The ‘IR35’ rules are designed to prevent the avoidance of tax and national insurance contributions (NICs) through the use of personal service companies and partnerships.
The rules do not stop individuals selling their services through either their own personal companies or a partnership. However, they do seek to remove any possible tax advantages from doing so.
Summary of approach
Removal of tax advantages
The tax advantages mainly arise by extracting the net taxable profits of the company by way of dividend. This avoids any national insurance contributions (NICs) which would generally have been due if that profit had been extracted by way of remuneration or bonus.
The intention of the rules is to tax most of the income of the company as if it were the salary of the person doing the work.
To whom does it apply?
The rules apply if, had the individual sold his/her services directly rather than through a company (or partnership), he/she would have been classed (by HMRC) as employed rather than self-employed.
For example, an individual operating through a personal service company but with only one customer for whom he/she effectively works full-time is likely to be caught by the rules. On the other hand, an individual providing similar services to many customers is far less likely to be affected.
The main points to consider if you are caught by the legislation are:
- the broad effect of the legislation will be to charge the income of the company to NICs and income tax, at personal tax rates rather than corporate tax rates
- there may be little difference to your net income whether you operate as a company or as an individual
- to the extent you have a choice in the matter, do you want to continue to operate through a company?
- if the client requires you to continue as a limited company, can you negotiate with the client for increased fees?
- if you continue as a limited company you need to look at the future company income and expenses to ensure that you will not suffer more taxation than you need to.
The last point is considered in more detail below.
Employment v self-employment
One of the major issues under the rules is to establish whether particular relationships or contracts are caught. This is because the dividing line between employment and self-employment has always been a fine one.
All of the factors will be considered, but overall it is the intention and reality of the relationship that matters.
The table below sets out the factors which are relevant to the decision.
HMRC will consider the following to decide whether a contract is caught under the rules:
- Mutuality of obligation
- – the customer will offer work and the worker accept it as an ongoing understanding?
- – the customer has control over tasks undertaken/hours worked etc?
- – the customer provides all of the necessary equipment?
- – the individual can do the job himself or send a substitute?
- Financial risk
- – the company (or partnership) bears financial risk?
- Basis of payment
- – the company (or partnership) is paid a fixed sum for a particular job?
- – the individual is entitled to sick pay, holiday pay, expenses etc?
- – the customer and the worker have agreed there is no intention of an employment relationship?
- Personal factors
- – the individual works for a number of different customers and the company (or partnership) obtains new work in a business-like way?
Exceptions to the rules
If a company has employees who have 5% or less of the shares in their employer company, the rules will not be applied to the income that those employees generate for the company.
Note however that in establishing whether the 5% test is met, any shares held by ‘associates’ must be included.
How the rules operate
The company operates PAYE & NICs on actual payments of salary to the individual during the year in the normal way.
If, at the end of the tax year - ie 5 April, the individual’s salary from the company, including benefits in kind, amounts to less than the company’s income from all of the contracts to which the rules apply, then the difference (net of allowable expenses) is deemed to have been paid to the individual as salary on 5 April and PAYE/NICs are due.
- normal employment expenses (eg travel)
- certain capital allowances
- employer pension contributions
- employers’ NICs - both actually paid and due on any deemed salary
- 5% of the gross income to cover all other expenses.
Where salary is deemed in this way:
- appropriate deductions are allowed in arriving at corporation tax profits and
- no further tax/NICs are due if the individual subsequently withdraws the money from the company in a HMRC-approved manner (see below).
Points to consider from the working of the rules
Income and expenses
The income included in the computation of the deemed payment on 5 April includes the actual receipts for the tax year.
The expenses are those incurred by the company between these two dates.
In order to perform the calculations, you need to have accurate information for the company’s income and expenses for this period. You may need to keep separate records of the company expenses which will qualify as ‘employee expenses’.
Timing of corporation tax deduction for deemed payment
A deduction is given for the deemed payment against profits chargeable to corporation tax as if an expense was incurred on 5 April. This means that relief is given sooner where the accounting date is 5 April.
Payments made by your company into a personal pension plan will reduce the deemed payment. This can be attractive as the employer’s NICs will be saved in addition to PAYE and employee’s NICs.
Other points to consider
Extracting funds from the company
For income earned from contracts which are likely to be caught by the rules, the choices available to extract funds for living expenses include:
- paying a salary
- borrowing from the company and repaying the loan out of salary as 5 April approaches
- paying interim dividends.
The advantage of paying a salary is that the tax payments are spread throughout the year and not left as a large lump sum to pay on 19 April (22 for cleared electronic payment). The disadvantage is fairly obvious!
Borrowing from the company on a temporary basis may mean that no tax is paid when the loan is taken out, but it will result in tax and NICs on the notional interest on the loan. There may also be a need to make a payment to HMRC equal to 32.5% of the loan under the ‘loans to participators’ rules.
The payment of dividends may be the most attractive route. If a deemed payment is treated as made in a tax year, but the company has already paid the same amount to you or another shareholder during the year as a dividend, you will be allowed to make a claim for the tax on the dividend to be relieved to avoid double taxation.
The company must submit a claim identifying the dividends which are to be relieved.
