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What UK consultants need to know about IR35

Under UK law IR35, Her Majesty's Revenue and Customs may examine the contract between contractor and client to determine if its terms could describe an employment relationship.

If you're an independent consultant (or any other type of contractor, for that matter) in the United Kingdom, you'll want to know about IR35, a piece of legislation that could cost you a bundle in taxes.

Similar to the U.S. rules regarding statutory employment, IR35 is a law that seeks to close tax loopholes related to classifying workers as contractors rather than employees. In the UK, a typical incarnation of this tax dodge would be to have clients pay to a service company, and then the contractor would withdraw funds from the company in the form of dividends, with a small salary. Since dividends aren't subject to National Insurance Contributions (NICs), this practice saved contractors a lot of money.

Setting up a company and drawing dividends from it is perfectly legal. However, if the relationship between contractor and client is virtually the same as that between employee and employer, its taxation should be no different -- at least, that was the reasoning behind the introduction of IR35, which took effect in 2000.

Under IR35, Her Majesty's Revenue and Customs (HMRC) may examine the contractual relationship between contractor and client to determine if its terms could describe an employment relationship instead. If so, HMRC would deem the contractor a "disguised employee," and all fees paid to the contractor's company would then be taxed as salary. While that may sound fair enough, studies show that contractors whose contracts fail IR35 end up paying approximately 12% more in taxes than permanent employees making the same salary.

HMRC use three main tests of employment: control, substitution, and mutuality of obligation.

Control, as in the United States, means whether the contractor controls his/her own business. Ideally, clients should request an end result, and leave the "how" to the consultant. If the client exerts too much control over the process, then it could be deemed an employment relationship.

Substitution means that the contractor can use any of his/her own personnel or subcontractors to complete the work on their behalf. If the client specifies that only the individual who signed the contract may perform the work agreed upon, then they are treating the contractor as an employee.

Mutuality of Obligation means that the client is obligated to provide a certain amount of work to be performed, and the contractor is likewise obligated to perform it. In the UK, that's more like an employment relationship. Contractors, by contrast, are expected to get individual jobs with no guarantees of future employment. Conversely, a contractor should have the right to refuse a specific job.

Other factors also come into consideration, but these are the big three. However, the nuances of each of these factors and their interactions need to be taken into account with regard to almost every business-related activity. For instance, travel should ideally be booked and paid by the consultant, and then charged back to the client. Otherwise, HMRC could raise the issue of control. There are cases where limited control of such activities by the client does not invalidate the control test.

Unfortunately, HMRC will not review any contract until after it is signed, which means you either roll your dice and take your chances, or you contract a lawyer who specializes in these rules to vet the contract terms.

If you're a foreign contractor in the UK, the question of whether IR35 applies to you probably resolves into the question of where you pay your taxes. For instance, a US contractor would pay tax on UK income to the US Treasury as foreign income. In that case, IR35 does not apply -- but US rules do.

Conversely, if you're a UK contractor working for companies outside the UK, then IR35 may apply to your relationship with those companies. Check with a lawyer to be sure.

As we might expect, IR35 has sparked a lot of controversy in the UK. The revenue it has generated has fallen short of the projected £220 million for National Insurance and £80 million for income tax by somewhere around 99%. We might hope that the UK will repeal or simplify this legislation, but from all signs the government only intends to expand its applicability.

Thanks to Bob Eisenhardt (reisen55) for leading me to this topic.

About

Chip Camden has been programming since 1978, and he's still not done. An independent consultant since 1991, Chip specializes in software development tools, languages, and migration to new technology. Besides writing for TechRepublic's IT Consultant b...

10 comments
FreelanceScribbler
FreelanceScribbler

Considering how many contractors there are, the chances of the HMRC targeting you for a breach of the [url=http://www.sjdaccountancy.com/about/ir35_advice.html]ir35 rules[/url] are very slim indeed. But if you can proove that you use all your own equipment, plus a list of other tediously obvious things, it really isn't a problem. The biggest problem is probably having to use your own equipment - so you'll have to bring your own laptop into work every day if a client likes you to be on site. You can't just use one of their PCs.

Tony Hopkinson
Tony Hopkinson

Substitution was always a good one. Initially this was posited as using kit provided by the "employer", course that was a nonsense as not many serious organisations let you plug personal kit into their network. Another one was most contractors didn't legally have holidays or sick pay, etc, unless they provided it themselves. Seeing as employers and the state have to meet statuary minimums in the UK, they had to mess about again. While I'll be the first to admit pre IR35, a lot of contractors were taking the urine, they went way too far with this and threw the baby out with the bath water. I also find it typical that they went after the little guys.

ivan
ivan

My understanding has always been that another key point is having multiple (simultaneous) clients (sorry if this is obvious/implied). This is again looking at the base point of whether you are "self employed" or not, and if you do have multiple clients then that helps show you aren't in "employment status". Another useful resource for IR35 stuff is http://www.contractoruk.com/ir35/.

pjpfowler
pjpfowler

I had been running my own IT consulting business in the UK for many years leading up to 1993 when I took a contract overseas and never bothered returning to the UK for work. I've seen a flood of contracts and consultants arrive in Asia since the early 2000's and many of them on short term assignments that decide it's not worth going back to the UK. IR35 has killed much of the spirit that drives or used to drive individuals to take a chance and set up their own business. They take the risks - no work no pay, cover their own medical, insurance, indemnity and pension costs and the benefit was the extra they could earn through the "flexibility" of the tax system. That's gone. The expertise and entrepreneurial spirit has in many cases gone overseas or died as a result and the tax man has nothing to show for it. Have I missed something or is this just another blind accounting decision with no view to the development of business, professional services and well being of the country and it's people?

Sterling chip Camden
Sterling chip Camden

... I hope I haven't missed or messed any important details. If so, perhaps some of our UK readers could help me out.

Sterling chip Camden
Sterling chip Camden

... they usually end up creating a bigger one -- and as you observed, the little guy is the one who pays for it. Which only makes sense, because they don't have the resources to fight it or buy it.

Sterling chip Camden
Sterling chip Camden

Multiple clients is a key factor in the US and in France, but in my research I didn't find any mention of that with regard to IR35. I'm sure it can't hurt, though.

Sterling chip Camden
Sterling chip Camden

... the whole idea was spawned from political motives, so of course it's more concerned with looking like it's doing something than it is with actually accomplishing anything useful. Par for the course when it comes to government.

melbert09
melbert09

Being a contractor in the UK for a couple of years now and from what I understand (not an expert, that’s why I hire them) are the following: 1. Length of Contract can be an issue. You need to be careful if a contract is over a year. 2. If you are in a management position. i.e. responsible for permanent personnel; doing reviews, holidays etc.. Im sure that there are other rules, but Im not clear of them, also from what I understand and have read even after a couple of years with IR35 in place everyone is still confused on this, from HR, Lawyers, Accountants and even the HMRC.