Inside IR35: Navigating the Tax Landscape for Contractors

Work arrangements have significantly changed over the years. As our work environments and needs continue to evolve, employment has become more flexible. However, this means contractors need to navigate through the complex web of tax regulations and compliance requirements.

In the United Kingdom, increased work flexibility means contractors and employers need to pay attention to IR35, which holds significant implications for their tax status and financial obligations. In this blog, we have already discussed what IR35 is and the differences between contracts.  

The idea of being inside or outside IR35 can cause some confusion, especially if contractors work under an umbrella company or have recently terminated employment contracts. 

In this article, we will discuss what it means to be inside or outside IR35, what defines employment in the UK and the penalties contractors may face if they breach IR35 regulations. 

What does it mean to be inside IR35?

Being “inside IR35” refers to the tax status of a contractor or freelancer. According to the HM Revenue & Customs, the IR35 rules exist to ensure a worker pays the same income tax and national insurance as an employee. Therefore, being inside IR35 means a worker provides services to a client through an intermediary company in a way that is similar to what an employee would provide. 

If a contractor is deemed to be “inside IR35”, it means that they are subject to Pay As You Earn (PAYE) tax and National Insurance Contributions (NICs) like a regular employee. In this case, the contractor’s client or the organisation that engages their services is responsible for deducting income tax and NICs from their payments. 

The key factor in determining whether a contractor is inside or outside IR35 is the nature of the working relationship. If the contractor is effectively working as an employee, with a high degree of control and direction from the client, and lacking autonomy and independence, they are more likely to be deemed inside IR35. 

What does it mean to be outside IR35?

In contrast with contractors “inside IR35”, being “outside IR35” means that an individual is classified as self-employed and is not subject to these specific tax regulations. 

When a contractor is determined to be outside IR35, they can continue to operate through their own limited company or as a sole trader, being responsible for managing their own tax and National Insurance contributions.

By being outside IR35, contractors have more flexibility in how they structure their remuneration, typically taking a combination of salary and dividends when operating through a limited company.

Determining IR35 status requires careful assessment of the working arrangements and consideration of various factors. For this reason, it is important that contractors and businesses seek professional advice, therefore ensuring compliance with regulations and avoiding potential penalties. 

What defines employment?

As we explained, what determines if a contractor is deemed inside or outside IR35 is the employment relationship they have with clients. 

Under UK tax laws, here are some of the factors considered when determining employment relationships:

Control

Contractors who are outside IR35 have a high level of autonomy and control over how, when, and where they carry out their work. 

When there is an employment relationship – meaning contractors fall inside IR35 – clients will determine how things will be made and delivered. 

Business on own account

Self-employed individuals typically take on multiple contracts with different clients, which shows they are running a business on their own account. They have the freedom to accept or decline work and actively market their services. 

When a contractor works with a single client regularly, it indicates an employment relationship, meaning that they fall inside IR35. 

Financial risk

The level of financial risk assumed by the individual is important. Contractors outside IR35 bear all of the financial risks associated with their work, managing their own finances. For example, they are not entitled to employment benefits. 

Employees, on the other hand, have minimal financial risk. Their employment relationship means they have the right to sick pay or paid leave. 

Substitution

When an individual is self-employed and, therefore, falls outside IR35, they can provide a substitute to fulfil their contractual obligations. This means they are independent when delivering their services.

If that is not the case, if the company or client requires the contractor to perform the services themselves, it suggests an employment relationship. 

Mutuality of obligation

While the existence of a contract is necessary, contractors outside IR35 operate on a project-by-project basis. There is no ongoing obligation for the client to provide work nor the obligation for the worker to accept it. This lack of mutuality of obligation distinguishes the relationship from that of an employee. 

Self-employed individuals are not obligated to accept every work offered. They can choose what they want to do and when. By the same token, companies working with self-employed workers do not need to provide work constantly.

Integration

Self-employed individuals are not treated as employees. They are not integrated into the company and normally do not attend staff meetings. If a company demands that contractors are part of the team as much as employees are, it suggests that the relationship is not with an independent worker. 

Provision of equipment

If the client provides the necessary equipment and tools for the individual to perform the work, it leans towards an employment relationship. 

Self-employed individuals generally supply their own equipment. 

What is working through an umbrella company?

An umbrella company is a business recruitment agencies use to pay independent or temporary workers. Working through an umbrella company inside IR35 means that a contractor or freelancer operates through an intermediary and is deemed to be within the scope of IR35 regulations. 

