In April 2020, IR35 will expand from the public sector into the private sector and freelancers are worried they will not comply with IR35. IR35 is a legislation that was implemented to prohibit an employee from leaving their permanent job only to return as a contractor and provide the same service while at the same time, avoid paying tax and National Insurance at the higher rates.
What is IR35?
Disguised Employment and PSC
The IR35 tax implemented in April 2000 aims to ensure that those who are in “disguised employment” are paying the correct amount of tax. It is designed to combat tax avoidance by workers supplying their services to clients via an intermediary, such as a limited company, but who would be an employee if the intermediary were not used.
An example of someone who is in disguised employment or inside IR35 would be a permanent employee who was to leave their job on a Friday and then return to the same company the following Monday to do exactly the same job, but on a self-employed basis rather than as a permanent employee.
An individual in this situation is deemed to be inside IR35 because they are effectively in the same position as they were before, but receiving the tax benefits available to self-employed workers. When deemed inside IR35, the self-employed person was liable to pay the missing contributions which is now subject to change.
The most notable event over the years to date involved U.K’s public company - the BBC. Since the 1990’s hundreds of BBC presenters and staff were ‘coerced’ into forming personal service companies (PSCs) to gain work at the corporation so that it could treat them as freelancers for tax purposes.
By working through PSCs, both employer and employee would be able to justify not paying national insurance contributions, though the employee would also be ineligible for basic employment rights including paid holidays, pensions and sick pay.
After 9 years of investigation, multiple presenters, as well as the BBC, were given large tax fines. However, liability remained in a grey area. In 2017 report, it was estimated that the cost of non-compliance in the private sector is continuing to increase: the latest estimate is that tax losses to the Exchequer will grow from £700 million in 2017/18 to £1.2 billion in 2022/23.
Updated IR35 rules were introduced to the public sector in April 2017 making it the responsibility of the employing business, not the contractor, to determine whether a role sits inside or outside IR35 and which tax rate should properly apply.
Public companies include:
- Government departments
- The BBC
- Channel 4
- The Bank of England
- The NHS
- Police and Fire authorities
In July 2019, it was proposed to extend the legislation to private companies taking effect in April 2020. The responsibility for deducting and paying tax from the contractor’s pay will also move to the party which pays the contractor’s limited company (usually, this will be an employment agency).
The change will not apply where the end-client is a small company, meaning a company which meets any 2 of the following criteria:
- Annual turnover of not more than £10.2 million;
- A balance sheet total of not more than £5.1 million;
- No more than 50 employees. Where the end-client is a small company, the responsibility for assessing and paying tax will stay with the contractor’s limited company.
- The size of the employment agency, if one is involved, is not relevant.
If your clients are medium or large business, as of April 2020, it will be down to them to carry out employment status assessments to determine whether individuals fall ‘in’ or ‘out’ of the IR35 legislation. For smaller companies and sole traders, options such as Freelance Management Systems, Umbrella companies and managing your company outside of IR35 are available.
Accountants need to be knowledgeable on the matter in order to provide adequate information and confidence to their clients. Although IR35 increases costs and risks, it is possible to continue working through a limited company as long as freelancers follow a few steps and precautions.
How IR35 benefits government and self-employed
Government increases pressure on tax avoidance
Theresa May shared her thoughts on how disguised employees should be paying the same National Contributions as any other employee doing the same job. The current situation is that “disguised employees” get tax breaks as well as the advantage of taking out dividends at a lower tax rate.
She stated “It is an unfair anomaly that a self employed person earning £100,000 a year pays less tax than a permanent employee earning £100,000 a year.” This point can and has been debated.
Self-employed working as contractors believe that big corporations and consultancy companies who see contractors as rivals, would have implanted this idea of unfairness in her mind. Corporations in the meantime are seeing lower tax rates with a decrease of 3% over the last 5 years. In 2014, rates were at 20% and in 2020, rates will be 17%.
This is coming just after May agreed to increase NI for sole traders as well based on Richard Hammond’s promise to implement new legislation that would benefit sole traders instead. John McDonnell, the shadow chancellor, said: “This is yet another betrayal of the self-employed. These people are the engine of the economy and have been let down again, while giant corporations have seen their tax bills slashed.”
Protecting contractors who should be hired as employees
When IR35 was introduced to the public sector two years ago, thousands of contractors were wrongly placed “inside IR35” by end clients that took a risk-averse approach to reform. This resulted in independent workers being taxed at a similar rate to an employee, but without being offered employment rights for paying significantly more in taxes.
In a bid to stop this, HMRC revealed in the draft legislation that it plans to make it a requirement that end clients share with contractors and agencies the reason behind a particular decision so that liability can be adequately allocated.
