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.