Nichola Ross Martin's Tax Consultancy

At a glance

IR35 refers to a set of tax and NICs rules which apply when:

• An individual performs services for a client under an arrangement involving an intermediary, (commonly a personal service company), and
• If the arrangement had been made directly between the individual and the client, after considering the employment status indicators, the individual would have been treated as its employee.

Under IR35 the intermediary is deemed to be the employer, and the worker is treated as its employee (not the employee of the client).

• Income under the contact is subject to PAYE and NICs.
• The client is not subject to any tax charges.

IR35 has no effect on employment law. So even though the worker is the deemed employee of the client for the purpose of considering if IR35 will apply to the contract income, no employment rights are created.

An intermediary can be a company or a partnership, providing that the individual who is supplying his services has a material interest in the intermediary.

The practical problems of IR35 are that:

• It is necessary to make a decision as to the individual’s deemed employment status with the client.
• There is no simple test for employment status: each case has to be decided on its individual facts.

When IR35 applies to all of a company's income there is little point in it paying dividends too. It is much simpler to pay its owner a salary based on the IR35 deemed payment.

Overview and FAQs

IR35 is designed to bring income that would not otherwise be treated as employment earnings into charge for PAYE and NICs.

For example:
John sets up his own company, John’s Company Limited (JCL). JCL then enters into contract for services with Big Client and supplies the services of its worker, John.

If John had supplied his services directly with Big Client, Big Client would have been required to consider his employment status. Had it done so it would have had to treat him as its employee,

• Under this arrangement, Big Client avoids having to become an employer and amongst other savings also avoids employers’ NIC. It pays JCL its fee without any deductions. JCL can then pay John in the most tax-efficient way it can, see Salary v dividend.
• If IR35 applies to John’s contract, he is treated as being JCL’s employee, and the income which derives from Big Client is subject to PAYE and NICs. Some deductions for expenses are permitted within the rules.
• It makes no difference to IR35 if JCL contracts via an agency.

Will IR35 apply to all companies which are intermediaries?

IR35 only applies to companies where:

• The worker (or his family) controls more than 5% of the ordinary share capital of the company, or
• The worker (or his family) is entitled to receive more than 5% of any dividends from the company, or
• The worker receives, or could receive, payments or benefits from the company which are not salary, but could reasonably be taken to represent payment for the services provided to clients.

IR35 applies to partnerships where:

• The worker (or his family) is entitled to 60% or more of the partnership's profits, or
• where most of the partnership profits come from work for a single client, or
• where a partner's share of profits is based on his income from relevant contracts

A 'family' includes blood relatives and civil partners.

Employment status

In potential IR35 cases it is essential to review the contract made with the end client and then to examine what actually happens in practice while considering which employment status factors are relevant and to then determine whether the contract is one of service or for services.

This is often easier said than done but contractors have no option; they must self-assess their employment status and if HMRC does not agree, then status will be determined by a tribunal or the courts.

The Managed service company (MSC) regime

The MSC regime were brought in to counteract schemes which had been set up to avoid IR35. A MSC would be set up to manage the affairs of a group of workers, each who would own shares in and be paid by the MSC, avoiding NICs by using dividends. The MSC tax rules apply to income earned in periods after 6 April 2007.

When a workers supplies their services via a MSC the income paid into the MSCs is treated as deemed employment income. The MSC must then apply PAYE and NICs. Additionally, there are tracing rules, these ensure that if an MSC does not deduct PAYE and NICs and subsequently absconds or goes out of business, HMRC can pursue those who have been involved with the MSC. This will include the worker, as well as the end client.

Avoiding the MSC rules

An accountancy service provider is not an MSC, and so as a result some MSCs have now become accountancy firms. This a high risk strategy as although it is difficult for HMRC to track down these companies the penalties if you are caught are very high.

The alternative way to avoid the legislation is to ensure that the worker's intermediary falls within the IR35 rules. IR35 "trumps" the MSC regime. This is done by ensuring that the required elements of control are in place.

How IR35 works in practice

When IR35 applies to a contract the intermediary is required to calculate a deemed salary payment in order to calculate how much PAYE and NICs is due to HMRC on the contract income (see next tab "Example).

Given that PAYE and NICs apply to his income it is practical for the worker to pay himself by salary throughout the year. At the end of the year, or end of the contract, which ever ends first, he must make a deemed payment calculation. He can deduct any actual salary and NICs paid, paying HMRC any balance that is still owning.

There is little point in paying dividends as well as PAYE and NICS on the deemed payment you may as well just treat the deemed payment as if is actual pay.

When the intermediary company incurs costs over and above the fixed 5% or those which would be allowable under normal employment rules, these will result in it making corporation tax losses.

