Contractors' Questions: What's the 5% expenses rule under IR35?
Contractor’s Question: I began contracting in 1997 but in light of IR35 in 2000 I decided to invest in engineering design software. It cost me £15,000 plus £1,800 in annual maintenance.
I then freelanced alongside agency/intermediate work and slowly began contracting alone, without the agent. In 2008, I invested £8,000 in CAD software with annual maintenance of £1,500 and, more recently, invested in 3D equipment at a cost of about £20,000. Currently, I have decided to return to contracting via an agency and have landed a new contract.
The rub is that I’ve been told by my accountant that if IR35 applies to the contract, I would not be able to claim expenses for my annual maintenance software, because my other expenses would push me over the 5% mark. Please advise on the IR35 5% expenses rule.
Expert’s Answer: When IR35 applies, the earnings of your intermediary (your personal service company, limited company or partnership) for that engagement are deemed to be the income of the worker. This is called the deemed employment payment.
Therefore, if IR35 applies to a contract, you must:
- calculate the deemed employment payment and pay any tax and National Insurance Contributions due, at the end of the tax year
- account for those payments correctly
- reassess the IR35 position if your contracts vary or change
- take into account the deemed employment payment when paying Corporation Tax, making distributions (or operating the Construction Industry Scheme).
The deemed employment calculation allows a flat-rate 5% reduction from the total IR35 income received by your limited company or partnership. There is no restriction on the use of this allowance and you are not required to demonstrate this expenditure - the 5% deduction will be allowed in all cases and no proof of the expense is required by HMRC.
The 5% reduction is for expenses which the worker could have claimed as a deduction under the normal rules if they had been directly employed by the client and the expenses had been met from their earnings e.g. administration costs, which can include
- Premises costs including home as office
- Administration and secretarial support
- Accountancy and tax advice
- Costs of seeking contracts
- Printing, postage and stationery
- Employer’s and Public Liability Insurance
- Training costs
- Computer equipment (if not eligible for capital allowances)
- Bank and overdraft interest
- Hire purchase payments
A deduction for the same expenses can only be given in the deemed employment payment calculation once.
Income earned from relevant engagements is treated as if it were earned from a single continuing employment with your limited company or partnership. The rules for travel expenses are applied on this basis when working out whether a particular location is a temporary or permanent workplace.
Allowances for corporation tax
The 5% is in respect of the deemed salary calculation only and is not taken into account when preparing the company’s accounts and corporation tax computation.
The company accounts should take into account the actual expenses only, which may be higher or lower than the 5% allowance.
If the contract is deemed by HMRC to be caught by IR35 and the contractor is using an umbrella company, then the 5% rule will not apply as it would be unusual for the contractor to have any administration expenses, other than the umbrella company fee.
The expert was Nigel Nordone, a senior tax consultant at Abbey Tax and former PAYE inspector for HMRC.