In this case, contractors are subject to PAYE tax and National Insurance contributions as if they were an employee of the umbrella company. By working through an umbrella company, contractors avoid the administrative burden of managing their own taxes and NICs. 

Here’s how this arrangement typically works:

Engagement

The contractor is engaged by a client or organisation to provide a service.

Contractual relationship

The contractor signs a contract with the umbrella company, becoming an employee. 

The umbrella company acts as an intermediary between the contractor and the client.

Payments

The client pays the agreed fee to the umbrella company for the contractor’s service.

Payslips and deductions

The umbrella company processes the payments and issues payslips to the contractor, detailing the salary and deductions for income tax and employee NICs. 

The umbrella company deducts the applicable taxes and NICs from the contractor’s earnings. 

Tax and NIC payments

The umbrella company is responsible for making the necessary tax and NIC payments to the HMRC on behalf of the contractor. 

Employment benefits

As an employee of the umbrella company, the contractor may be entitled to certain employment benefits, such as sick pay, holiday pay, and pension contributions.

What are the expenses while inside IR35?

When working inside IR35, there are certain charges associated with the arrangements and compliance requirements.

It is important that individuals carefully evaluate and understand the fees or charges associated with their employment circumstances. Comparing and researching different service providers, such as umbrella companies or professional advisors, can help assess the costs involved.

It’s also advisable to consult with a tax specialist or accountant to gain a comprehensive understanding of the expenses involved in operating inside IR35.

Here are some of the things to consider:

Umbrella company fees

If a contractor is working through an umbrella company, they will typically incur fees for the services provided. 

These charges depend on the company and the services provided, such as processing payments, handling payroll, administering taxes, and providing employee benefits. 

It’s important to review the fee structure and understand the costs associated with working through an intermediary, ensuring that contractors remain compliant with the regulations.

Administration and compliance costs

Contractors inside IR35 may need to invest in additional administration and compliance measures to ensure they are meeting their tax obligations. This can include the cost of engaging an accountant or tax specialist to help with tax calculations, submitting tax returns, and ensuring compliance with IR35 regulations.

Professional advice fees

Seeking professional advice from an accountant, tax advisor, or legal professional to assess IR35 status, review contracts, or provide guidance on tax matters may involve fees or charges.

Insurance costs

Some contractors choose to obtain insurance coverage to protect themselves against potential tax investigations or claims arising from their work. This can include professional indemnity insurance, public liability insurance, or tax investigation insurance. Insurance premiums would be an additional cost to consider.

Potential penalties for IR35 breaches

Under the IR35 legislation, there are potential penalties and consequences for companies or individuals who fail to comply with the rules. 

These penalties can vary depending on the specific circumstances and the severity of the breach. 

Tax and NICs liability

If a contractor is found to be inside IR35 but has not paid the appropriate income tax and NICs, they may be liable for the outstanding tax and NICs payments. The contractor will need to settle any unpaid taxes, including interest and potential penalties.

Interest charges

HM Revenue and Customs (HMRC) may impose interest charges on any outstanding tax and NICs liabilities that have not been paid within the required timeframe. The interest accrues from the original payment due date until the date of payment.

Penalties for inaccurate status determination

If an entity, such as the client or the intermediary responsible for determining the employment status, provides inaccurate or false information regarding the contractor’s status and it results in incorrect tax treatment, penalties can be imposed. The penalties are usually calculated based on a percentage of the tax liability.

Failure to operate PAYE

If the client or intermediary fails to operate the Pay As You Earn (PAYE) system correctly, including deducting and paying the appropriate income tax and NICs from the contractor’s payments, penalties can be applied. The penalties can be levied against the entity responsible for operating PAYE.

Transfer of liability

In some cases, if there is an intermediary involved, such as a personal service company (PSC) or an umbrella company, the liability for unpaid tax and NICs can be transferred from the contractor to the intermediary or from the intermediary to the end client. This transfer of liability is aimed at ensuring that the tax liabilities are properly addressed.

Final thoughts

While there are many advantages to working independently, it is crucial that contractors stay informed and understand what it means to fall inside or outside IR35. Navigating tax implications can be challenging, and seeking professional advice is often necessary.

While being inside IR35 may restrict certain tax advantages and impose additional administrative burdens, contractors can still proactively manage their finances. By understanding eligible expenses, adhering to proper record-keeping practices, and engaging with reputable umbrella companies or professional advisors, contractors can optimise their earnings within the confines of the law.

Contractors and umbrella companies need to be fully aware of their responsibilities and obligations. Failing to comply with these regulations can result in significant penalties. For this reason, expert advice can ensure both parties are aware of what is required of them.