Formally introduced in 2000, IR35 rules were designed to combat tax avoidance by so-called “disguised employees.” These are workers who perform similar duties to full-time employees, but bill their services through a personal service company, or PSC. The use of a PSC allows workers to draw income in the form of dividends, which are exempt from National Insurance Contributions (NICs).
By contrast, a regular full-time employee’s wages are subject to an income tax of up to 45 percent and NICs of up to 12 percent. The use of a PSC can, then, significantly increase a workers’ take-home pay. According to HM Revenue and Customs (HMRC), this arrangement is unfair, as two individuals who work in the same way should pay broadly the same income tax and NICs. IR35 rules were implemented to address this inequity.
To comply with IR35, an employer must properly classify a worker’s status as either a contractor or a regular employee. To assist with the assessment process, the UK government developed a series of tests that focus on three key principles of employment:
- Control: A worker will be considered an employee if the client has a right to exercise control over what, how and when the work should be completed.
- Substitution: A worker will be considered an employee if they are not permitted to send a substitute to complete the work on their behalf.
- Mutuality of obligation: To be considered an employee, a worker must be obliged to offer their services and an employer must be obliged to accept them.
Other factors to consider are how a worker is paid, who supplies the necessary equipment to complete the job and employment exclusivity, among others.
Originally under IR35, the contractor was responsible for determining their own status. Following a 2015 review of the legislation, however, HMRC found that only 10 percent of contractors who should be applying IR35 rules do so.
Recent IR35 reforms and effective dates
In an effort to at least partially address the problem of contractors failing to apply IR35 rules, in 2017 the government reformed the rules for the public sector. The reforms shifted the responsibility of IR35 assessments from the individual to the public organisation that engages them.
Since 2017, increased compliance within the public sector has raised an additional £550 million in income tax and NICs. In response to the reform’s success, the government announced plans to extend these provisions to the private sector, effective April 2020. HMRC extended the changes to 6 April 2021 due to the pandemic. It also allowed for a 12-month grace period until 6 April 2022, during which it refrained from issuing penalties to businesses, except in cases of deliberate non-compliance.
These changes significantly affect UK-based: individuals who provide their services through a PSC; recruitment agencies and other intermediaries that supply staff through PSCs; and the large and medium-sized companies outside the public sector that engage them (known as end-clients).
The remainder of this article covers the specifics of IR35 private sector provisions and the steps your business should take to comply.
Small business exemption
The smallest 1.5 million UK businesses are exempt from the provisions if they meet two or more of the following criteria:
- No more than 50 employees
- Annual turnover of no more than £10.2 million
- Balance sheet total is no more than £5.1 million
Where the end-client qualifies as a small business, the responsibility for determining the IR35 status of a contract remains with the private service company. (There is no small business exemption for public sector organisations.)
Additionally, HMRC has included clauses in the legislation to prevent off-payroll workers from being routed to small associated companies and subsidiaries connected to a large end-user.
IR35 status determination statement
The end-client must confirm the IR35 status of a contractor who operates via a PSC by providing a status determination statement (SDS). The SDS must be provided in writing to both the contractor and the party responsible for paying the private service company.
IR35 status dispute resolution process
According to the private sector provisions, if a PSC does not agree with an IR35 status decision, it may dispute the decision. In the event of a dispute, the end-client must review the decision and provide a reasoned response within 45 days.
Transfer of employment tax liabilities
The legislation is designed to ensure that the end-client, or the fee-payer if an agency is involved, is responsible for any employment tax liabilities. The new rules allow HMRC to recover tax liabilities from another “relevant person” if the fee payer fails to pay taxes due under IR35. A relevant person is any party involved in the payment to a private service company.
5 percent administration allowance
A 5 percent allowance is available to private service companies to reflect the cost of administering the off-payroll working rules. Because responsibility has shifted from the PSC to the end-client, this allowance has been removed for medium and large organisations, but will continue to be available for small businesses that qualify for exemption.
Consequences of non-compliance
Effective 6 April 2022 — the end of the HMRC’s grace period — medium and large businesses that fail to take reasonable care in determining the employment status of their contractors (who operate via their own personal service companies) face the prospect of fines ranging from 30 to 100 percent of unpaid PAYE and NICs. This is an addition to the unpaid tax itself.
HMRC is pursuing non-compliance under the IR35 regime. As recently as December 2021, it issued an eye-watering tax bill of £72 million to the Ministry of Justice for its purported breaches of the public sector IR35 rules. This comes after similar multi-million-pound bills were issued in 2021 to the Home Office, DEFRA, DWP and HM Courts & Tribunal Service.
Businesses operating in the UK should also keep in mind that, since the private sector IR35 rules were changed on 6 April 2021, HMRC are no longer focusing on individual contractors and their personal service companies. Instead, as in the public sector, the medium to large entities engaging these contractors have been made legally responsible for determining their employment status and will be the subject of HMRC’s scrutiny. In the wake of the HMRC grace period, it’s increasingly crucial that private sector businesses take steps to mitigate their tax risks and protect against penalties.
How to comply
The impact of IR35 changes should not be underestimated. Many businesses are now faced with immediate cost implications and substantial operational challenges. In addition to following HMRC’s guidance, we recommend taking the following actions.
Issue status determination statements to all new intermediary contractors
It is the responsibility of the end-client of the contractor’s services to issue a status determination statement to a contractor and any third party he or she contracts with. Failure to pass on the SDS will result in the business being responsible for the deduction and payment of tax and NICs — along with any apprenticeship levy — to HMRC.
An SDS must be issued with “reasonable care,” or liability won’t be effectively discharged. This means that (among other things) individual SDSs should be issued for each engagement; group determinations should be avoided.
Develop policies and procedures, and regularly review SDSs
In order to ensure IR35 compliance, a business should have clear and easy-to-follow policies and procedures in place to evidence, execute and issue SDSs. This will significantly reduce the risk of incorrect determinations.
There is no set guidance on how frequently SDSs should be reviewed for an existing engagement. As a general rule, however, we advise reviewing and where necessary updating SDSs every six months, and more frequently if circumstances change.
You should issue new SDSs when:
- A new contract is negotiated with a contractor who operates through an intermediary.
- The circumstances of an existing engagement change, for example when a contractor is suddenly required to work specific hours.
- An engagement lasts for a significant period of time. (The length of an engagement may increase the risk of a contractor becoming an employee for tax purposes.)
This is an updated version of a previously published article.
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The contents of this article are intended for informational purposes only. The article should not be relied on as legal or other professional advice. Neither Vistra Group Holding S.A. nor any of its group companies, subsidiaries or affiliates accept responsibility for any loss occasioned by actions taken or refrained from as a result of reading or otherwise consuming this article. For details, read our Legal and Regulatory notice at: http://www.vistra.com/notices . Copyright © 2023 by Vistra Group Holdings SA. All Rights Reserved.
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