IR35 Contractor Tax Demystified

Contractors and freelancers who choose not to be permanent
employees and work flexibly for many clients have been
targeted by UK tax legislation called IR35.

IR35 tax legislation is designed to tax as if they were
‘disguised employees’ workers providing their skilled and
predominantly knowledge-based services to clients via their
own limited company. IR35 can result in these workers
losing up to 25% of their normal take-home pay in extra
taxation.

Unfortunately, IR35 was poorly thought through and
subsequent tax tribunals and court cases have made things
so complex that prudent contractors pay professional
advisers to ensure they are not caught by IR35.

Her Majesty’s Revenue and Customs (HMRC) mounts IR35
investigations into many contractors’ tax affairs every
year, and is able to investigate contractors’ tax returns
and working practices up to six years in arrears. And many
contractors end up in IR35 tax tribunals or court cases
because they dispute having to pay the extra tax demanded.

When deciding on whether or not a contractor is inside IR35
and therefore must pay extra tax, HMRC inspectors – and
later tax tribunals and courts – look at three key areas:

- The written contract between the contractor and the
agency and end-user client

- The contractor’s business as a whole

- The actual working relationship between the contractor
and their client.

What tax inspectors want to prove is that the contractor is
really a ‘disguised employee’, and if the contractor did
not have an intermediary like their limited company between
them and the client, they would be a permanent employee and
should be taxed as such. This is why IR35 is also called
the ‘Intermediary’s Legislation’.

HMRC uses key ‘tests of employment’ to check if a
contractor is a disguised employee, including:

- Whether the contractor is controlled, or told how to
work, by their end user client

- The ability of the contractor to use a substitute on the
contract – Mutuality of obligation, or ‘MOO’

- where an employer is obliged to provide work and an
employee is obliged to do it.

Generally, if a contractor fails one of these tests, a
tribunal or court will find that they are outside of IR35
and so do not have to pay extra tax as an employee.
Unfortunately, though, tests of employment are rarely
straightforward. So contractors can undergo long periods of
stress during the course of an IR35 investigation, and
still fall foul of IR35 legislation due to technicalities.

There are easy actions contractors should employ to reduce
the chances of them being found within IR35, eg to invest
in tax investigation insurance, to get contracts checked by
an expert, and to get clients to confirm the contractor’s
working arrangements.

Contractor organisations have tried to abolish IR35 for
many years, but it is likely that the legislation, or
something very similar to IR35, will remain on the statue
books for the foreseeable future. Therefore, contractors
should always ensure they manage their contracting careers
so that they never fall foul of IR35.