The impact on businesses and contractors
Expect paperwork and costs increase
Due to the IR35 changes, all workers, except those working for small companies within the private sector, will pass the liability for determining employment status to the client.
Companies and contractors will feel an impact in a few areas including rising costs, extra paperwork, loss of income and a risk of fines. In addition, being aware of IR35 and ensuring that compliance is met before 2020 increases workload and creates delays in projects within a very short time frame.
Every contract needs to be reviewed and agreed with the worker or the intermediary. In addition, each hiring employer will have to keep detailed records on how the classification and decision was made - why the contract has been written up the way it is and of course, pass on the information to the worker in a way that the worker fully understands what is going on.
Having a contract that is sound may incur extra legal, consulting costs. Employers must also be prepared to have a dispute process in place in case workers do not agree with the reasoning of the contract. Last but not least, all records and proof of decision-making must be securely kept on file for each worker so that the documentation is ready for HMRC should an audit take place.
It will also be important for the self-employed who are at risk of being inside IR35 to keep an eye on their position. Most will invest in using an umbrella company and will also feel better if they have an accountant who can consult and advise on the matter. Self-employed who are already feeling the reduced rates, and the extra costs will also feel the increase in tax payments.
Get a good accountant
Ahead of the public sector reforms, the government launched a tool – Check for Employment Status for Tax (CEST) – for organisations to assess IR35 status, but it was slammed as inaccurate.
In a Harvey Nash report, research reveals that 1 in 3 found the tool to be “very ineffective”. The tool has proved unreliable, often determining incorrect results. The CEST tool supplied by HMRC for determining IR35 status has also come under heavy criticism for its exclusion of the Mutuality of Obligation (MOO) and the fact it was never formally assessed to be fit for public use, among other flaws.
The survey reveals HMRC is failing to provide the affected parties with clear information, with just 8% of contractors citing it as a reliable source of information. Many are turning to industry press (20%), their accountant (24%) and external experts within the industry (24%) for advice.
The freelance advisory service ContractorCalculator published a white paper co-authored by Philip Manley, a former HMRC inspector, who brands CEST "not fit for purpose" and does not see it as useful until the HMRC can back it up with substantial evidence.
The failings include the fact that only 16 questions are tested instead of 50 to 100 that are usually asked during an inquiry. In addition, it has not formally been tested by Government Digital Service.
It also brands it "hopelessly unreliable and biased", citing an investigation ContractorCalculator carried out by testing the tool using previous cases, which found it returned a flawed assessment in 42 per cent of cases.
A further criticism was that HMRC has made assumptions on contractor engagements and not included "key elements of status law", such as a test for Mutuality of Obligation – which refers to the obligation of an employer to provide work and the employee to accept it.
1. Make sure they “contract for service”
Contractors usually sign a “contract of service” rather than a “contract for service: and the difference is important. In the former, the agreement is between an employer and the employee and meets the following criteria:
- The worker is controlled by their employer – they must perform the tasks they are instructed to by a line manager according to their job description
- The worker is expected to work at a specific place during specific hours on specific days (even flex-time has core hours)
- The worker must present themselves for work and cannot send someone else as a substitute
- Employees have statutory rights to holiday pay, sick pay, maternity and paternity rights and redundancy payments
- Employees have statutory rights regarding how they can be asked to leave their employment
- Employees enjoy a range of additional benefits, which can vary according to the employer, but might include company cars, private health insurance, staff canteens, health clubs and gyms and so on
- Employees are not personally liable for any errors they make when completing work for their employer, nor are they expected to make good in their own time.
The liability may have shifted, but the way that IR35 status is assessed remains the same: an employment test is carried out, on a case to case basis. The employment test focuses on actual working practices as opposed to what is contracted. There are four main criteria used to determine whether the IR35 legislation is applicable to your clients or not:
Control: Does line management dictate tasks and the hours in which those tasks ought to be completed? It is important to highlight the details in the contract. Perhaps line management does not dictate the above, yet it may be important for your client to be present at the company for practical or legal obligations.
Substitution: Is your client able to substitute their role with another, qualified person?
Mutuality of Obligation: Does the contract have a specific end-date and clearly state no obligation for future work once the project has been completed and the contract has ended?
The right of dismissal: Is there a notice period on the contract? According to HMRC, a notice period is characteristic of employment. If your client is unable to end the contract immediately, they will be deemed as working under IR35.
In order to be working ‘outside” of IR35, the answer to most, if not all questions should be no. If, on the other hand, the answer is yes, there is a high probability that you client is working “inside” IR35 and needs to prepare for the extra tax bills at the end of the fiscal year.
2. Inform your clients on precautionary steps
According to inniAccoutnants your client can take further steps in staying IR35 compliant:
- Provide own insurance
- Work with many clients at once (or have the ability to do so).
