Over 20 years ago, Gordon Brown announced new measures to combat tax avoidance through the use of personal service companies (or, more accurately, ‘intermediaries’). Although the law forms part of the Income Tax (Earnings and Pensions) Act 2003, it is more commonly known as ‘IR35’, being the 35th press release issued by HM Revenue and Customs following the Chancellor’s budget speech.
Due to the way in which income and corporation taxes were levied, it was often advantageous for workers to avoid being classed as employees (and therefore having to pay income tax and national insurance contributions), and instead set up their own company, and be paid through share dividends at a lower tax rate. That loophole was closed with changes to the rate of tax on share dividends in April 2016, but there are still tax benefits that arise when working for a client through your own company rather than as an employee.
How effective has IR35 been so far?
Well, the answer is ‘not very’.
When first introduced, HMRC stated that they expected IR35 to increase the overall tax contribution by £300 million a year.
Over the next 10 years, the enforcement of IR35 resulted in roughly £1.5 million of extra tax per year, around 0.5% of HMRC’s estimates.
Indeed, in the last year for which we could readily find published information, HMRC stated that an extra £219,180 had been generated through IR35. That’s hardly going to solve the UK’s national debt.
Does IR35 apply to me?
Different rules apply where the client is a public authority, or where the intermediary is a partnership, so let’s consider the most common scenario of a client in the private sector and an intermediary company.
Rather than the client hiring the worker as an employee, the worker has set up an intermediary (or ‘personal service company’). Not all intermediary companies are affected by IR35, only those where:
- the worker owns 5% or more of the shares in the intermediary,
- the client pays the intermediary, and the intermediary pays the worker, and
- the intermediary is not a group company or associate or affiliate of the client.
If one of those tests is not satisfied, then the intermediary company does not fall within the scope of IR35. In other words, the use of that intermediary company would not be considered by HMRC as a tax avoidance measure.
All three tests are satisfied – what now?
Satisfying the three tests above merely means that the intermediary company falls within the legal definition of an ‘intermediary’ for IR35 purposes. It still doesn’t mean that IR35 actually applies. For the arrangement to be deemed to be a tax avoidance measure, three more conditions would need to be satisfied:
- there is a contract for services between the client and the intermediary (whether recorded in writing or not),
- the worker is under an obligation to perform the services for the client, and
- if those same services were provider by the worker without the intermediary, the worker would be classed as an employee of the client.
Whilst a worker may argue that the second condition isn’t satisfied if he’s able to delegate services to others, or use substitute or replacement workers to complete the services, it’s normally the third bullet-point that is the deciding factor.
If it looks like a duck, swims like a duck and quacks like a duck, then it probably is a duck.
If the worker looks like an employee, acts like an employee and is treated like an employee, then (for IR35 purposes) he probably is an employee, which means that the intermediary would effectively be ignored by HMRC, and the worker taxed as though he was an employee, not a shareholder of the intermediary company. In reality, whether any individual satisfies the legal tests for employment status is an often-complex question that would be dealt with by colleagues in BPE’s Employment Team.
So what’s changing?
It has always been the worker’s duty to decide whether they are, or are not, an employee of the client under the IR35 rules. This has meant clients can largely ignore the question – if they pay a worker through an intermediary company and HMRC decides the arrangement was a tax avoidance measure, it’s the worker’s responsibility for having made the wrong decision.
And it’s this burden that is changing. From April 2020, clients that are classed as ‘medium or large-sized’ organisations will become responsible for deciding whether a worker providing his services through an intermediary is actually an employee of that client. To be classed as ‘medium’ or ‘large’ an organisation must satisfy two or more of the following conditions:
- an annual turnover of more than £10.2 million,
- a balance sheet total (ie. total assets before deducting liabilities) of more than £5.1 million, or
- more than 50 employees.
For those organisations that cannot satisfy two of those conditions, then the rules do not change – the decision as to whether a worker is an employee remains that of the worker.
But for those clients where the rules are changing, they will be required to:
- take reasonable care in deciding whether any worker engaged through an intermediary falls within the IR35 regime,
- notify intermediaries and the workers whether those workers are considered to be the client’s employees for tax purposes,
- provide reasons for having made that decision, and
- allow intermediaries to dispute that decision, and consider and respond to any dispute within 45 days.
It is widely anticipated that clients, fearful of getting the answer wrong and becoming embroiled in tax avoidance allegations, will err on the side of caution and determine that most workers providing their services via an intermediary should be paid as though they were employees, and recent anecdotal experience is already supporting this belief.
What should I do before April 2020?
If you are a ‘medium or large-sized’ private sector organisation that outsources the supply of services, then you will need to identify all outsourced service providers (ie. intermediaries), make a decision for each of them on whether IR35 applies and notify them accordingly. If you decide that IR35 does apply, and neither the service provider nor any of its workers disputes your decision, then you must deduct and pay tax and national insurance contributions to HMRC.
If you are an ‘intermediary’ and provide your services to ‘medium or large-sized’ private sector organisation, then you should expect to receive an IR35 determination in good time before April. If you have not already done so, then it would be a good idea to ask for a determination sooner rather than later. Upon receipt, consider the outcome and reasons and, if you agree, no further action is required. If you disagree, most likely because the client has decided you fall within IR35 and you don’t accept that is correct, then notify the client in writing without delay, setting out the reasons why you consider they are incorrect.
If you are a public sector organisation, then you’ll already be used to applying these rules and, if you’re a ‘small’ private sector organisation, then the rules aren’t changing.
But regardless of whether you are a client, an intermediary or a worker, if you have any questions with regards to the application of IR35 to your business, then don’t hesitate to contact BPE’s Commercial Team and we’ll be happy to explain how the rules, and the new changes, will affect you and your business.
We are running an event focussing on IR35 and everything you need to know on Wednesday 18 March. If you would like more information about the event, or would like to book yourself a place, click here.
These notes have been prepared for the purpose of an article only. They should not be regarded as a substitute for taking legal advice.