IR35 has been a hot topic in the last month or so since HM Revenue & Customs' (HMRC's) consultation on IR35 reform.
It is apparent from recent discussions and the consultation itself that it is extremely important for businesses to begin preparing for the IR35 changes now as the new rules will apply from April 2020. To assist with this process, this article explains what IR35 is, who it will affect, when it applies, the effect of the changes and the steps companies can take to prepare for it.
What is IR35?
Originally, IR35 legislation was introduced to address a form of perceived tax avoidance where individuals may seek to avoid paying employee income tax and national insurance contributions (NICs) by providing their services to clients through an intermediary. Such intermediaries are usually personal service companies (PSCs), however, the IR35 rules can also apply to other intermediaries such as partnerships.
Broadly, the IR35 rules apply if the individual would have been considered an employee of the client, had the individual not been engaged through the PSC (i.e. if there is an employment relationship).
What are the changes in a nutshell?
From 6 April 2020, all medium and large private sector businesses which engage individuals through PSCs will be responsible for determining if, but for such PSC, the individual should be considered an employee for tax purposes. If so, such a company (referred to as ‘client’ throughout the remainder of this article) will be responsible for income tax and NICs. Previously, it was the PSC’s responsibility and for the PSC to make such a determination. This brings the private sector in line with the public sector which has been subject to these IR35 rules since April 2017.
Who will be affected by the new IR35 changes?
Medium and large private sector clients will be affected by the changes to IR35. It is important to note that the changes will not apply to clients which are small businesses, in which case, it is the relevant PSC which will remain liable for applying the IR35 rules.
The sectors which will be particularly affected will be those that heavily rely on PSCs such as IT, media and construction. In reality, any clients which employ freelancers and contractors through intermediaries such as PSCs and partnerships will need to consider and comply with the IR35 regime.
The precise test for the exception is currently subject to consultation, but the current proposal is that a client which is a company will be considered to be a small business and exempt if two or more of the following criteria are satisfied:
- Annual Turnover of not more than £10.2 million;
- Balance Sheet total of not more than £5.1 million; and / or
- Number of employees of not more than 50.
There are other rules for determining when non-corporate entities are small.
When does IR35 apply?
In simple terms, IR35 will apply when two elements are satisfied:
- the managed service company rules do not apply; and
- there is an employment relationship between the client and the individual (ignoring the PSC).
In respect of the first element, the managed service company rules are only engaged where such managed service company (the intermediary) is managed by a scheme provider and the relevant individual does not exercise control over such company (even if they are a shareholder). More details can be found about the managed service company rules on HMRC’s website.
In relation to the second element, there are a number of factors which indicate whether there is an employment relationship (rather than a consultant or self-employed relationship). In summary, IR35 requires the application of four main principles to determine an individual’s employment status:
- Control: What degree of control the client has over the individual (e.g. what, how, when and where they work);
- Substitution: If there is a personal service requirement or if a substitute can be sent;
- Financial risk: What degree of financial risk there is for the individual (e.g. if fees are contingent on a particular outcome); and
- Mutuality of obligation: If there is an obligation to provide work and for it to be accepted.
There are a number of other factors which would also need to be considered including benefits, integration with the client, provision of equipment, and the contract type.
What is the effect of IR35?
Ultimately, the IR35 changes make the fee-payer (usually the client which pays the individual’s PSC) responsible for accounting for, and paying, income tax and NIC under PAYE to HMRC on behalf of the individual.
The requirements from April 2020 include:
- making a determination of an individual’s employment status;
- communicating the determination; and
- making deductions for income tax and NIC and paying any employer NICs.
Clients will need to make the status determination and communicate it by the time the contract starts or before any services are provided. There will also be the right for the party the client contracts with (e.g. the PSC) to request reasons and / or a review of the determination. Clients will have to respond to any such requests within a certain period of time.
Importantly, if a client fails to undertake a determination or provide reasons in the timescales, the liability for income tax and NICs will transfer to the client until the determination is completed or the reasons are given.
What can be done to prepare?
In its recent consultation document, HMRC issued a warning to businesses not to delay in preparing for changes to the IR35 rules. The consultation will inform the draft Finance Bill which covers the IR35 changes and which is expected to be published in summer 2019.
Clients likely to be caught by the April 2020 IR35 changes should start taking steps now to prepare. This should include:
- assessing what use is made of PSCs;
- assessing if the legislation will apply by considering whether or not the small company exemption applies;
- reviewing any current contracts with PSCs and considering if the client will be required to account for income tax and NICs through PAYE;
- deciding what approach will be taken regarding PSCs caught by the IR35 rules (e.g. whether the client will absorb this additional cost or share the burden with the PSC via the renegotiation of fees);
- reviewing internal systems, such as payroll software, process maps, HR and any existing on-boarding policies to see if any changes need to be made;
- implementing suitable policies and joined-up processes to ensure engagement or on-boarding of new PSCs includes an appropriate IR35 assessment prior to engagement (it is important that clients can show evidence of a clear assessment process);
- ensuring that different departments communicate and assess roles from a procurement, HR, tax and line management perspective for consistent decisions about the employment status of the individuals that are engaged;
- ensuring new contracts are appropriately drafted to reflect IR35 requirements and to include appropriate IR35 indemnities;
- identifying a legal adviser who can advise on IR35, support with reviewing contracts, drafting and the preparation exercise generally; and
- making provision to process income tax and NICs through PAYE if IR35 is engaged.
HMRC has brought a number of cases before the courts challenging the legitimacy of the PSCs of a number of high profile individuals in the media. Our tax consultant examines the implications of these cases for those potentially affected by the change in the IR35 rules.