IR35, self employment and tax

Article reference: UK-IA-SEM03
| 7 min read

A business is allowed to set the majority of its costs of operation and materials against its sales receipts before tax is paid on the remainder.

For an employee selling his services under a contract of employment, the option of setting off expenses is not available. Expenses such a travel costs are not generally allowable against his or her tax liability.

In order to take advantage of the expense offset, as well as to benefit from limited liability for their work, many sole traders or contractors have formed service companies. As a director and shareholder, the contractor is able to offset business expenses, then choose whether to draw money from the company as employment income or dividends so as to reduce his tax liability.

This device has been used at all commercial levels, particularly in the IT sector.

IR35 - Intermediaries legislation

IR35 is the tax and National Insurance contributions law that may apply if you’re working as a contractor through an intermediary company. It aims to make sure that you pay the same amount of tax as if you had been directly employed.

IR35 provides that anyone using a limited company intermediary for his contract work, (we will call him or her a consultant from now), who fails the "self employed" test is now deemed to be in "disguised employment", and will no longer be able to take advantage of the tax regime available to a business. Accordingly, he or she (or the business) will have to pay income tax and National Insurance contributions on the money he has received from the company (less certain small allowable expenses).

HMRC decides whether IR35 applies or not. It does not matter what written agreement is in place, nor what the parties have agreed, but rather on the relevant facts about the contract.

The basis of a decision is many years of case law. It is therefore possible to make a considered judgement as to whether a particular set of facts constitutes employment or self-employment.

The starting point is that the consultant must work under the terms of a proper contract for services - a consultancy agreement of some sort. Whilst the existence of such a document is not conclusive evidence of the status of the parties, any such agreement will be drawn in a way that tends to show the relationship as being that of consultant-client, not of employee-employer.

The agreement matters only because of the terms it contains. The terms only matter, first if they tend to show a contract for services and secondly if the parties are complying with them.

If a consultant works through an agency, it is particularly important that the agreement is in the right form, because agency employment tends to fall short of the rules.

Factors to take into account include:

  • Is there a "business" beyond merely the sale of services of one person? For example, does the business have a bank account? Does it have stationery and business cards? Is there an ongoing provision for selling the services to new clients? Does the business own equipment such as computers, but also other larger items such as photocopiers?

  • Are there other employees working for the consultant under contracts of employment? This is a very strong marker. We have never come across a case where a business employing others was deemed to be the self-employment of one or more individuals.

  • Is the consultant "at risk" in the performance of the contract? The provisions of the agreement relating to liability, indemnity and insurance should make this clear. This is another strong indicator. Employees cannot generally be sued for an accidental disaster, but consultants can.

  • Is the subject matter of the contract expressed in terms whereby the client pays for an outcome or merely for work to be done in accordance with his direction? This includes the timing and method of payment and the degree of control enjoyed by the client. Does the client say how many hours a week shall be worked or where the work will be done?

  • Is the consultant at financial risk? Could he make a loss if things go wrong? Can he make more profit if they go well?

  • Is the consultant restricted from working for others? Employees are not generally allowed to have two jobs. Consultants can work for numerous clients simultaneously. Some restriction to prevent assisting a competitor is normal and should make no difference. It is good if the consultant has more than one client at once, and preferably several. Generally speaking, the more clients, the more clearly the business is just that, and not a disguised employment.

  • What overhead expenses are incurred? If the consultant operates from a self contained purpose built office, that points to a business. If he works from home, the matter is still open. Even for a home worker, the exclusivity of space is important. But beware of allocating space exclusively to business use, 365 days a year, or that proportion will be subject to capital gains tax when you sell the house.

  • To what extent can the consultant subcontract the work? This is not the most important item because it is quite common for a client to insist that the work is not subcontracted.

Who has to pay the tax and NI?

The responsibility for payment of tax (and subsequent liability for penalties for non-payment) falls on both the service company employing the consultant and (if it does not pay), the consultant himself. Note that he or she is not protected by the limited liability of his company! The employing client is not responsible. Note that this is different from a normal situation where HMRC deems a relationship to be that of employer-employee, and where accordingly, the employer has to pay the amount due as PAYE.

Our general advice

Play fair. If your work really is employment, accept that you will have to pay the tax.

If you are in any doubt, put your case to HMRC for an opinion. Take a budgeted account; showing what overheads you will have to pay and a narrative explanation of how you will operate. It is likely the outcome will be favourable. Yes, HMRC does try to collect as much tax as possible, but they have better things to do than to take on "no hoper" cases where you will make then look foolish before the commissioners.

If HMRC do not give the answer you want and you feel they are wrong, do appeal. The commissioners will give you a fair run. When your appeal has been made, go back to HMRC with some additional information. If you give then half a chance to change their mind, they may do so.

If you really do not want to be "a business" and you want an intermediary employer so as to show a "consultant" presence to a client, and then choose a properly qualified firm of accountants who run such a scheme. Above all, obtain references you can speak to on the phone.

Don't hesitate for a moment in operating as a business. You do not need a company to qualify for the less unfavourable tax regime enjoyed by businesses. If you can operate a simple piece of accounts software, that is great. If not, just record everything carefully and find an accountant to put it together each month. You will enjoy greater prestige and may be able to charge higher fees for the same work.

Example case law

Issues of substitution and control were key factors in the case of Tilbury Consulting Limited v Margaret Getting (Her Majesty's Inspector of Taxes), in which the Inland Revenue sought to show that the director, Mr Tilbury was a disguised employee of his end client, Ford Motor Company.

Tilbury Consulting Limited won the case based on an examination of three relevant areas: the written agreement; the actual working practice and the situation “in the round”. A good agreement was a crucial feature.

It was noted:

  • Tilbury Consulting had the 'qualified right' to send a substitute, although it was never exercised;

  • it was not part of the direct manager from Ford's function to tell Tilbury how to do the work, and;

  • Mr Tilbury had a different colour pass from the Ford employee pass, which did not entitle him to use of the gym.

Mr Tilbury was paid by the hour, and that it was not a matter of concern to Ford who provided the services, or that some of the work was undertaken at Tilbury Consulting Premises.

Mr Tilbury would not have been regarded as Ford's employee:

  • firstly because neither Tilbury Consulting nor Mr Tilbury did not have operational control over how the project was undertaken.

  • secondly because Tilbury Consulting was not part of Ford's business or undertaking.

Further information and useful documents

If you are considering becoming a consultant under a company structure, you will need documents for the new company. You will also need a consulting agreement that sets out as clearly as possible your relationship with your client as one not of employment.

If you work in the construction industry, you may wish to read about the CIS scheme.

Please note that the information provided on this page:

  • Does not provide a complete or authoritative statement of the law;
  • Does not constitute legal advice by Net Lawman;
  • Does not create a contractual relationship;
  • Does not form part of any other advice, whether paid or free.
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