What determines IR35 status?

Welcome to one of our series of articles for HR, procurement and finance decision makers responsible for ensuring IR35 compliance.

The new off-payroll working rules shifted responsibility for determining contractor employment status to clients. It also shifted the financial risk.

It’s important to remember though that all other aspects of the IR35 guidelines are the same as before. There are no extra hurdles to declaring contractors as self-employed than there were before.

For most organisations, we know that your preferred outcome is to keep contractors working outside IR35. It’s better for you and them financially.

In this article, we look at what determines IR35 status focusing on:

The impact of IR35 status determination
The eight key factors determining IR35 status
Maintaining outside IR35 status throughout the term of the contract
Creating an outside IR35 welcoming environment for talented contractors

To speak to the IR35 determination for employers specialists, please call CoComply on +44 (0) 203 051 9792, email [email protected] or fill out the form below.

The impact of IR35 status determination

IR35 determines the type of relationship you have with self-employed contractors for tax purposes. Most contractors operate through their own limited company (sometimes called a personal service company).

When assessing a contactor’s employment status, they will either be outside IR35 or inside IR35.

If you declare your contractor outside IR35, the relationship you have with them is that of “customer-supplier”.

They are self-employed people operating in an independent capacity to provide the services set out in your written contract.

If you declare them inside IR35, the relationship you have is closer to that of an “employer-employee”.

While they may have a small additional degree of autonomy compared to standard employees, their working practices are essentially very similar.

IR35 and the taxes contractors pay

The way contractors and employees pay tax is very different.

It’s much better financially for your company if your contractors have self-employment status.

Every week, fortnight or month, your contractor sends you an invoice.

Your contractor handles all tax matters arising from that payment.

They pay corporation tax on it.

Once corporation tax has been paid, they pay themselves via salary and dividends.

With this arrangement, contractors earn far more than employees, even if they’re paid at the same hourly rate.

Contractors inside IR35 pay income tax and National Insurance contributions at the same rate as full-time employees.

This means their take-home pay is far lower than their contractor colleagues.

They do however receive employee benefits like sick pay, holiday pay, and parental leave pay.

How your organisation benefits from outside IR35 employment status

It’s not just your self-employed contractors who benefit from being outside IR35.

Being self-employed status means that you don’t have to pay 15.05% gross employer NICs on top of their gross salary.

This is why a contractor’s employment status has a real financial impact on both your company and the contractors you work with.

You might advertise a contractor role at £500 a day and you can be certain that, if you advertise the role as being outside IR35, you’ll get more applications from better contractors.

HMRC want to clamp down on IR35

HMRC is not happy about the disparity in pay between contractors and employees.

They believe that only 10% of IR35 status determinations are correct.

As a result, they estimate that they lose out on hundreds of millions of pounds worth of tax and National Insurance as a result.

Previously, contractors determined their own IR35 status and they got very good at it.

As there are hundreds of thousands of contractors in the UK, HMRC did not have the resources to launch investigations into anything other than a small percentage of them.

So they switched focus.

In April 2017, public sector bodies became responsible for determining contractor employment status. In April 2021, these rules were extended to private sector businesses whose turnover averaged £10.2m or more over the previous two consecutive financial years.

Contractors working for small businesses with lower turnovers can still determine their own IR35 employment status.

Why did HMRC do this?

IR35 (Off Payroll) was introduced by HMRC to close a perceived tax avoidance loophole. The legislation is designed to tax external workers' that are doing a similar job to an employee, at a rate like an employee. The rules apply where a worker provides their services to a client through an intermediary but would be classed as an employee if they were contracted directly. The legislation puts the responsibility for correct classification onto the customer. If the correct classification is not applied, HMRC will penalise the customer directly, and not the worker.

HMRC’s belief was that many employers would err on the side of caution and blanket determine all contractors within IR35.

They were right.

What are employers afraid of with IR35?

Employers are afraid of being fined and paying back taxes they didn’t budget for.

You have to pay all uncollected income tax and National Insurance contributions due from each misclassified contractor.

