IR35 guide

An Introduction to IR35

The legislation known as IR35 is intended to tackle the avoidance of tax and national insurance contributions (NICs) through the use of intermediaries such as service companies or partnerships.

The rules target circumstances where a worker would be treated as an employee of the client, if it were not for the existence of the intermediary. Where this was a limited company, the worker was able to take money out in the form of dividends instead of salary. Dividends are not liable to NICs so the worker would pay less in NICs than either a conventional employee or a self-employed person.

Scope of the rules
The IR35 rules apply to income earned in respect of work done after 5 April 2000 under contracts which would have been contracts of employment if the worker had been working direct for the client (relevant engagements). They do not introduce any statutory definition of employment or self-employment, so the existing case law will still apply to decide employment status (see : Employed or Self Employed?). The rules catch those employed in a domestic situation - eg nannies - as well as workers in the wider business sense after 5 April 2003.

Workers with up to 5% share in the intermediary (taking into account the holdings of family and domestic partners) are not subject to the rules, unless they receive payments or benefits which are not taxable under Schedule E.

Calculations
If you are caught by the IR35 rules, you are treated as receiving a notional salary on the last day of the tax year (5 April) equal to the company's gross income from relevant engagements less certain specified deductions. You will have to pay over PAYE and NICs on this notional salary by 19 April and include it on the year end return P35 by 19 May. It is evident that there is very little time to process the calculations, and HM Revenue & Customs have indicated that they will not penalise the use of provisional payments and calculations in order to meet the deadlines.

The deductions cover expenses that would normally be available to direct employees, contributions to approved pension schemes and the actual salary and employers NIC plus the employer's NIC on the deemed salary. Also allowed is a 5% flat rate deduction to cover the company's running costs. The following example illustrates some of the main features of the computation of the deemed payment.

Apportionment
Where a company has relevant engagements and other business which does not fall within the new rules, allowable expenses will have to be apportioned. Likewise, if a payment for a relevant engagement covers more than one worker, the payment can be apportioned between them on a 'just and reasonable' basis.

Other taxes
Corporation Tax is computed in the normal way, including the deemed salary and associated employers' NICs as allowable expenses. VAT operates regardless of any IR35 adjustments.

Dividends and other payments
Nothing in the legislation prevents a service company from paying money to the worker or others in the form of dividends, or retaining cash in the company. It will simply mean that an extra payment of PAYE tax and NICs will be calculated on 5 April. Dividends which are reclassified as deemed salary are relieved from tax so the PAYE takes priority, thus preventing double taxation of the payment.

Amending contracts
Workers who think they may be caught by IR35 should consider their position carefully, and should seriously think about renegotiating contracts so that they are no longer relevant engagements. Particular items to cover are:

Who is Caught by These Rules?

The IR35 rules aim to catch anyone who, by placing an intermediary between himself and his employer, gains some tax (including NIC) advantage.

Personal service companies

The example most frequently quoted is the consultant who, rather than working under a direct contract with a customer, contracts his services through his one-man company. Such a company has become known as a personal service company - a company which exists to provide the services of one or more particular individuals. The test for IR35 is whether, ignoring the existence of the company, the contract as it operates between the customer and the consultant is one which would lead to the consultant being classified as an employee of the customer, rather than self-employed. If the answer is that the consultant would, indeed, be classified as an employee, then IR35 applies. If he would be classified as self-employed, it does not.

If you operate your business through a personal service company, IR35 will only apply to you if:

Partnerships
Another example is a member of a partnership - self-employed - who is contracted by the partnership to a client under terms that would amount to an employment if the contract had been directly between the partner and the client. HM Revenue & Customs have in the past quoted the example of a vet in a large veterinary practice who is contracted to work by the local zoo for set hours per week. In this example, it is the services of one particular partner which are contracted, and as such, IR35 would apply. But if the zoo had instead contracted for the practice to provide any vet of suitable qualification and experience, it is unlikely the contract would be caught by IR35.

