Freelance contractors are now a significant part of the working population of the UK and contribute hugely to the economy. As business owners, the likelihood is that it’ll become more and more common for you to engage the services of a contractor on an ongoing basis. For example, to maintain your website or help with your accounting.
If you are engaging the services of a contractor, it’s essential, for tax purposes, that they are genuinely self-employed and not, to all intents and purposes, an extension of your employee pool. Otherwise, you and the contractor will be liable to pay the respective tax and national insurance due – and you may incur penalties.
What is IR35?
IR35 was originally introduced by Gordon Brown, to prevent employees from avoiding tax by being treated as contractors. With an employee, an employer must provide a workplace pension, paid holiday, sick pay, other benefits and pay employer’s National Insurance contributions. A contractor, on the other hand, is paid a flat fee and can be dismissed easily if there is no more work for them to do.
IR35 is also known as ‘off-payroll working’. IR35 is designed to prevent workers from avoiding tax by operating as contractors, when really they are employees in all but name. So for example, if a contractor operates via their own limited company, but is otherwise treated the same as their client’s employees, they are ‘inside IR35’ and will need to make additional tax payments.
Private businesses and contractors were bracing themselves for this to be effective from April 2020 but in response to the ongoing spread of Covid-19, these reforms have been delayed until 2021.
But from April 2021, private sector companies will be held responsible for determining whether IR35 applies to any contractor they hire – which would require them to treat the contractor as an employee for tax purposes. This is already the case in the public sector.
Small business exemption to new IR35 rules
There is an exemption for ‘small businesses’ as defined by the Companies Act 2006 which means meeting two or more of the following criteria:
- Annual turnover is no more than £10.2 million
- Balance sheet total is no more than £5.1 million
- No more than 50 employees
Where a company meets two or more of these criteria, responsibility for determining the IR35 status of an assignment remains with the contractor and the new rules do not apply.
There’s no small business exemption for public sector organisations.
How can you determine if IR35 applies to your contractors?
Firstly, IR35 is a complicated set of rules, with no clear ‘yes’ or ‘no’ answers so it’s important that you seek expert advice from your accountant.
There are, however, some obvious indicators, which will help you assess your level of risk:
- Direction and control – how much control do you have over your contractor and how they carry out their work? If you control the hours they work and the working pattern this would indicate employment. As would specifying the requirement for them to be present at your office or place of work regularly.
It’s also important your contractor ‘looks’ like a contractor in their day-to-day work for you. For example, having an internal email address or phone number, or managing employees and budgets would indicate they are an employee.
- Right of substitution – a contractor should have the right of substitution, for all or at least some part of the project. In other words, as the client, you are paying for a service not a specific person.
- Mutuality of obligation – there should be no mutuality of obligation on the contractor to undertake the work and, for your company, no obligation to provide any work.
- Length of engagement – if you have been engaging with the same contractor for a long time or if you provide them with regular work this may indicate employment – it is not conclusive but if coupled with lots of other factors pointing to employment, it could mean you’re caught by IR35. Make sure you don’t enforce a contract that states your freelancer/contractor can’t work with anyone else as this points to employed status.
What is a personal service company?
Most contractors operate as limited companies. A personal service company (PSC) is merely a company through which a contractor operates to do their freelance work.
However, operating as a company doesn’t prevent a contractor from being an employee in all but name – which is where IR35 comes in.
Broadly, IR35 says, ‘If it looks like a duck and quacks like a duck, it’s a duck.’ In other words, if the contractor is working like an employee, with similar obligations, then they should be treated as one for tax purposes. This is why HMRC looks very closely at what it calls ‘personal service companies’.
If you’re concerned that a contractor you hire might be considered an employee by HMRC, then you may not want to risk hiring them at all. In this case, both your business and the contractor will lose out. This is what many small businesses fear will happen post-April 2021.
But fears that the changes to IR35 will spell the death of freelancing are exaggerated. By taking the appropriate steps, both contractors and businesses can ensure they do not fall foul of IR35.
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