The Intermediaries Legislation, often known as IR35, was first put into effect in April 2000 as a means of preventing tax evasion.
It was predicated on the idea that independent contractors may avoid paying taxes by working through a middleman, such as their own limited business, as opposed to being treated as workers under the PAYE system.
Others obtained employment through umbrella firms or recruitment agencies, which handle tax and salary payments.
In some circumstances, such as when a long-term contract had been agreed upon or when HMRC viewed contractors as “disguised employees,” employment status was regarded doubtful by HMRC
What is ‘disguised employment?
‘Disguised employment’ refers to a situation where an individual is effectively working as an employee but is engaged and classified as a contractor or self-employed. This arrangement allows both the individual and the employer to potentially benefit from tax and National Insurance contributions (NICs) advantages.
By shifting the employment relationship to that of a contractor, the individual may pay less tax, while the employer can avoid making Employers’ National Insurance contributions and providing employment benefits or rights.
This practice has been a concern as it undermines tax and employment regulations, leading to the introduction of legislation like IR35 in the UK to address and prevent such disguised employment arrangements
Testing for employment status
Testing for employment status involves evaluating various factors to determine whether a worker should be classified as an employee or self-employed. Here are some key points to consider during the testing process:
- Control: Assess whether the worker has control over their working hours, methods, and how the work is carried out.
- Right of substitution: Determine if the worker has the ability to send a substitute to perform the work on their behalf and if they would bear the associated costs.
- Mutuality of obligation: Examine whether there is an obligation for the client to provide work and for the worker to accept it when offered.
- Employment rights: Check if the contract mentions provisions for employment rights, such as holiday or sick pay.
- Equipment and materials: Consider whether the worker provides their own tools, equipment, or materials needed to carry out the work.
- Financial risk: Evaluate the level of financial risk undertaken by the worker, such as bearing the costs of rectifying mistakes or the potential for incurring losses.
- Length of engagement: Consider the duration of the engagement and whether it implies a more temporary or permanent arrangement.
Overall, it is the combined assessment of these factors that helps determine the employment status of a worker for tax and National Insurance contribution purposes.
Changes to IR35 legislation in 2017
The information you provided gives an overview of the changes to IR35 legislation in the 2017 Budget and the reasons behind those changes. The IR35 rules in the UK are designed to determine the employment status of individuals working through intermediaries, such as personal service companies. The government identified two primary reasons for changing the legislation:
- Complex IR35 rules: The existing IR35 rules were considered difficult to understand and apply, leading to confusion and uncertainty among contractors and employers. The complexity of the rules made it challenging for individuals to determine their employment status correctly.
- Extensive non-compliance: The government estimated that non-compliance with IR35 rules was costing approximately £440 million per year in lost tax revenue. This non-compliance primarily arose from situations where directors of personal service companies would have been classified as employees if they did not operate through a limited company.
To address these issues, the government introduced changes to the IR35 legislation. In April of a specific year (mentioned as “this year” in your statement, but I don’t have the exact year), the responsibility for determining IR35 status and ensuring correct tax payment shifted from the contractor to the end-client for those working in the public sector. This change aimed to improve compliance and make it the responsibility of the party in the best position to assess employment status.
To assist in determining employment status, HMRC introduced the Employment Status Service Tool, an online tool that asks questions about various aspects of a contract. This tool helps both contractors and clients evaluate whether IR35 rules apply to a particular engagement. The public sector client is given a maximum of 31 days to make a determination regarding a contractor’s employment status based on the information provided.
It’s worth noting that since my knowledge cutoff is September 2021, there may have been further updates or changes to the IR35 legislation beyond that point. Therefore, it is advisable to consult the latest information from authoritative sources or seek professional advice for the most up-to-date details on IR35.
What does this mean for company directors?
The changes to IR35 legislation and the shift in responsibility for determining employment status can have significant implications for company directors running their own personal service companies. Being deemed “inside IR35” means that the director will be treated as an employee for tax purposes, resulting in increased tax liabilities and National Insurance contributions.
This can lead to a substantial loss of earnings for company directors who are caught by IR35. Furthermore, there is a concern that public bodies, in an attempt to avoid making the wrong decision, may have a bias towards deeming contractors as inside IR35. This situation raises the risk of triggering an IR35 tax investigation by HMRC into previous contracts, potentially going back several years.
Such investigations can result in retrospective tax charges, requiring the director to pay additional tax and NICs, including interest and possible penalties. As a result, company directors are advised to carefully assess their IR35 status, seek professional advice, and ensure compliance with the relevant regulations to mitigate potential financial and legal risks.
How IR35 rules lead to company insolvency
The implementation of IR35 rules can pose a significant risk of company insolvency for personal service companies. When a contractor or company director is deemed inside IR35, they are obligated to pay income tax and National Insurance contributions as if they were an employee.
This can result in a substantial decrease in take-home pay, as well as increased administrative and compliance costs. The financial strain caused by higher tax liabilities and reduced income can push personal service companies to the brink of insolvency. Additionally, the potential retrospective tax charges for previous contracts, combined with the ability of HMRC to review contracts for several years, further exacerbate the financial burden.
The combination of reduced income, increased tax liabilities, potential penalties, and the cost of tax investigations can create a downward spiral of debt that becomes difficult to escape, ultimately leading to company insolvency in some cases.
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With over three decades of experience in the business and turnaround sector, Steve Jones is one of the founders of Business Insolvency Helpline. With specialist knowledge of Insolvency, Liquidations, Administration, Pre-packs, CVA, MVL, Restructuring Advice and Company investment.