UPDATE: Due to the COVID-19 pandemic, the UK government postponed April 2020 IR35 updates. All IR35 updates slated for April 2020 will now take place on April 6, 2021.
On April 6, 2021, updates to the IR35 legislation went into effect, impacting more than 170,000 independent contractors in the UK and their employers. Among several updates to consider, the liability for defining employment status now falls to the employer instead of the employee.
For employers who hire independent contractors in the UK, it is crucial to understand this legislation and how it affects you. This guide will help you understand what IR35 legislation is, whether it applies to you, and how you can ensure compliance with the newest regulations.
What is IR35 Legislation?
Inland Revenue 35 (IR35) legislation is a set of anti-avoidance tax laws designed to ensure that contractors who would be considered employees if not for their intermediary still pay the same tax rates as employees.
Also known as “off-payroll working rules,” IR35 redefines employment statuses to eliminate the tax discrepancy between contractors and employees with the same roles and responsibilities. With the employer now responsible for determining employment status, IR35 increases the risks associated with hiring independent contractors.
Who Does IR35 Legislation Apply To?
IR35 legislation is applicable in situations in which a contractor provides their services to a client through an intermediary. The intermediary is typically the contractor’s own limited company (or “personal service company”), but it could also be a partnership or an individual.
IR35 applies to:
- Workers who provide services through an intermediary
- Clients who receive services from a worker through their intermediary
- Agencies who provide workers’ services through their intermediary
How IR35 Works
Essentially, IR35 dictates that “deemed” or “disguised” employees—contractors who would be classified as employees if they provided services directly to the client without an intermediary—should pay the same amount of income tax and National Insurance Contributions (NICs) as employees.
After the 2017 and 2021 updates to the IR35, the clients (with the exception of small private businesses) are responsible for determining the employment status of contracted workers and whether the contract is inside or outside IR35. If Her Majesty’s Revenue and Customs (HMRC) investigates and judges that a deemed employee has been misclassified, it becomes the employer’s responsibility to pay the evaded taxes.
Inside IR35 vs. Outside IR35
If a contract is inside IR35, it means that the off-payroll working rules apply and the contractor is considered an employee of the client for tax purposes. The fee-payer will deduct income tax and NICs from the payment the contractor receives, and will also pay NICs for the employer (which are not deducted from the worker’s wages). The fee-payer is the party that pays the contractor’s personal service company (PSC), whether it’s the client, agency, or another third party.
If a contract is outside IR35, the contractor is considered self-employed and operates as their own business. They can be paid on invoice with no taxes deducted and are responsible for managing their business’s taxes. If the contractor is a self-employed sole trader and does not use a PSC, they are outside IR35.
Why Does the IR35 Legislation Exist?
IR35 legislation was created to combat the practice of “deemed employment,” in which firms hired contractors to fulfill the roles of employees. This allowed firms to avoid paying employment taxes or providing employee benefits. Contractors also benefited since by billing for services through a PSC, they could split their income into a small salary and dividends, which are exempt from NICs. This allowed the contractors to pay less income tax and take home more pay than a full-time employee, who pays up to 45% income tax and 12% NICs.
IR35 legislation, also known as intermediaries’ legislation, was first introduced in 2000 in order to prevent this practice by distinguishing deemed employees from true contractors. It was originally the responsibility of the contractor to determine whether or not their contract fell inside IR35, but this proved difficult to enforce.
A 2015 IR35 review revealed that IR35 noncompliance cost the country over £400 million in unpaid taxes annually. Because of this, IR35 was updated in 2017 to make status classification and reporting the responsibility of public sector employers (extended in 2021 to the private sector as well) instead of employees.
Classifying Independent Contractors From Full-Time Employees
It can be difficult to know whether a worker should be classified as an employee or a contractor under IR35. Fortunately, IR35 case law has established a set of tests of employment which employers can use to classify all workers under their purview. The assessment criteria include:
- Control: An individual is an employee if the client controls how and when they execute their responsibilities, as well as which duties they perform.
- Substitution: An individual is an employee if the client does not allow them to pass off or substitute responsibilities to another individual.
- Mutuality of Obligation: An individual is an employee if they are obliged to offer their services, and the client is equally obliged to accept those services.
- Miscellaneous Factors: Other factors to consider include the type of contract, how the individual is paid, their level of financial risk, and if they supply the equipment necessary to complete their responsibilities.
These tests should be evaluated holistically, so be wary of making a decision based on a single factor. Employers should also keep in mind that the HMRC assesses these factors not only based on the written contract but also on the actual working practices. Thus, “implied” terms can supersede the written terms of a contract if the two are not consistent.
Recent Changes to IR35
The 2017 IR35 reporting reform transferring the responsibility of determining employment status from workers to employers in the public sector resulted in an additional £550 million in income tax and NICs. Because of its success, UK regulators extended public sector employers’ classification responsibilities to private sector employers in April 2021. This update continues to reduce noncompliance and generate additional income tax. The reform extends the 2017 provisions to the following private sector employers in the UK:
- Independent contractors
- Recruitment agencies
- Medium- to large-sized companies
However, the 2021 IR35 updates exempt 1.5 million private small businesses meeting at least two of the following criteria:
- 50 or fewer employees
- Annual turnover not exceeding £10.2 million
- Balance sheet totaling £5.1 million or less
No exemptions exist for small businesses in the public sector.
How to Ensure 2021 IR35 Compliance
To ensure compliance, the UK government requires employers to provide Status Determination Statements (SDSs) to their workers. The SDS is an official form that establishes the status of the worker and provides the reasoning behind the determination.
IR35 updates also include a provision that allows contractors and PSCs to dispute the status. If PSCs challenge the status, employers must revisit the status decision and reply within 45 days. Any tax liabilities exposed by the SDS are the employer’s responsibility to pay.
Employers are mandated to take “reasonable care” when determining a worker’s employment status. HMRC’s definition of reasonable care is subjective, but essentially an employer should consider each situation specifically, with the amount of care appropriate for the client’s ability, experience, and resources.
You may choose to avoid IR35 liabilities altogether by deciding to no longer use PSCs. However, it is unwise to make a blanket assessment classifying all of your contractors as inside IR35 regardless of individual situation; this is not considered reasonable care.
How Should Your Business Accommodate IR35 Updates?
With the new 2021 IR35 updates in effect, businesses need to make sure they have made any necessary adjustments to comply with the changes. In light of the updates, companies who engage contractors should take the following steps:
- Prepare for increased costs, such as employment taxes and increased rates from contractors
- Speak with all contractors and agencies about IR35 changes
- Determine the statuses of workers employed via PSCs or other intermediaries
- Use an SDS to communicate your determination to the contractor
- Determine whether you are the fee-payer for contracts inside IR35 (and if so, set up payroll processes for deducting the correct employee income tax and NICs)
- Put a process in place to deal with disputes over the status determination
- Keep an audit trail
- Establish a protocol for any future IR35-relevant working relationships
Employees Benefit Businesses. Hire Compliantly with an Experienced Partner
Independent contractors invite risks. With the IR35 updates, businesses must expose any intentional or unintentional worker-employer relationships, and employers face penalties for misclassifying workers.
Navigating the hiring process in the UK can be difficult thanks to IR35, but businesses can save time and effort by outsourcing the job to an International PEO (Professional Employer Organization). With the assistance of a PEO solution, employers can compliantly hire talented employees, ensure independent contractor compliance, and build a robust and scalable team.
Want to learn more about how Velocity Global’s team of employment law experts can help your firm understand the IR35 changes, complexities, and other UK employment law considerations? Reach out to us today.