Getting ready for 5 April
There is a tight deadline for the calculation of the deemed payment and paying HMRC. The key dates are:
- the deemed payment is treated as if an actual payment had been made by the company on 5 April
- tax and NICs have to be paid to HMRC by 19 April
- final RTI submissions showing details of the deemed payment has to be submitted to HMRC by 19 April.
- Where a provisional payment of tax and National Insurance contributions has been made because it has not been possible to accurately calculate the deemed payment and deductions by 19 April, then any adjustments should be reported via an Earlier Year Update (EYU) submitted electronically to HMRC before the following 31 January. However, interest on overdue tax is chargeable from 19 April if tax and NICs are underpaid on the basis of provisional figures
It is therefore in your interests to have accurate information on the company’s income and expenses on a tax year basis and, in particular, separate records of the amount of the company expenses which will qualify as ‘employee expenses’.
Where individuals sell their services through a partnership, the rules are applied to any income arising which would have been taxed as employment income if the partnership had not existed.
In other words, where a partnership receives payment under an ‘employment contract’:
- income of the partnership from all such contracts in the year (net of allowable expenses as described above) are deemed to have been paid to the individuals on 5 April as salary from a deemed employment with PAYE/ NICs due accordingly and
- any amount taxed in this way as if it were employment income is not then taxed as part of the partnership profits.
Partnerships excluded from the rules
Many partnerships are not caught by the rules even if one or more of the partners performs work for a client which may have the qualities of an employment contract.
The rules will only apply to partnerships where:
- an individual, (either alone or with one or more relatives), is entitled to 60% or more of the profits or
- all or most of the partnership’s income comes from ‘employment contracts’ with a single customer or
- any of the partners’ profit share is based on the amount of income from ‘employment contracts’.
Where a personal service company or partnership fails to deduct and account for PAYE/NICs due under the rules, the normal penalty provisions apply.
If the company or partnership fails to pay, it will be possible for the tax and NICs due to be collected from the individual as happens in certain circumstances under existing PAYE and NIC legislation.
Intermediaries - travel and subsistence
Tax relief is not available on travel and subsistence expenses for workers engaged through an employment intermediary, such as a recruitment agency or a personal service company.
No relief is allowed for home to work travel and subsistence where a worker:
- personally provides services to another person
- is employed through an employment intermediary
- is under (the right of) the supervision, direction or control of any person, in the manner in which they undertake their work.
An employment intermediary is defined as a person, other than the worker or the client, who carries on a business (whether or not with a view to profit and whether or not in conjunction with any other business) of supplying labour.
Where a personal service company is also within the scope of the IR35 legislation this rule only applies to those contracts where a deemed employment payment is made, or would be made if all the individual's remuneration was not being taken as employment income. In these circumstances the supervision, direction or control test will not be used.
Managed Service Companies (MSCs)
MSCs had attempted to avoid the IR35 rules. The types of MSCs vary but are often referred to as ‘composite companies’ or ‘managed PSCs’. HMRC had encountered increasing difficulty in applying the IR35 rules to MSCs because of the large number of workers involved and the labour-intensive nature of the work. Even when the IR35 rules had been successfully applied, an MSC often escaped payment of outstanding tax and NIC as they have no assets and could be wound up.
The government has introduced legislation which applies to MSCs. The rules:
- ensure that those working in MSCs pay PAYE and NIC at the same level as other employees
- alter the travel and subsistence rules for workers of MSCs to ensure they are consistent with those for other employees
- allow the recovery of outstanding PAYE and NIC from ‘specified persons’, primarily the MSC directors, if the amounts cannot be recovered from the company.
MSCs are required to account for PAYE on all payments received by individuals.
Off-payroll working in the public sector
Rules have been introduced which affect the operation of IR35 in relation to engagements in the public sector.
Under these rules the decision to apply IR35 is made by the public sector body, agency or third party rather than by the individual worker’s own service company.
Where IR35 applies, the public sector engager or agency is treated as an employer for the purposes of tax and Class 1 NICs (including employer NICs) and the amount paid to the worker’s intermediary will be deemed to be a payment of employment income to that worker.
The 5% allowance used by the worker’s intermediary for certain business expenses is not available for contracts with the public sector.
HMRC has provided a digital tool to help identify whether engagements fall within these rules.
Off-payroll working rules in the private sector
New tax rules apply to individuals who provide their personal services via an 'intermediary' to a medium or large business. The new rules apply to payments made for services provided on or after 6 April 2021.
The off-payroll working rules apply where an individual (the worker) provides their services through an intermediary (typically a personal service company) to another person or entity (the client). The client will be required to make a determination of a worker's status and communicate that determination. In addition, the fee-payer (usually the organisation paying the worker's personal service company) will need to make deductions for income tax and NICs and pay any employer NICs.
The legislation uses an existing statutory definition within the Companies Act of a 'small company' to exempt small businesses from the new rules. A small company is one which meets two of these criteria:
- a turnover of £10.2 million or less
- having £5.1 million on the balance sheet or less
- having 50 or fewer employees.
If the business receiving the work of the individual is not a company, it is only the turnover test that will apply.
Status Determination Statement
The Status Determination Statement (SDS) is a key part of the status determination procedure. The client must provide the SDS to the worker and should include not only the decision of the client but also the reasons underpinning it. The client must take 'reasonable care' in coming to its conclusion. If it does not, the statement is not a valid SDS.