Again, there are restrictions on cases where IR35 will apply. For those providing their services through a partnership, the rules will not apply unless:

How Can I Avoid It?

There are several ways you can avoid IR35 - although they may not be palatable to you, or your customers.

First, you can avoid IR35 altogether by rewarding yourself for all work done in a form subject to PAYE. IR35 was intended to stop the avoidance of tax and NICs through the use of intermediaries - if there is no avoidance, there will be no IR35 liability.

Second, you could give up your current arrangements and seek to join the staff of your main customers. This might get around IR35, but it will limit your options and increase the costs of your customers (through NIC, holiday pay, etc.)

Finally you could examine and, where appropriate, re-write your contracts. A great deal of care must be taken, not only to ensure that the terms of your contract(s) are not such that IR35 will apply, but also to ensure that they will stand up to HM Revenue & Customs scrutiny. In particular, HM Revenue & Customs might seek to prove that although your contract might on the face of it be one to which IR35 could not apply, in fact the manner in which your relationship with your client operated was one which fell within IR35. In this case HM Revenue & Customs will insist that IR35 be applied to earnings under the contract.

If you wish to put your contracts to the IR35 test, HM Revenue & Customs will give its views - but remember that this view will be based on the information provided. If, in fact, IR35 should apply, HM Revenue & Customs will not be bound by any previous decision.

The Construction Industry Scheme to 5 April 2007
The Contractor's Viewpoint

For many years there has been a scheme to combat the black economy in the construction industry.

Under the present scheme, all self employed subcontractors have to hold either a Certificate or a Registration Card in order to get paid.

If you use subcontractors who do not trade as limited companies, the first priority is to establish whether, in all the circumstances, they are entitled to be treated as self employed. This matter is discussed in our leaflet Employed or Self Employed? You must pay workers classed as employees in accordance with the PAYE system.

To qualify for a Subcontractors Tax Certificate (CIS6), individual subcontractors have to have been up to date with their tax affairs during the previous three years, and have had an annual turnover from construction work (net of materials) of at least £30,000 for a continuous period of three years within the previous four years. There are alternative turnover tests which relate to partnerships, companies and newly started businesses. The construction business must be run from proper premises, have proper records and be conducted primarily through a bank account.

For self employed or limited company subcontractors with Subcontractors Tax Certificates (CIS6), you may make payments without deducting any tax. You should ensure that you are given a Subcontractor's Gross Payment Voucher (CIS24) for each payment made within each tax month.

Certificates need to be inspected only once during their validity, but you should ensure that no payments are made after the expiry date.

Self employed or limited company subcontractors who do not qualify for a subcontractors tax certificate should apply for a Registration Card (CIS4). When paying such subcontractors you are required to make a deduction on account of tax and National Insurance contributions at 18% from the labour element of each payment. You need to check the Card before making the first payment and you have to prepare Tax Payment Vouchers (CIS25) for each subcontractor on a monthly basis.

Each month you must pay over any tax deducted and distribute copies of all vouchers (CIS24 and CIS25) as follows:

Please note that a new Construction Industry Scheme will apply from April 2007

The Construction Industry Scheme from 6 April 2007
The Contractor's Viewpoint

For many years there have been schemes to combat the black economy in the construction industry.

A new variant was originally scheduled to take effect from 6 April 2006, but the start has now been delayed until 6 April 2007.

Under the new scheme CIS4, CIS5 or CIS6 cards and vouchers CIS23, CIS24 and CIS25 are all discontinued.

If you are a contractor and you want to engage somebody to work for you, you must first establish whether or not the type of work involved falls within the construction industry scheme. HM Revenue & Customs (HMRC) Factsheet CIS348 is a useful starting point for this.

Once you are satisfied about the status of the work, you need to obtain basic details from the subcontractor, such as name, unique taxpayer reference (UTR) and national insurance number.

