IR35: taxation of off-payroll workers explained

Background to IR35

Businesses often engage with contractors and other off-payroll workers through PSCs, rather than directly on a self-employed basis. There is no definition of a PSC - it is a company where there is usually only one employee/officeholder, and the purpose of the PSC is to supply that individual's services to a business. The fee for those services is then paid by the business to the PSC. It is possible for a PSC to have more than one employee/officeholder.

Broadly, where a business engages an individual ‘off-payroll’ and through an intermediary such as a PSC, the individual is often paid outside the Pay As You Earn (PAYE) system – achieving employment tax savings; whilst the business is not required to pay employer National Insurance contributions (NICs) – currently at 13.8%.

However, IR35 requires that the individual should be taxed as an employee, if they would have been deemed to be an employee for tax purposes if they had engaged directly with the business.

How does IR35 work?

From 6 April 2021, when a business engages with an individual through a PSC, the business is required to determine if the engagement falls ‘inside IR35’ – that is, whether the individual would be an employee for tax purposes if they had engaged directly with the business. The engaging business, known as the ‘client’, is also required to issue a ‘status determination statement’ (SDS) to the individual worker and any other intermediary the client contracts with, confirming its determination and providing reasons.

If the client determines that an engagement falls “inside IR35”, the worker should be paid through the PAYE system. Employer NICs (and apprenticeship levy where applicable) in respect of payments made to the individual will also be due. Where the client engages with the PSC indirectly through another intermediary, such as a recruitment agency, the agency, known as the fee payer, will be responsible for deducting and accounting for PAYE taxes and NICs.

The new rules do not apply to private sector businesses which are “small”. Where a small business engages a contractor through a PSC, the PSC remains responsible for determining whether the IR35 rules apply and paying any taxes due.

Employment status for tax purposes

There is no codified legal test to determine employment status for tax purposes. The test has been developed through court decisions and is based on several factors – including whether there is a 'mutuality of obligation' between the parties, the level of control that a business has over the worker, whether the worker can provide a substitute, how integrated the worker is in the client’s business and whether the worker is in business on their own account. HMRC has published detailed guidance and has also developed the ‘Check Employment Status for Tax’ (CEST) tool to determine employment status for tax purposes of individual workers.

HMRC has said that it will stand by a CEST determination, as long as the information inputted remains true and accurate. CEST may not always provide a determination and is estimated to fail in 15% of cases. Therefore, when making status determinations, it is often recommended that a business uses a combination of CEST and its own judgment.

Where an individual is engaged through a PSC to provide services that otherwise would be undertaken by an officeholder, such that if the individual had engaged directly with the business they would have been a director/officeholder, the engagement will be “inside IR35” and the individual should be paid through the PAYE system. IR35 also applies where an individual provides the services of a director, including a non-executive director, through a PSC. This is reflected in the CEST tool.

Managing IR35 tax risks

Since April 2021, the IR35 rules have created significant cost and compliance challenges for businesses that rely heavily on a flexible workforce.

HMRC expects all businesses engaging off-payroll workers to consider IR35 and introduce comprehensive compliance programmes. Prior to engagement, PSC workers should be identified, status determinations completed and SDSs issued to the workers and relevant third parties in the contractual chain. Contractual arrangements with PSC workers and intermediaries (e.g. agencies) should include provisions outlining IR35 requirements and managing risks.  

IR35 compliance procedures should be regularly reviewed to ensure that they remain fit for purpose and that individuals responsible for compliance receive adequate training.

Complex supply chains

Managing IR35 risks may be less straightforward in complex supply chains. It may be difficult to identify the client where a business engages a contractor as part of a wider supply of services to another company, since it may be unclear whether the client is: (a) the company engaging the contractor; or (b) the company which is the ultimate recipient of the services being supplied. If the services are “fully contracted-out” of IR35, the client is the business engaging the contractor as part of the wider supply of services (often referred to as the service provider). 

HMRC distinguishes between businesses entering into a contract for a supply of labour, which are clearly clients under IR35; and those which contract with a service provider for the supply of a fully contracted-out service, which are not clients. Determining whether a supply of services is fully contracted-out can be complex and is a question of fact, based on actual working practices. HMRC has published limited guidance on how to determine whether a service is fully contracted-out; however, confirming the identity of the client remains difficult in complex supply chains.

The client is legally responsible for making status determinations and issuing SDSs. If the client has been wrongly identified then, strictly speaking, the 'true' client will have inadvertently failed to comply with its legal obligations under IR35. Therefore, if HMRC disagrees with a decision regarding whether a service is fully contracted-out and the identity of the client, there is a risk that the business that is the true client could face unexpected tax liabilities and penalties for non-compliance.

It is crucial that businesses engaging with large numbers of PSC contractors, whether directly or indirectly, or that are part of complex supply chains have comprehensive processes in place to manage their exposure to IR35 risks.

HMRC compliance activity

HMRC is increasingly seeking to review IR35 compliance by businesses across a variety of sectors. There is no uniform approach to how enquiries commence. HMRC tends to request a wide range of information, broadly focused on a business’ IR35 compliance processes and status determinations. The first contact from HMRC may involve a generic information gathering exercise, with no indication that a protracted enquiry could follow. However, initial communications often precede more formal exchanges asking targeted questions.  To manage risks and reduce the scope of a possible HMRC enquiry, businesses should seek advice before responding to any IR35 information request from HMRC.