Example

IR35 worked example

Paul is an ex-Ministry of Defence (MOD) tank engineer. He finds short-term contract work via an employment agency working for his old employer. His agency insists that he works through an umbrella company or his own company. The umbrella company charges high fees and so Paul forms his own company. He is sole shareholder and director.

Paul is paid £200 per day, and he signs a standard contract with the agency and starts to work for the MOD.

He is not party to the contract made between the agency and the MOD but under IR35 he must self-assess his company’s income by working out his employment status.

If Paul was positive that his contract is outside the scope of IR35 he would probably, on the advice of an accountant, reclaim all his expenses from his company and then extract the company’s profits by dividend.

As it happens, Paul is doing the same job to the one that he did when he was an employee, and having run through the different employment status factors concludes that IR35 applies to his contract income.

Paul’s company's profit and loss account for the period ending 31 March 2011 is as follows:

• He also uses his personal laptop which costs him £225.

Under IR35 Paul must work out a deemed employment payment for 2010/11.

Timing
The deemed employment payment is treated as being made on 5 April. This is after the date of his year end. He will not obtain corporation tax relief on this deemed unless he makes a decision to vote or pay himself an actual salary for his accounting period ending 31 March.

The deemed payment calculation
Paul can automatically deduct 5% of his income as an expense and is permitted to also claim a deduction for certain other expenses as follows:

IR35 deemed payment calculation:

Notes

1. The flat rate deduction of 5% covers the expense of running a company. If actual administration costs exceed this sum, there is no further tax relief. In this example Paul's administration costs include insurance, accountancy, stationery and company formation costs.

2. If Paul or any member of his family had received benefits or payments which have not been taxed as a result of this contract, these would be added in as income.

3. A deduction is allowed for contributions made by Paul's company into an approved pension scheme.

4. Tools, protective clothing and cleaning costs are allowed as a deduction because if Paul was still employed by the MOD he would be entitled to reclaim these costs from his employer.

5. Travel is allowed in this example. However, it will only be deducted in the IR35 deemed payment calculation if the cost would have been allowable if the worker were directly employed by the client. In this case we assume that the engagement is short-term and travel qualifies under the temporary workplace rules. In practice, you would need to consider each assignment on its merits.

6. Subsistence is allowed in this example because travel is allowed. As one follows the other, you would not allow this cost if travel were not allowed too.

7. Capital allowances are allowed on any capital expenditure incurred by Paul or his company, if Paul had been able to claim these had he been an employee of the MOD.

8. Employers National Insurance: if a salary has been paid as well this part of the calculation will have to be modified to take into consideration NI thresholds.

Accounting for PAYE and NICs

Paul's deemed salary payment is gross income and must be entered onto his P60. His company must deduct PAYE and NICs and pay these, together with the employer's NICs to HMRC. All the figures are also submitted on the employer's P35.

Payment is made by 19 April following the end of the tax year, except in the situation where the contract ends before the end of the tax year. In that case, it is by the 19th following the month in which the engagement ended.

If Paul has been paying himself a salary this is deducted from the deemed salary payment.

Paying himself

Paul will need money to live on throughout the contract period.

• He can advance cash to himself, but he should apply PAYE and NICs when he makes a payment which is earnings. The easiest method to achieve this is by running a regular payroll.
• His company can advance him funds by way of a loan until the year end when he could pay himself an amount equivilent to the company's IR35 deemed payment calculation to clear the loan. However, beneficial loan interest will apply unless he is paying interest on the loan at HMRC's official rate. If he gets this wrong and does not repay the loan within nine months of the end of company's accounting year, he could also fall foul of the close company tax rules which would cost the company 25% of the outstanding loan.
• The company can pay him dividends throughout the year. This can be a complicated way to progress as the company obtains tax relief for the amount of the deemed payment. A claim has to be made to HMRC to ensure that dividends are not taxed, this also means that the non-repayable tax credit which attaches to the dividend is cancelled out.

The simplest way for Paul to pay himself a regular salary. To ensure that he obtains tax relief in his company's year ending 31 March 2011 he must also vote a bonus at his year end which will mop up any balance of income, otherwise he will not obtain corporation tax relief on any deemed payment until the following accounting period.

Corporation tax

Paul's company's corporation tax is calculated on normal principles, so that items such as the company formation cost are disallowed and added back to profits. Any deemed payment made under IR35 in a tax year is allowable as a corporation tax deduction. In this example we suggest that Paul pays himself a salary and votes a bonus before 31 March 2011 of an amount as close as possible to the amount of deemed payment that is due on 5 April 2011, this way he obtains tax relief on the payment sooner.

Small print and links

At a glance: Employment status checklist

HMRC IR35:

• IR35 pages & index
• Deemed payment calculator