What is IR35 and What Does It Mean for Your Business and Contractors? | Mellow

As a business that engages with freelance talent or plans to incorporate remote workers into your team, navigating the complexities of international employment regulations is crucial.
One such regulation, particularly relevant if you work with contractors based in the United Kingdom, is known as IR35.
This legislation can have significant implications for your business operations and the individuals you engage.

What is IR35?

IR35, also known as Inland Revenue 35, is UK legislation aimed at preventing tax avoidance by contractors working through intermediaries like Personal Service Companies (PSCs).
It ensures that contractors who work like employees pay similar Income Tax and National Insurance contributions.
Essentially, IR35 determines a contractor's employment status for tax purposes: "inside IR35" if their work resembles employment, and "outside IR35" if they operate with genuine independence.
The goal is to create a level tax playing field between employees and PSC contractors who previously could reduce tax liability through dividends.

Who is Affected by IR35?

IR35 primarily affects two key groups:

• Contractors operating through Personal Service Companies (PSCs): This includes freelancers, consultants, and other self-employed individuals who provide their services to clients via their own limited companies or other intermediaries.
• Businesses engaging contractors: This encompasses companies of all sizes that hire individuals through PSCs. Since April 2021, the responsibility for determining a contractor's IR35 status shifted from the contractor to the end-client (the business receiving the services) for medium and large-sized organizations. Small companies are currently exempt from this responsibility, and the contractor remains responsible for determining their own status.

It's crucial for businesses to understand their obligations under IR35, as non-compliance can lead to significant tax liabilities, penalties, and reputational damage.

Does IR35 Apply to Non-UK Companies?

IR35's application to non-UK companies depends on the contractor's location and where services are performed.
Generally, IR35 may apply if the contractor is UK-based, regardless of the client's location.
However, it typically doesn't apply if the contractor is based outside the UK providing remote services to a UK client, as IR35 focuses on those within the UK tax system. Non-UK companies must still comply with the tax laws of the contractor's country.

Is There IR35 in the US?

No direct equivalent of IR35 exists in the US.
While the US also distinguishes between independent contractors and employees for tax purposes, it uses different rules and tests based on the degree of control and direction.
The IRS considers factors like behavioral and financial control, and the relationship of the parties.
Businesses hiring US contractors must comply with US labor and tax laws, such as the ABC test in some states or the federal common-law test.

What Does It Mean to Be Subject to IR35 Legislation?

Being subject to IR35 legislation means that a contractor's working arrangements are assessed to determine if they resemble employment for tax purposes.
The outcome of this assessment dictates how the contractor's income is taxed.
There are two possible outcomes: "inside IR35" and "outside IR35."

Outside IR35

If a contractor's engagement is deemed to be outside IR35, it means that their working arrangements are considered to be those of a genuinely independent business.
In this scenario:

• The contractor continues to operate through their PSC and is responsible for paying Corporation Tax on their profits and can extract funds as dividends and salary.
• The client (the business engaging the contractor) does not need to deduct Income Tax and National Insurance contributions at source.
• The contractor is generally seen as being in business on their own account, with more control over how, when, and where they work. They may also have multiple clients and bear financial risk.

Inside IR35

If a contractor's engagement is determined to be inside IR35, it signifies that their working relationship with the client is akin to that of an employee for tax purposes, even though they are technically engaged through their PSC. In this situation:

• The client (for medium and large-sized organizations) or the contractor (for small companies) is responsible for deducting Income Tax and National Insurance contributions (both employee and employer) from the contractor's fees and paying these to HMRC (Her Majesty's Revenue and Customs).
• The contractor receives their net pay after these deductions, similar to a traditional employee.
• The contractor's PSC still exists, but the tax advantages of operating through it for this particular engagement are largely negated.

Does a Contractor Inside IR35 Become a Full Employee?

It's crucial to understand that being inside IR35 for tax purposes does not automatically make a contractor a full employee in terms of employment law.
While their income is taxed similarly to an employee's, they generally do not gain the same employment rights and benefits, such as holiday pay, sick pay, or pension contributions from the client company.

The IR35 rules are solely concerned with taxation. Employment status for rights purposes is a separate legal concept determined by different factors.
A contractor inside IR35 remains a contractor operating through their PSC, but their income from that specific engagement is taxed at source as if they were an employee.

How Does an SDS Help Companies Comply with IR35 Rules?

Since April 2021, medium and large-sized businesses in the UK have been responsible for determining the IR35 status of the contractors they engage.
To comply with this obligation, businesses must issue a Status Determination Statement (SDS) to the contractor.

An SDS is a document that outlines the client's decision on whether a contractor's engagement falls inside or outside IR35 and the reasons for that determination. A compliant SDS must:

• State the client's determination of the contractor's IR35 status (inside or outside).
• Provide a comprehensive explanation of the reasons for the determination, including the specific factors and evidence considered.
• Include a statement confirming that the client has taken "reasonable care" in reaching the determination.
• Be passed to the contractor and any agency involved in the supply chain before the commencement of the engagement or before any payment is made.

Issuing an SDS demonstrates that the client has fulfilled its obligation to assess the IR35 status. Taking "reasonable care" in making the determination is crucial, as failure to do so can leave the client liable for any unpaid tax and National Insurance contributions if HMRC later disagrees with the status determination.

What Happens if the Contractor Disagrees with the SDS the Company Creates?

