What does Inside IR35 mean?
The concept of being Inside IR35 (or Outside IR35) results from the issue that faced the Inland Revenue in 1999 -- ‘disguised employment,’ writes Danny Batey, senior tax consultant at Markel.
Determining IR35 status
HMRC perceived unfairness because contractors were being paid to undertake the same work as employees, but could benefit from a less taxing regime by operating through their own limited company (or Personal Service Company -- PSC).
Remunerating themselves via a low salary and taking the remainder of their income as dividends, which attracted neither employer nor employee National Insurance Contributions (NICs), contractors emerged as paying less tax than their conventionally employed counterparts.
The Intermediaries legislation came into force to tackle “disguised employment” in April 2000, and it was announced by Inland Revenue budget press release No 35. The term ‘IR35’ was born.
Creating the hypothetical contract
The Intermediaries legislation requires the creation of a ‘hypothetical contract.’ It asks the question, ‘If the individual worker was engaged directly by the end-client; what would that relationship look like? Employment or self-employment?’
If the answer is ‘self-employment,’ engagements are deemed ‘Outside IR35,’ meaning IR35 does not apply.
Inside IR35: the ramifications
Conversely, if the answer is employment meaning IR35 applies, an engagement is ‘Inside IR35.’
Outlining what it means to be ‘inside IR35’ is not straightforward and depends upon who has responsibility for determining IR35, which, in turn, affects the tax treatment.
The original IR35 (or ‘old’ IR35 - as it’s sometimes described)
The initial Intermediaries legislation, found at Part 2 Chapter 8 Income Tax (Earnings and Pensions) Act (ITEPA) 2003, was a consideration for all engagements by PSCs since April 6th 2000.
But later, the legislation wase amended by the public sector off-payroll working rules of April 6th 2017 and the private sector off-payroll working rules of April 6th 2021.
Under Chapter 8 (2000), every contractor trading through their own PSC had the responsibility to determine whether their engagements were Inside IR35 or Outside IR35. Any income from an ‘Inside’ engagement was required to have the ‘deemed employment calculation’ applied to it.
Deemed Employment Calculation: How HMRC says to calculate it
Available online, HMRC guidance on how to make this calculation takes you through nine steps and includes a link to a deemed employment calculator.
In short, the contractor applies a 5% flat-rate deduction from their fee income for general expenses incurred in running their business. On the remaining 95%, the contractor can claim deductions allowable for any employee (e.g. subscriptions, protective clothing and training paid for by the contractor), as well as pension contributions.
Once these deductions have been accounted for, Employer NICs and PAYE is deducted from the total and paid across to HMRC.
How much does Inside IR35 cost?
A typical contractor might see a difference in take-home pay 30% less for an ‘Inside’ engagement using the deemed employment calculation.
The old Chapter 8 rules also currently apply today to PSC engagements with ‘small companies’ (as defined by the Companies Act), or entities based wholly overseas with no UK presence. The contractor retains the responsibility and liability for IR35 and uses this calculation for engagements deemed inside.
The impact of the April 6th 2017 and April 6th 2021 IR35 reforms
Legislated for by Chapter 10 ITEPA 2003, IR35 decision-making responsibility transferred from the PSC to medium and large-sized businesses on April 6th 2021 (as it did in the public sector on April 6th 2017 albeit with no exemption pertaining to the size of the public sector body).
Who is the fee-payer?
The 2021 legislation also introduced the concept of the ‘fee-payer’ i.e. the entity in the contractual chain closest to, and responsible for paying, the PSC. For direct engagements, the fee-payer would be the end-client, but in contractual chains involving agencies, the agency closest to the PSC assumes the fee-payer liability.
Crucially, Chapter 10 fundamentally alters the tax position of a PSC engaged ‘Inside IR35’ as it requires the fee-payer to deduct PAYE, Employers NICs and the Apprenticeship Levy (where applicable), all at source, and from the amount paid to the contractor. Essentially, for tax purposes only, the PSC is added to the fee-payer’s payroll as an employee.
No 5% expenses deduction for contractors caught under Chapter 10
In addition with Chapter 10 (oft-called ‘the 2021 the off-payroll rules’), contractors lose the 5% general expense deduction of the deemed employment calculation, i.e. the PSC receives the net amount after all taxes have been deducted. Contractors on Inside IR35 engagements for a complete tax year will have no profit against which to deduct expenses.
Therefore, the business’s running costs effectively come out of the contractor’s own pocket. That raises the question, ‘If all engagements are deemed inside IR35, why undertake them through a PSC?’
In response, many contractors closed their companies and either took staff jobs or operated through an umbrella company where they get paid under PAYE. This has had a profound effect on contractor opportunities. But end-clients have also felt the pinch in terms of contractor retention, having to increase day rates to compensate contractors for their additional tax burden.
Inside IR35 contracting, HMRC enquiries, IR35 status factors
Very often, operating Inside IR35 under Chapter 10 has little or no appeal to the contractor. On the other hand, where the contractor retains the liability under Chapter 8, this is more difficult to police. And the enforcer of the off-payroll rules, HMRC, has the practical issue which has plagued them throughout IR35’s history -- undertaking detailed and expensive IR35 and off-payroll enquiries into individual contractors, testing for Control, Mutuality of Obligation, Personal Service/Substitution as well as other important but less determinative IR35 status factors, like Financial Risk.
With professional contracting, the real benefits for all parties lie in genuinely ‘Outside IR35’ engagements, which will be considered in our next article for ContractorUK.