You then pay an additional fine on top of that which can reach 100% of the unpaid taxes if:

You did not take reasonable care when determining employment status
Your company either misled or was uncooperative with HMRC during an investigation.

In addition to the financial penalties, there is a risk to your professional reputation as HMRC tends to publicise the case they way.

Contractors may be less inclined to provide services to you if they’re not confident in your ability to correctly classify their employment status.

The key factors determining employment status under the off-payroll working rules

For HMRC to agree to an outside IR35 status for a contractor, both the written contract and the working practices of your contractor must demonstrate the following eight characteristics:

Level of control

You need to show that your contractor has autonomy in how, where and when they provide services to you.

The relationship between you should be like that of a garage mechanic and a client whose car has broken down. You present the car to the mechanic and it’s up to him or her to fix the car. They don’t need you to tell them how to fix the car or monitor your performance on a granular level.

If you want to be able to move contractors from task to task whenever you want, this is indicative of an “employer-employee” relationship.

Requiring a contractor to perform their services at a place of your choosing is indicative of the same unless the contractor could not provide the service required at any other location.

In general, your contractors should also have as much autonomy over their working practices as possible.

Mutuality of obligation

Following the completion of a job, your contractor should not expect to receive any more work from you.

Nor should they feel obliged to perform any work you want to provide them with, especially if it’s not covered by the governing contract of service.

HMRC may attempt to declare your relationship with a contractor as de facto employment if you provide continual work to them or your contracts span months or years.

To them, this may indicate that there is a single and continuing contract akin to that of an employee. They may argue that this would make your engagement with them inside IR35.

Substitutability

You should allow your contractors to send substitutes to do the work set out in your contract of service.

Your contractor must pay any substitute sent – they should not be paid by your company.

You should only veto a substitute if you are concerned that they do not have the qualifications, experience or the security clearance required.

Financial risk

In any standard “client-supplier” relationship, there is a risk for both parties.

If your contractor is responsible for an error which costs your company or organisation money, they should be liable to pay to rectify it on their own account.

Where practical, they should provide their own equipment to carry out the work agreed on. You should also require your contractors to have business insurance including professional indemnity insurance and public liability insurance at a minimum.

Office holders

If a role is created within a company or organisation that is a ‘permanent, substantive position which had an existence independent from the person who filled it, which went on and was filled in succession by successive holders’, the work must be declared as inside IR35 unless you can provide a substitute to do the work.

In other words, if the board creates a new position or the position filled by a contractor existed before and will continue to exist after the work is completed, this will be viewed in nearly all cases as an “employer-employee relationship”.

Exclusivity

If your contractor works for the same client all the time on a near-constant basis, this is likely to be an “employer-employee” relationship meaning that it would be inside IR35.

Although not always clear-cut, your relationship with a contractor is likely to be outside IR35 if they service multiple clients.

Dismissal

Although you can include a reasonable notice period in a contract with an independent contractor, it’s probably better if both parties can leave the contract with immediate effect although this is often difficult to achieve depending on the project

You should include reasonable grounds to terminate a contract unilaterally in your contract.

Signs of separation

Your contractor’s business should look and feel like any other autonomous business. Your contractor will appear more independent if they have their own trading style, their own website and business stationery.

You should not provide outside IR35 contractors with their own dedicated office space, business cards, inbound telephone number and so on.

IR35 status is an ongoing project

In IR35 terms, your business or organisation is the end client as it directly benefits from a contractor’s expertise.

You must create a status determination statement for every self-employed contractor they work with.

Under the new off-payroll rules, you must tell your contractor the IR35 status you’ve determined before they start work for you. You must also inform any other party involved in the supply chain like recruitment agencies.

You’ll need to do further work throughout the life of the contract to make sure that the outside IR35 status enjoyed by your contractor is maintained.

Although the written contract is very important, HMRC puts more store in the actual working practices of contractors if they dispute your employment status assessment.

Turning the new off-payroll working rules to your advantage

We’re CoComply, a professional services firm specialising in creating welcome, outside IR35 workplaces for contractors.

Outsource your IR35 compliance work to us with confidence to save your business money and attract the most talented contractors to your business or organisation.