If your organisation works with contractors or freelancers, you have likely come across the IR35 rules. Originally introduced to tackle tax avoidance, these rules play a significant role in determining whether contractors should be treated (for tax purposes) as employees. If you are new to IR35, this blog provides a straightforward breakdown of what the rules mean, who they apply to, and the key compliance considerations for businesses.
What is IR35?
IR35 refers to tax legislation designed to identify situations where a contractor is, in reality, working as an employee but through an intermediary, most often a Personal Service Company (PSC) or Employer of Record (EOR).
The rules were first introduced in the Finance Act 2000. In April 2017, an extended version known as the Off-Payroll Working rules came into effect for the public sector, and later for medium and large private sector organisations. While “IR35” and “Off-Payroll rules” are technically separate, they are now commonly used interchangeably.
At its core, IR35 ensures that contractors who are effectively employees for tax purposes pay broadly the same Income Tax and National Insurance Contributions (NICs) as directly employed staff.
Who does IR35 apply to?
The rules affect three key parties:
- Workers (contractors/freelancers): Typically individuals providing services through a PSC or intermediary structure.
- Clients (end-hirers): The organisation receiving the contractor’s services. Depending on size, they may also be responsible for determining employment status.
- Agencies or suppliers: Intermediaries that place contractors into roles.
Business size plays a role in determining who is responsible for the IR35 assessment. For example:
- In the public sector and medium/large private sector clients, it is the hirer’s duty to assess IR35 status.
- For small businesses, the responsibility falls on the contractor’s intermediary.
Why was IR35 implemented?
Before IR35, many businesses engaged contractors through PSCs to save on employment costs. Clients avoided NICs and employment obligations, while contractors could reduce their tax liabilities compared to being directly employed. HMRC introduced IR35 to combat this tax avoidance, ensuring fair contributions and a level playing field for genuine contractors.
Personal Service Companies (PSC) and IR35
A PSC is typically a limited company owned and operated by one individual who delivers services to clients. While PSCs are common and legitimate, IR35 is designed to ensure they are not used solely as a mechanism for tax avoidance. Contractors and clients must establish a genuine business-to-business relationship rather than one that mirrors employment.
When do IR35 rules apply?
The rules apply when, despite working through a contractor’s company, the relationship between the contractor and client is essentially that of an employee/employer.
Key differences depend on:
- Whether the client is public or private sector.
- Whether the client meets HMRC’s definition of a small business.
- The degree of control, substitution rights, and level of mutual obligation in the arrangement.
Common IR35 pitfalls (“disguised employment”)
Businesses and contractors should consider the following red flags:
- Control: The client dictates how, when and where the contractor works, rather than the contractor deciding independently.
- Substitution: The contractor cannot send a substitute to perform the work.
- Mutuality of Obligation (MOO): Ongoing expectations of work and payment are similar to employee arrangements.
- Integration: The contractor is treated as part of the permanent workforce, e.g., attending staff meetings, using client equipment, or working fixed hours.
- Payment structure: Contractor income resembles a salaried role, rather than project- or milestone-based invoicing.
Penalties for getting IR35 wrong
Breaching IR35 can result in significant backdated tax, NICs, and penalties. HMRC considers intent:
- Careless mistakes: Up to 30% of unpaid tax.
- Deliberate avoidance: Up to 70% of unpaid tax.
Clients may also face tribunal action if found intentionally non-compliant.
Staying compliant
To reduce the risk of failing an IR35 assessment:
- Review contractor arrangements regularly.
- Ensure written contracts clearly outline the independent nature of the engagement.
- Document the right of substitution and clarify project-based delivery.
- Use HMRC’s Check Employment Status for Tax (CEST) tool or an independent IR35 specialist to assess risk.
IR35 is complex, and every arrangement depends on its specific circumstances. Taking the time to understand the rules, draft robust contracts, and assess working practices will help businesses and contractors alike stay compliant and avoid costly penalties.