If you use subcontractors who do not trade as limited companies, the first priority is to establish whether, in all the circumstances, they are entitled to be treated as self employed. This matter is discussed in our fact sheet Employed or Self Employed? All wages for employees must be paid under PAYE.

If you believe your worker should be categorised as self employed, you need to set up an appropriate contract. The next stage is Verification. You need to contact HMRC to verify the subcontractor, and to establish whether the subcontractor is to be paid gross or net. For net payments there are two rates of deduction - a standard rate (18%) for those who have registered with HMRC ("matched") and a higher rate (up to 40%) for those who have not ("unmatched").

You will be given a verification reference number for each set of subcontractors verified in the same telephone call or internet session. These will be in the format V0000543267 for matched subcontractors but will have one or two letters on the end that are unique to each unmatched subcontractor (eg V0000543267/B).

Please note that the verification process should be used only when a contract is in place, or a tender accepted. It cannot be used speculatively to establish payment status details of a subcontractor.

You can continue to pay a subcontractor without further verification so long as the previous payment was made in the current or two previous tax years. As part of the transition to the new scheme, you do not need to verify subcontractors if you have paid them since 6 April 2005 and when you last paid them you had seen a registration card, temporary registration card or tax certificate (these latter two with an expiry date later than 03/2007).

Contractors must issue a payment statement to each subcontractor for whom they have made a deduction from a payment. The statement may cover all payments in a tax month, or each individual payment. There are penalties if payment statements are not issued within 14 days of the end of the tax month. There is no prescribed format, but they must contain the following information:

Contractors must also make monthly returns of all payments to subcontractors, showing for each subcontractor most of the details shown on the payment statements, together with declarations that:

Nil returns must be made if no subcontractors have been paid in the month. There are no annual returns.

Contractors who are also subcontractors must pass the compliance test to remain eligible for gross payments. The old compliance test focused on the contractor's compliance over a three year period. The new test looks at a 12 month period, but the rules are much stricter - for instance if you pay your PAYE/CIS deductions more than 14 days late even just once you will lose your gross payment status and future payments will be net of tax.

IR35 and Cessations

You need to consider the impact of IR35 and the effect it has on those workers providing their services through intermediaries. In general, the effect of IR35 is to deem a payment at the end of the tax year, a payment subject to PAYE tax and both primary and secondary NICs, and that is treated as paid on the last day of the tax year.

There are, though, circumstances in which the date of the deemed payment will be brought forward from 5 April:

Note that unlike deemed payments at the end of the tax year, when it is possible to pay based on provisional calculations, the PAYE payments on deemed payments brought forward by one of the events listed above must be made based on actual figures.

Interest and Tax Payments

HM Revenue & Customs charges interest on underpayments of tax, and pays interest (repayment supplement) on overpayments. The rate of interest paid on overpaid tax is lower than the rate charged on underpayments, and interest rates are adjusted frequently in line with commercial interest rates.

Detailed calculation of interest and supplement are not shown on Statements of Account, so it is worth checking when these items are large.

Income Tax and Capital Gains Tax - self assessment
Interest is charged on underpaid payments on account and balancing payments from the due date to the date of payment. Repayment supplement is paid from the date of overpayment to the date the repayment is issued. The interest or supplement is based on the final amount of tax and Class 4 national insurance contributions, taking into account all later adjustments.

Interest is also payable on late-paid penalties and surcharges (but not on interest!).

For individual taxpayers interest charged by the Revenue is not tax-deductible, but neither is interest paid by the Revenue taxable income.

Corporation Tax - self assessment
Similar principles apply with regard to corporation tax. However, interest rates are not necessarily the same as those applying to income tax and capital gains tax. In addition, there are different rates of interest for companies required to make quarterly payments of corporation tax.

In contrast to the position with personal taxpayers, under corporation tax self assessment interest charged is allowed against company profits and interest received is treated as taxable income.

Typical interest rates
As mentioned above, interest rates move with commercial rates. The rates since 6 September 2005 have been as follows: