Updated on: Sep 18, 2023
In this article I want to look at limited company contractors who work inside IR35. There are lots of phrases used to describe this type of work. You may see phrases such as “caught by IR35”, “working inside IR35”, “caught by the off payroll rules” or even “disguised employment”. They all mean the same thing so let’s get into a bit more detail and understand how this all works. For the current state of play also refer to our IR35 News article.
What is IR35?
Firstly, let’s have a bit of background. No article about IR35 is complete without reminding you how IR35 came about, what it means, and how it gets assessed. However, because it has been around since 2001 let’s keep this brief. Over 20 years ago there were significant tax advantages in working as a limited company contractor (and some employees left their employer on a Friday and returned on a Monday as a limited company contractor). The employer liked it because it made some of the workforce more flexible and easier to manage, and the employee who was willing to forgo the safety net of holiday pay, sick pay, and other employment benefits, could gain significant tax advantages by becoming a contractor.
However, this created a large gap in the tax revenue collected from that worker and these arrangements were purely seen as a way of paying less tax with very little else in the way of commercial rationale. Artificial arrangements purely to avoid paying tax are generally disliked by tax departments, so it’s understandable that some action was taken to address this particular issue.
Keep in mind this legislation was introduced in 2001, so there is very little in the way of working remotely, tax rules for limited company contractors were extremely favourable, and many businesses had not yet grasped the benefits of using a more flexible and agile workforce.
How is my IR35 status determined?
Over the years there have been significant changes in this area and the current method of determining your IR35 status and how that impacts your tax position are wrapped up in the Off Payroll Working rules. Note that the actual IR35 rules are unchanged from 2001 but the introduction of these new Off Payroll rules significantly impacted how they are applied.
Previously it was up to the limited company contractor to get their IR35 status correctly determined, and if they got it wrong any additional taxes or penalties were applied to the limited company itself. In order to enforce these rules the HMRC needed to visit one limited company at a time, which as you can imagine was an extremely drawn out process with many IR35 investigations running across several years simply due to a lack of resourcing with the HMRC.
The Off Payroll rules were introduced for all public sector workers in April 2017, and were then extended to private sector workers from April 2021. The off-payroll rules apply when a worker provides their services through their own limited company, and there were two important changes that were introduced. One, in most cases the end client is now responsible for determining the employment status, and two, if the employment status is determined incorrectly the financial risk of facing additional taxes falls with the end client.
So you can see these changes place a large burden on the end client, and as a result we found that a number of end clients preferred to avoid the risk altogether and stop using limited company contractors. This of course significantly reduced their access to a large, skilled pool of workers, and in 2023 we are now starting to see a shift as many end-clients realise that they can successfully engage limited company workers and de-risk the impacts of IR35.
And, from the perspective of the HMRC, compliance checks now got significantly easier. If an end client has engaged, say, 100 limited company contractors, the HMRC now only needs to visit that one end client and not the 100 contractors individually. So, we now have an environment where the end client takes responsibility for the working status of the employee and compliance checks by the HMRC a far less resource intensive.
What does it mean for tax purposes?
OK so let’s say you are a limited company contractor, and your end client has determined that you work inside IR35. We have some clients like this and although there is no tax advantage to using a limited company in these cases, they may have other non-IR35 contracts in place, or this could just be a temporary thing where the contractor is expecting to only be working inside IR35 for a short period of time.
Note that your IR35 status is determined on a contract-by-contract basis, so things can easily change.
Each time your invoice is paid by your agency (or end client) you are issued with what effectively looks like a payslip. This will show your invoice total along with payroll deductions and a net pay which will be paid into your business bank account. This amount has already been fully taxed so you would pay this out to your personal bank account without suffering any further tax deductions. There is no corporation tax, no dividends, and no tax planning. You are effectively being taxed as if you were an employee (but without any of the employee benefits such as sick pay and holiday pay). Often clients in this situation would look to use a PAYE umbrella company instead of their company, especially if the contract was expected to run for a decent period of time.
How is my income tax calculated?
Let’s take a look at an actual example of a worker who uses their own limited company and whose contract is caught by IR35.
Roger is a consulting engineer who has worked through his own limited company for several years. The tax status of his current contract has been determined by his end client to be caught by IR35. The contract only runs for five weeks and Roger has decided to complete the contract using his limited company. His company is VAT registered on the standard rate scheme, and his rate is £400 per day.
After the first week Roger submits his invoice to his agency for £2,000 + VAT = £2,400.
A week later his receives the pay advice slip from his agency (the fee payer). It details the following deductions;
(a) Net invoice £2,000
(b) Deduction for PAYE, £558.20
(c) Deduction for employee national insurance contributions, £136.52
(d) Net pay, £1,305.28
So, after suffering deductions of £694.72, Roger receives £1,705.28 into his business bank account which is made up of (a) net pay of £1,305.28, and (b) VAT of £400.
Because of these off-payroll deductions, the accounting treatment of these transactions also needs to change.
Firstly, the reported sales income for his business reduces from £2,000 to £1,305.28. And secondly his reported salary for the week becomes £1,305.28. The salary transaction is specially marked in the payroll software as an Off Payroll payment to ensure no further PAYE or National Insurance deductions are made.
So you can see with income of £1,305.28, and expenses of £1,305.28 (salary), the overall net profit for the company is £0, which means there is no corporation tax due. It’s also clear to see there is zero opportunity for any tax planning.
Public sector vs Private sector contractors
The off payroll working rules were introduced for all public sector workers in April 2017. This includes all workers in government departments including their executive agencies, companies owned or controlled by the public sector, schools or universities, local authorities, and parts of the National Health Service. The rules also apply to the UK Parliament, National Assembly for Wales Commission, and Northern Ireland Assembly Commission.
When the rules were initially introduced, we saw a small drop in our contractor client base as those affected contractors could no longer use their limited companies. Over the years the numbers have come back as the public sector have got to grips (in a lot of cases but not all!) with how to handle the engagement of limited company contractors.
The same rules were then introduced for private workers from April 2021. The rules were applied to all medium and large-sized private and voluntary sector clients. To fall in this group, these clients must meet 2 or more of the following conditions:
(a) have an annual turnover of more than £10.2 million
(b) have a balance sheet total of more than £5.1 million
(c) have more than 50 employees
If you provide services to a private or voluntary sector client that does not meet the above conditions, then the off payroll working rules do not apply. Note that the working conditions around IR35 must still be assessed, but this falls onto the individual contractor and any additional taxes due from an incorrect determination must be paid by the contractor’s company. So, in this case we’re back to the scenario where the individual contractor needs to be approached by the HMRC, which is I have mentioned above is extremely time consuming for the under resourced tax department.
IR35 is only for Limited Company Contractors
I also wanted to quickly make the point that IR35 and the off payroll working rules only apply to limited company contractors. Sometimes these contractors are referred to as workers who provide services through a PSC (eg through personal service companies). They do not apply to contractors who are self-employed or who work through a partnership (in most cases).