IR35

Before IR35 came into effect in 2000, some workers would set up PSCs to avoid paying employee-level taxes. These workers, while working like employees, paid less tax and NICs compared to someone in the same role as a direct employee. IR35 was then introduced to curb this “disguised employment.” For example, a project manager working for a company might leave their position as an employee, set up a limited company, and return to the same role as a contractor through their PSC. Despite performing the same duties, they would pay lower taxes. To address this loophole, IR35 was introduced to ensure fairness and to maintain the integrity of the UK tax system.

Over the years, HMRC (His Majesty’s Revenue & Customs) has tightened IR35 regulations, recognising that disguised employment affects not only tax revenue but also the broader labour market, leading to an uneven playing field between employees and contractors.

IR35 has a direct impact on how businesses and contractors structure their working relationships. For contractors, their classification as “inside IR35” or “outside IR35” determines how they are taxed:

• Inside IR35: A contractor is classified as “inside IR35” when their working arrangement is determined to be similar to that of an employee. In this case, they are deemed to be “employed for tax purposes,” even if they are technically engaged as a contractor. They are subject to deductions for income tax and NICs at source through PAYE (Pay As You Earn). This means the hiring business or agency deducts taxes before the contractor receives their pay, leaving them with a reduced take-home amount.
• Outside IR35: A contractor is classified as “outside IR35” when their working arrangement is determined as genuinely independent. In this case, they are viewed as running their own business, providing services to the client. They can pay themselves through a combination of salary and dividends from their personal service companies (PSCs), which often results in lower overall tax liabilities. Contractors outside IR35 typically have greater control over their earnings and financial arrangements. They are also not subject to NICs in the same way as those inside IR35.

Understanding whether a contractor is inside or outside IR35 is essential for both contractors and businesses. For employers, complying with IR35 means taking responsibility for assessing a contractor’s status and ensuring accurate deductions for those deemed inside IR35. This requires a careful evaluation of the contractor’s working arrangements and relationship with the business.

Here is the summary of the most recent IR35 reforms and what to expect moving forward:

• Public sector (2017): Since April 2017, public sector organisations have been responsible for determining the IR35 status of their contractors. This reform was introduced to address the issue of “disguised employees”—individuals who operate as contractors but work under conditions similar to employees, thereby avoiding full income tax and NICs. Under the Intermediaries Legislation, the responsibility for ensuring correct tax deductions shifted from the contractor to the public sector client or the fee-paying intermediary in the supply chain.
• Private sector (2021): In April 2021, similar rules were extended to medium and large businesses in the private sector. Before this date, contractors were responsible for determining their own IR35 status. Now, the hiring organisation must decide whether a contractor falls inside or outside IR35. This shift was intended to bring greater accountability and consistency to off-payroll arrangements across the UK.
• Addressing double taxation (2024): Starting April 6, 2024, the UK government addressed the issue of double taxation under IR35 by introducing a legislative fix. This change ensures that both the contractor and the fee-paying party (e.g., the client or agency) are not taxed twice on the same income. If a contractor has already paid taxes on disputed income, the fee-paying party can offset those amounts against their own tax liability. This amendment promotes fairness, reduces financial risks for businesses engaging contractors, and eliminates unnecessary tax burdens on contractors, fostering a more balanced and compliant workforce.

Risks of IR35 non-compliance for employers

• Higher tax liabilities: If HMRC determines that a contractor has been misclassified as outside IR35 when they should have been inside, the hiring business could be required to pay all the unpaid taxes, employer NICs, and penalties, including interest on overdue payments. In some cases, if the employer fails to comply with IR35, employees in the company may face indirect consequences in terms of resource reallocation or future tax increases.
• Hefty fines and penalties: On top of paying backdated taxes, businesses may face significant fines if HMRC determines they failed to exercise reasonable care in assessing IR35 status. Other factors, such as poor documentation, blanket classifications, failure to reassess roles, or deliberate misclassification, can also increase the risk of penalties.
• Legal risks: If contractors are misclassified, it can trigger HMRC investigations, which may lead to fines, back taxes, and penalties. Such issues can disrupt a contractor’s business, strain client relationships, and potentially impact job security, as clients may become hesitant to continue working with contractors who pose a compliance risk. 
• Reputational damage: Non-compliance with IR35 can harm your company’s reputation, making it harder to attract contractors or employees in the future. Contractors may view the company as disorganised or unfair, while clients or partners may lose trust in the business.
• Competitive disadvantage: An organisation that is known for a poor approach to legislation would suffer a disadvantage to its competitors and may be excluded from applying for government contracts and be removed from preferred supplier lists.
• Contractual breaches: The organisation may even be in breach of contracts or terms and conditions they have agreed to and could be liable for indemnities and warranties under these if they have not complied with the legislation.

Risk of IR35 non-compliance for contractors

• Financial penalties: Contractors misclassified as outside IR35 may result in the client company being liable for back taxes and NICs, as the client is responsible for IR35 status in medium and large enterprises. HMRC can charge penalties, and interest may be added to any unpaid taxes. If non-compliance is deliberate, penalties could be as high as 100% of the unpaid tax.
• Loss of tax benefits: Contractors who are incorrectly classified as outside IR35 may lose the ability to benefit from legitimate tax advantages, such as drawing income through dividends or offsetting expenses. This can lead to unexpected reductions in take-home pay.
• Legal consequences: Non-compliance can trigger an investigation by HMRC, which can be time-consuming and costly. Contractors may need to hire legal or tax experts to defend their status. In extreme cases, deliberate tax evasion could lead to legal action or criminal charges.

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