If a contractor disagrees with the IR35 status determination outlined in the SDS, the client must have a client-led disagreement process in place. This process allows the contractor to challenge the determination and for the client to reconsider their decision.

Key aspects of a robust disagreement process include:

• Clear communication channels: The client should provide the contractor with clear instructions on how to submit their disagreement, including who to contact and what information to provide.
• Timely review: The client should acknowledge receipt of the disagreement promptly and commit to reviewing the contractor's representations within a reasonable timeframe.
• Reconsideration of the determination: The client must genuinely reconsider the original determination based on the information provided by the contractor. This may involve reviewing the working practices, contractual terms, and other relevant factors.
• Provision of a revised SDS (if applicable): If the client changes their original determination, they must issue a new SDS to the contractor and any relevant agency, explaining the reasons for the revised decision.
• Maintaining records: The client should keep detailed records of all disagreements, the information provided by the contractor, and the outcome of the review process.

Failing to have a proper disagreement process or ignoring a contractor's challenge can be viewed negatively by HMRC and may indicate a lack of "reasonable care" in the initial determination.

What is "Reasonable Care" in the Eyes of IR35?

"Reasonable care" is a fundamental concept in IR35 compliance. It means that the client must take adequate steps to ensure the accuracy of their IR35 status determination. Failing to demonstrate reasonable care can result in HMRC holding the client liable for any unpaid tax and National Insurance contributions, even if the status determination itself is later deemed incorrect.

Examples of demonstrating "reasonable care" include:

• Conducting a thorough assessment: Taking the time to understand the contractor's working practices and comparing them against the tests of employment.
• Considering all relevant factors: Evaluating the contractual terms, the day-to-day reality of the engagement, and the level of control, direction, and supervision.
• Using HMRC's CEST tool appropriately (see below): While CEST is not legally binding, using it correctly and providing accurate information can contribute to demonstrating reasonable care.
• Seeking expert advice: Consulting with tax advisors or IR35 specialists to ensure a correct determination is made.
• Documenting the decision-making process: Keeping records of the assessment, the factors considered, and the reasons for the determination.
• Having a robust disagreement process: As outlined above, this shows a willingness to engage with contractors and reconsider decisions.
• Avoiding blanket determinations: Assessing each contractor engagement individually based on its specific facts and circumstances, rather than applying a one-size-fits-all approach.

Conversely, actions that are likely to be considered a failure to take reasonable care include:

• Making a blanket determination without assessing individual circumstances.
• Ignoring information provided by the contractor.
• Relying solely on generic contract templates without considering actual working practices.
• Failing to provide reasons for the determination in the SDS.
• Not having a process for dealing with disagreements.

What is the CEST (Check Employment Status for Tax)?

The Check Employment Status for Tax (CEST) tool is an online service provided by HMRC to help individuals and organizations determine the employment status of a worker for tax purposes.
By answering a series of questions about the working arrangements, the tool provides an opinion on whether the engagement is likely to fall inside or outside IR35.

While CEST can be a useful tool and HMRC states that it will stand by the result if the information provided is accurate and the tool is used correctly, it is not legally binding. HMRC can still challenge a status determination made using CEST if they believe the information provided was inaccurate or if the tool was not applied appropriately.

Therefore, while CEST can be a valuable part of the assessment process and contribute to demonstrating "reasonable care," businesses should not rely on it as the sole method for determining IR35 status. A more comprehensive approach that considers all aspects of the engagement and potentially involves expert advice is recommended.

How to Pay Contractors and Stay Compliant in the UK After IR35

Navigating contractor payments while ensuring IR35 compliance requires careful attention to detail. Here's a breakdown of how to pay contractors depending on their IR35 status and maintain compliance:

For Contractors Outside IR35:

• The contractor will invoice your business through their PSC.
• Your business will pay the gross amount invoiced to the PSC.
• The PSC is then responsible for paying Corporation Tax on its profits and distributing funds to the contractor as salary and/or dividends, subject to relevant tax and National Insurance obligations.
• As the end-client, you generally have no obligation to deduct tax or National Insurance from these payments. However, it's crucial to have a robust process for determining the "outside IR35" status and documenting your reasoning in the SDS.

For Contractors Inside IR35:

• Your business (as the end-client for medium and large organizations) becomes responsible for deducting Income Tax and National Insurance contributions (both employee and employer) from the contractor's fees before paying them.
• This process is similar to how you would pay a regular employee through your payroll system.
• The net amount, after deductions, is paid to the contractor's PSC.
• The deducted tax and National Insurance must be remitted to HMRC.
• It's essential to ensure your payroll system is set up to handle these deductions correctly for contractors deemed inside IR35.

Key Steps for Businesses to Stay Compliant:

• Establish a clear IR35 assessment process.
• Issue detailed Status Determination Statements (SDSs).
• Take "reasonable care" in all determinations.
• Implement a fair disagreement process for contractors.
• Maintain thorough records of all IR35 activities.
• Update contractor agreements to reflect IR35 status.
• Train relevant staff on IR35 responsibilities.
• Regularly review contractor engagements.
• Use compliant payment solutions for "inside IR35" contractors.

By understanding the intricacies of IR35 and implementing these steps, your business can effectively manage its relationships with contractors in the UK while remaining compliant with the relevant tax legislation. This will help mitigate the risk of penalties and ensure fair tax contributions from those working in a manner akin to employment.