IR35 is named after an Inland Revenue Statement of Practice 'IR35' which was published in 1999. It deals with the taxation of individuals who set up a service company through which they operate. It affects individuals who become self-employed consultants and who operate through a service company.
What was the problem?
Although many self-employed people operate legitimate companies, the government closed down what was seen as an abuse of the PAYE and National Insurance loop-hole.
Here are two examples that argue for and against the issue:
|Jo Bloggs is an IT specialist. She works for Client Ltd, and is paid £30,000 per year. She pays income tax and employee's National Insurance contributions on her salary. Client Ltd also pays Employer's National Insurance contributions in addition to the £30,000 salary.|
Jo subsequently sets up a company, Jo Bloggs Limited. She owns all the shares, and is the sole worker in the company which employs her to work on an IT 'consulting' contract which the 'company' has secured with Client Ltd. She then goes to work on the 'project' using Client Ltd's facilities and premises, doing the same job as before.
The difference is that each month instead of receiving a salary cheque from Client Ltd, Jo Bloggs Limited sends an invoice to Client Ltd which then pays for the consultant's services, without deducting PAYE or National Insurance contributions. This saves Client Ltd about £3,000 a year in NI contributions.
Jo Bloggs Ltd, in turn, pays Jo no salary at all. Instead it pays its sole share holder (Jo) a dividend. This therefore makes it possible for Jo to avoid paying any National Insurance, saving her about £2,400 per year.
Jo is also able to offset other expenses against the profits and recover VAT on many purchases.
She continues to carry out IT work with Client Ltd but this arrangement has significantly reduced the amount of tax and National Insurance that has been paid.
In many cases the situation was as simple as the above example. There is nothing illegal in any of this. These contractors have simply organised their affairs in a very tax efficient way. A significant rise in self-employed contractors triggered the introduction of the IR35 legislation.
Here is another simplified example, taken from the lobby-group website www.ir35.com, which, depending on your viewpoint, either demonstrates how IR35 has increased the tax bill of the contractors or illustrates how much tax these contractors had been able to avoid.
|A. Pre-IR35 scenario|
Annual Gross Pay = £64,400
By working via his/her own Service (Limited) Company, drawing minimum wages and drawing the remaining monies (after allowable company expenses), as dividends, the consultant could presently expect an annual net take home pay of approximately £51,000 (21 per cent deductions).
B. Post - IR35 scenario
Annual Gross Pay = £64,400 - 5% Non taxable allowance (Allowed by Revenue under IR35 in order for consultant to run business) = £3,220
- Single persons Tax Allowance £4,385 approx.
i.e. Taxable Pay £64,400 - (£3,220 + £4,385) = £56,680
Employers NI contribution (@12.2%) = £ 6,914
Employees NI contribution (@ 10% to £28k) = £2,800
Income Tax (10% up to £1,500) = £150
Income Tax (22%, £1.5k thru £28k) = £5,830
Income Tax (40%, £28k +) = £11,518
Total Income Tax Payable = £17,498
The total annual deductions (NI + Tax) is therefore:
£6,914 + £2,800 + £17,498 = £27,212
Total post IR35 annual take home pay = £37,234 (42% deductions)
So how does IR35 threaten contractors?
Depending on your viewpoint, the above scenarios are either intelligent ways of organising one's affairs or blatantly immoral, though completely legal, tax planning that meant some individuals were paying a lot less tax than others, which was unfair on those who remained as employees.
The government took the view that this was an abuse of the system, claimed this was costing hundreds of millions of pounds in lost revenue and so introduced IR35.
In essence the Inland Revenue and National Insurance authorities will take the view that this is a 'disguised employment' of Jo by Client Ltd. They will look to Jo Bloggs Ltd for all the National Insurance and Income Tax that would have been paid/collected if Jo had continued as an employee of Client Ltd. The Inland Revenue will look through the legal structure involving Jo Bloggs Limited.
The IR35 legislation sets out tests for the status of the consultant/contractor, working (after 6 April 2000) via their own limited service companies. Central to this is the distinction between 'genuine self-employed' and 'disguised employee'. Those deemed to be falling into the latter category will be liable to pay schedule E income tax and Class 1 NI on the entire amount of money (less allowable expenses) being paid to the limited company for their services.
AM I EMPLOYED OR SELF-EMPLOYED?
If you can answer 'yes' to most of the following questions, you are probably employed:
- Do you have to do the work personally rather than hire someone else to do it for you?
- Can someone tell you at any time what to do or when and how to do it?
- Are you paid on a regular basis, without submitting invoices?
- Do you work set hours, or a given number of hours a week or month?
- Do you work at the premises of the employer you work for, or at a place or places he or she decides?
If you can answer 'yes' to the following questions, it will usually mean you are self-employed:
- Do you have the final say in how your business is run?
- Do you risk your own money in your business?
- Are you responsible for meeting the losses as well as taking the profits?
- Do you provide the main items of equipment you need to do your job, not just the small tools many employees provide for themselves?
- Are you free to hire other people on your own terms to do the work you have taken on? Do you pay them out of your own pocket?
- Are you free to work for other clients?
- Do you have to correct unsatisfactory work in your own time and at your own expense?
Further information on IR35 can be found at the Inland Revenue website here.
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