- Self-employed should accept a certain amount of financial risk - for example,
- Accept a certain amount of financial risk, for example rectifying errors at your own expense. Contractors can have remuneration terms and amounts set out in the contract.
- Self-employed should undertake their own training and pay for their own equipment necessary to complete the task. However, there are exceptions to the rule. For example, companies can pay for a self-employed person’s training if it helps complete the task of the contract.
- The self-employed cannot accept employee benefits from the hiring company. This includes parking spaces, ID and security passes that don’t state you are a visitor or contractor, business cards, or use of a subsidized staff canteen for example.
- Keep your business growing and visible via a website and other promotional material.
3. Suggest backup documentation
- Insurance policies and schedules – keep for five years as a minimum for Professional Indemnity cover.
- Business premises proof – lease or contract for premises and utility bills.
- Contracts – for all engagements with clients, especially the long-standing relationships.
- Efficiency gains – tenders and proposals for fixed-price job gains.
- Proof of assistance – employee records, accounting records.
- Marketing spend – receipts and briefs for the marketing undertaken. Copies of advertising and marketing materials.
- Repair at own expense – contract clauses, details of mistakes rectified, details of costs incurred by you to rectify your mistakes.
- Client risk – accounting records of write-offs, copies of correspondence with client involved, legal action records.
- Business entity – receipts for production as well as copies of the materials such as websites, business stationery and branding such as trade mark applications.
- Billing – invoices and correspondence related to payment terms.
- Substitution – contact clauses, level of sign-off by the client, payment terms, audit trail of previous substitutes and subcontracting.
You can advise your clients to have all contracts reviewed by an employment status specialist. The wording of the contracts should demonstrate that you client is working in the manner of a truly ‘self-employed’ person, and the working practices (the way your clients carry out the contract work) should also mirror the terms of the contract.
Your clients can also opt to pay for IR35 insurance which covers the cost of professional help should they be investigated by the HMRC.
4. Contract through Umbrella companies
Umbrella companies act as employers to contractors who work under a fixed-term contract on assignments at third-party companies. Self-employed who work through an umbrella company are seen as employees. Their income tax and National Insurance Contributions are taken from their income. The HMRC have also allowed a 5% deduction from the turnover in order to meet the costs of expenses self-employed face that employees do not.
Umbrella companies, often accused of ‘creativity’ when it comes to claiming expenses on behalf of their contractors (primarily for travel costs and subsistence) – which is why the government has rung the changes – have become more prevalent in the UK since the government introduced IR35, the legislation that determines employment status and ability to make use of small company tax reliefs. It applies to every sector, including broadcast.
An estimated 14% of the UK’s professional contractors manage their business by working through an umbrella company.
5. Automate workflow with a Freelance Management System
Freelance Management Systems (FMS) are online cloud-based platforms that are particularly useful for onboarding, managing contracts, invoicing and payments. In addition, they are automated workflow systems that keep track of paperwork which can be used during an IR35 audit.
As suggested by Deloitte, automating workflow is one of the best things employers and sole traders can do to keep all the information in tact. “For those with many thousands of PSC engagements, I think the best approach would be to adopt a workflow technology solution that will help to keep track of engagements. You’ll be able to upload status assessments so you really know where you stand and you have an audit trail as to how PSC’s are being engaged and what their status is.” Mark Groom - Partner in Deloitte’s Employer Services practice, specialising in employment tax and employee reward.
Because an FMS can be based outside the U.K, it is not subject to an audit, but the self-employed person must ensure that they are following the above guidelines to stay IR35 compliant and pay the taxes that are due.
“If your overseas intermediary does not take IR35 into account, any liability for tax and National Insurance is transferred. Under the off-payroll working rules, the worker, onshore agency, or end client will be responsible.” - Shield Accounting UK
An FMS differs from an umbrella company which has been subject to making the false promise that contractors can keep a large portion of their income. In addition, sole traders who used umbrella companies fell into a loan charge scheme where the salaries were “on loan” and not taxed.
Today, thousands of workers are facing large tax avoidance bills where most of these works have very little in terms of assets and cash to begin with. An FMS does not make fake promises. Instead it works towards compliance by providing transparency in the form of contracts, payments and any other relevant paperwork through a flawless automated workflow system.
Keep clients safe and informed
IR53 is an important legislation and accountants need to provide sound advice to their clients in order to ensure that they are paying their taxes correctly. The CEST tool from the HMRC has been deemed unfit for purpose. Accountants should consider widening their network to include specialists in the matter. Clients will need help from the moment the contract is drawn up to the final tax report filed with the HMRC. Your clients will be grateful knowing that their finances are in good hands and that large fines will not come chasing after them years later.