference between heavy tax burdens and operating with tax-efficient independence. Inside vs outside IR35 – what does it mean for you? Our guide cuts to the chase, offering critical insights to confidently determine your status and effectively handle its implications for your financial and operational freedom.
Overview:
Navigating IR35: Understanding your working status
The off-payroll working rules, known as IR35, were introduced by HMRC to ensure that contractors who would be considered employees if no intermediary was involved pay a similar amount of tax to employees.
This means that understanding the difference between being inside or outside IR35 is essential to determine who is responsible for making the determination and taking the necessary action to mitigate financial risks.
Knowing whether you are inside or outside IR35 directly affects your tax obligations. For example, a contractor classified as inside IR35 may be required to pay income tax and national insurance contributions similar to that of an employee.
This makes understanding your employment status, as well as the implications of your status determination statement, vital to your working arrangements.
The basics of inside IR35
If you are inside IR35, it means that for tax and national insurance purposes, you are treated as an employee of your end client. Several factors can suggest an inside IR35 status.
For instance, the degree of control the client has over when, where, and how services are provided, such as direct supervision or giving instructions, indicates an employment relationship. In other words, if you cannot move from one job to another without the client’s discretion or have set working times like employees, you are likely inside IR35.
Another key test for employment status, and hence for determining if someone falls inside IR35, is the mutuality of obligation, where the employer is obliged to provide work and the employee is obliged to accept it. While this is a topic of controversy within IR35, it is an important factor to consider.
Additionally, integration into the client’s organisation, as demonstrated by access to staff facilities or involvement in staff meetings, is an indicator of being ‘Inside IR35’. Therefore, an accurate determination of IR35 status involves assessing both how the contractor’s services are carried out in practice and the contractual terms set between the contractor’s limited company and the end client.
The freedom of outside IR35
On the other hand, private sector contractors outside IR35:
- Maintain autonomy over their work, demonstrating independence from their clients’ organisational structures
- Have the capacity to execute tasks with minimal client supervision
- Enjoy the freedom to manage their work time
- Bear the cost of rectifying defective work, highlighting the financial risk associated with running their own business.
Indicators of outside IR35 also include payment per job rather than hourly/daily rates, multiple income sources, and engaging in risky behaviours such as tendering and delivering speculative work.
For example, you may demonstrate business independence through actions like providing a substitute for your work. Enshrining the right to substitute in contractual agreements and actual exercise of this right strongly signals self-employment, placing the contractor outside IR35.
By providing services outside IR35, you can achieve tax efficiency, partly through the ability to:
- draw income through dividends in addition to traditional remuneration
- have a more flexible approach to taxation and business operations
- potentially earn greater earnings and tax benefits
Therefore, professional legal review of contracts and business practices, including marketing and financial risk assessments, reinforce the contractor’s position as an independent business outside IR35.
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Determining your IR35 position
Accurate determination of IR35 status is crucial, as it involves assessing both the contractual terms and the actual working practices.
Since April 2021, the IR35 status of contractors is determined by the client in both public and private sectors, except for small private sector businesses where contractors assess their own status. HMRC examines the working practices on each assignment and compares them to the written contract to establish IR35 status.
The significance of accurately determining your IR35 position is underscored by the potential financial risks associated with incorrect determinations.
Incorrect determination of IR35 status can lead to HMRC claiming unpaid income tax and National Insurance Contributions, accompanied by additional penalties and interest. Hence, engagements must be reassessed for IR35 compliance when material changes occur, either in the work arrangement or regulatory environment.
Seeking professional advice
Due to the nuanced nature of the legislation, guidance for some contractors when assessing IR35 status can be extremely complex. With no single situation definitively determining IR35 status, understanding the subtleties involved often requires specialist advice.
Hence, contractors are advised to seek specialist legal advice or consult with a professional accountant to successfully navigate the intricacies of IR35 regulations. A consultation with an IR35 contract review specialist for each new contract is essential to properly assess a contractor’s status.
Expert review services can support contractors by providing a pass/fail assessment of their contract’s compliance with IR35 and a detailed report advising how to position oneself outside IR35.
When seeking specialist help, public sector contractors should seek specialist advice and be prepared with details about the services provided to the end client, including when and where the services will be executed, and whether they will be using their own equipment.
Key tests for IR35 determination
Determining your IR35 status involves key tests such as the right of substitution, control, and absence of mutuality of obligation. The right of substitution is a strong indicator of a lack of personal service, demonstrating that the contractor may not be obliged to perform the work themselves, suggesting an outside IR35 status.
If a contractor has significant control over how, when, and where to perform their services and can demonstrate independence by refusing non-contractual work, it supports the case for being outside IR35.
An absence of mutuality of obligation—where there is no expectation of ongoing work from the client, nor an obligation for the contractor to accept it—indicates an outside IR35 status, aligning with self-employment rather than employment.
Contractual clarity: Ensuring compliance
For IR35 determination, it is essential that the contract terms mirror the real work practices of the contractor with their client, ensuring a genuine business relationship. During an HMRC investigation, the focus will be on the actual working relationship, even if it differs from the contract terms.
Therefore, contracts that clearly define the nature of services and avoid resembling an employment contract are crucial for complying with IR35 legislation. Additionally, end clients must issue a Status Determination Statement (SDS) that outlines the IR35 status decision and its justification to ensure regulatory compliance.
Crafting compliant contracts
Crafting compliant contracts is crucial for avoiding IR35 issues. First and foremost, contracts must be drafted to clearly indicate self-employment status, in line with HMRC’s definition, avoiding any language that suggests control, supervision, or direction by the client.
Contracts must explicitly detail the relationship between the contractor, the intermediary, and the end client, affirming a business-to-business engagement rather than an employer-employee relationship. To demonstrate self-employment, evidence of business-like characteristics such as having a business website, company stationery, and business liability insurance should be present.
Therefore, it is important to regularly review contracts with the help of independent experts to ensure they reflect a genuine self-employment status and thus support an outside IR35 position.
Contract reviews by experts
Regular contract reviews are key to confirming that contract terms align with actual working practices and that the outside IR35 status is maintained, even with the same client. Contract reviews by legal experts specialising in IR35 can demonstrate due diligence to HMRC, indicating a ‘reasonable step’ was taken to verify self-employed status.
IR35 legal experts can help with the following:
- Identifying fail clauses in contracts
- Negotiating new terms to unequivocally support self-employed status
- Conducting a comprehensive contract review to ensure legal soundness and compliance with IR35 regulations
- Preventing ambiguity and potential penalties.
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Tax responsibilities and liabilities
Contractors’ tax responsibilities and liabilities differ based on whether they are inside or outside IR35.
Contractors inside IR35 pay the same income tax as employees, seeing their take-home pay reduced, specifically Income Tax, and National Insurance Contributions that an employee would typically pay, which includes the ‘deemed payment’ at the end of the tax year.
On the other hand, contractors outside IR35 who contract through a limited company pay corporation tax at the current rate of 19% on all profits after allowable expenses, and they have the flexibility to draw remuneration in a combination of salary and dividends.
By structuring their remunerations wisely, contractors outside IR35 can reduce their tax liabilities by avoiding employee’s NIC if their income is structured not to reach the upper earnings bracket, completely avoiding the NIC on all revenue, and completely avoiding paying PAYE.
Regardless of IR35 status, contractors are required to ensure correct tax and national insurance payments for their employment status to comply with taxation laws.
Inside IR35: Financial implications
Contractors deemed inside IR35 are treated as employees for tax purposes, encompassing payment of Income Tax and National Insurance Contributions under PAYE. Inside IR35 contractors experience reduced net earnings due to being taxed at the same rates as employees.
More specifically, they pay employee’s NIC, in addition to the standard Income Tax. Being inside IR35 also limits tax advantages compared to outside IR35, where contractors can draw income in dividends at lower tax rates, and working through an umbrella company can help simplify the tax process for those inside IR35.
Outside IR35: Maintaining independence
Working outside IR35 enables contractors to benefit from tax efficiency by drawing income as dividends, which are not subject to National Insurance Contributions (NIC), and by having their limited company pay tax at a 19% corporate rate on profits under £50,000.
Remaining outside IR35 can significantly impact contractors’ net income, with contractors inside IR35 experiencing increased tax burdens by up to 88% and potential decreases in net income by as much as 24% at lower hourly rates.
Contractors outside of IR35 must ensure that both their company and personal taxes are managed correctly, which includes being timely and compliant with tax regulations, solidifying their position as a legitimate business entity.
Even while operating outside IR35, contractors may be subject to HMRC inquiries and should be prepared to demonstrate their compliance and independent contractor status.
Tools and resources for IR35 assessment
There are various tools and resources available for assessing IR35 status. The HMRC CEST tool is designed specifically for checking employment status for tax, providing a reliable solution for businesses. While using HMRC’s CEST tool for IR35 assessment is a known method, it is not mandatory.
This guide’s purpose is to help contractors understand the IR35 status determination process and the use of available tools to do so. However, due to the complexities involved, it’s always advisable to seek professional advice, especially in cases where the working arrangements are complex or ambiguous.
Accuracy and reliability of IR35 tools
While HMRC’s CEST tool is a common resource for assessing IR35 status, it has been criticised for its accuracy and reliability. For instance, the tool assumes mutuality of obligation is present if a contract exists, a point of view criticised as over-simplistic by some experts.
HMRC claims that CEST is accurate, but emphasises that this accuracy is conditional upon the tool being used in line with their guidance. Due to the tool’s simplistic assumptions and controversial accuracy, seeking additional professional advice could be beneficial for contractors to clarify their IR35 status.
Record keeping for IR35 compliance
Meticulous record keeping is essential for IR35 compliance. Here are some key steps to follow:
- Maintain an electronic dossier of day-to-day working practices.
- Halting an HMRC investigation early on and substantiating your IR35 status through clear evidence.
- Provide evidence demonstrating a distinction between contractors and employees of the client company.
- Keep detailed records of compliance with statutory requirements.
- These steps are vital for demonstrating your IR35 status and resolving disagreements.
Records should include:
- Any contract changes agreed upon
- Signed confirmations of these changes by the client
- Specific details like a Confirmation of Arrangements to further demonstrate self-employment
Contracts must be in writing from the start to preempt HMRC from inferring a ‘hypothetical contract’ based on perceived arrangements.
Maintaining a business website, a database of potential substitutes, and records of additional work beyond the contract strengthens the case for being outside IR35.
Finally, PAYE records must be kept for 3 years, and company tax records for 6 years from the end of the financial year they relate to, or possibly longer in specific circumstances.
Insurance against IR35 investigations
Consideration of IR35 insurance is advisable as it covers professional costs incurred in defence against HMRC investigations and legal penalties if found inside IR35 after an enquiry. IR35 insurance typically offers coverage for:
- Taxes owed
- Interest
- Penalties
- Legal expenses
Coverage levels can range up to £250,000.
Providers like personal service companies offer IR35 insurance with stand-out features such as:
- Dedicated account management
- Free contract assessments
- Legal expenses
- Flexible protection for all parties involved in an IR35 enquiry
Importantly, IR35 insurance coverage can extend to retrospective tax years, usually up to 6 years and further in cases of fraud, covering a wide range of inquiries including tax, PAYE, and NIC investigations.
IR35 insurance policies provide assistance from tax experts, including ex-tax inspectors, who can offer specialised support during the course of IR35 and other related investigations.
Staying informed: Latest IR35 Developments
The off-payroll working rules remained unchanged; however, consultation is considering introducing a ‘set-off’ mechanism before April 6, 2024, which would account for taxes paid by a worker when off-payroll rules weren’t applied correctly.
Contractors, recruitment agencies, and end clients are advised to stay informed on IR35 and off-payroll working rules to manage their effects and ensure compliance with current legislation.
It’s also worth noting that currently, small businesses are exempt from the new off-payroll rules, which means they do not have to determine the IR35 status of their contractors, leaving this responsibility with the contractor’s limited company or PSC.
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Summary
In summary, understanding and navigating the complex world of IR35 is crucial for contractors. Accurate determination of your IR35 status is key to managing your tax obligations and responsibilities.
This involves understanding the factors that indicate being inside or outside IR35, seeking professional advice when necessary, ensuring contractual clarity and compliance, maintaining meticulous records, considering IR35 insurance, and staying informed about the latest developments.
In the ever-evolving landscape of contractor taxation, staying ahead of the curve can ultimately lead to a smoother, more rewarding contracting experience.
FAQs
Being inside IR35 offers better job security and makes you more integrated within the company’s organisations. Your employer has an obligation to provide you with the work you are contracted for, but at the same time you as an employee are also obliged to accept it.
Being outside IR35 offers greater autonomy, tax efficiency, and control over working practices, making it a more preferable option for many contractors. It allows you to pay yourself a salary, draw the remainder of income as dividends, and be responsible for your own taxes.
To know if you are inside or outside IR35, HMRC will evaluate your contract and workspace. If you are treated like a full-time employee or receive similar benefits, you will be considered inside IR35.
The client decides if a contract is inside or outside IR35, and issues a Status Determination Statement (SDS) to indicate the worker’s status. This statement is given to the worker and any other relevant parties.
The main difference between being inside and outside IR35 is that being inside means you are considered an employee for tax purposes, while being outside means you are considered self-employed and have more flexibility in managing your taxes. Ultimately, it affects how you are taxed.
