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IR35 is the name of an inland revenue document which first described the new rules to intended stop employees from avoiding tax by forming or using service companies. We now use IR35 as a blanket term to cover all of the rules and guidelines surrounding the issue.


The Friday to Monday problem

The IR35 rules were introduced to stop companies from avoiding their national insurance contributions (NIC) by making their employees redundant and then re-hiring them again as contractors. This was called the "Friday to Monday" problem, because an employee could be fired on Friday only to be re-hired the next Monday in exactly the same job but as a freelance contractor, so saving the company from NICs (and other employee related obligations.)

For example:

If Paul works for MegaGameCorp as a programmer and is paid a salary, MegaGameCorp pays Paul's wage. However, first it deducts NIC and income tax which go to the Inland Revenue through its pay as you earn (PAYE) payroll system. MegaGameCorp also pays a separate NIC to the Inland Revenue as Paul's employer.

If MegaGameCorp makes Paul redundant and rehires him as a self-employed contractor (either through his own service company or an existing one) MegaGameCorp can now pay Paul's company the same wage as it paid before but without making any deduction through PAYE and without paying its NIC.

Under the old rules: Paul's company could then pay Paul a lower salary which, being more within his allowance avoids most of his own tax contributions. Paul's company would also pay tax on its profits, but the rates for that are much lower. And the company could also pay Paul a dividend from those profits gaining Paul extra income that is not subject to NIC.

The result was that MegaGameCorp paid less, Paul got more, and the Inland Revenue lost out. The new rules aimed to reclaim the missing money by forcing Paul and his company to cover the missing tax.

Tax of mass destruction

The inland revenue consider such a situation to be disguised employment. They say, because the company is created only as a convenience for the purposes of avoiding tax, such an employee should pay the same tax as a direct employee of the client company. (They don't think that if they pay the same tax as an employee of the client company they should necessarily be allowed the same employee rights. However, the courts disagree with them on that.) Contractors forced to accept terms that might bring them under these rules run the risk of paying extra tax and should increase rates accordingly.

While the rules were designed with this specific target in mind, many legitimate service companies have also been hit because the factors that make one person a disguised employee and another a freelancer are not very well defined within the legislation. Taking company profits through dividends is a normal and widely used practice and is not considered a problem except in this specific case. And those wishing to build a service company cannot rely on using company profits for growth unless their contracts are considered outside of IR35. This has been a major cause for concern among contractors, particularly in the IT sector because their traditional working practices are often considered disguised employment. The Professional Contractors Group formed in 1999 to oppose the legislation, and fight for the rights of freelancers.

Contracts effected

The rules target the job rather than the contractor or the service company directly. Any contract between a client and a service company is a possible disuguised employment. Even when working with different clients concurrently, one contract may fall under IR35 and the other not. Working history is taken into account, but only as an indicator in borderline cases.

Disguised employment contracts provide a contract of service. To avoid falling under IR35 tax rules, the terms and conditions of the contract with our client must be inconsistent with a contract of service. Preceding cases provide some guidelines that we can use when negotiating the terms and conditions of our contract.

People effected

The IR35 rules only apply when contractors work through an intermediate company. That might be our own service company if we trade as a limited company or partnership; or a third party such as an agency or umbrella company. Both the contractor and the service company are effected by the rules in that the tax they each pay is calculated differently.

Although, a contractor trading as a sole-trader is not effected by these rules, distinguishing contracts for the purposes of tax and NI is the similar. Although, this has always been the case for a sole-trader.

Money effected

The rules only apply if we receive money from our company, outside of our salary, that is deemed to have come from the contract. For example, if our company charges £50,000 for our services, but pays us £20,000 in salary and the rest in dividends or other bonuses, then we may have to pay tax and NI on the remaining £30,000.

Contract assessment

The Inland Revenue itself will assess contracts themselves through the IR35 unit:

North East Metropolitan (F)
IR35 Unit - 1st Floor
Tyne Bridge Tower
Church Street
Tyne & Wear

We must send all the contractual information between the contractor, service company, and client (written, spoken, or implied) to the unit to get an opinion. The service company can request an opinion at any time before the P35 filing date in the following tax year. The contractor must request an opinion before 31 January in the following tax year.

How is tax calculated

If our contract falls under IR35 we have to work out our deemed payment. This is 95% of the amount we receive, through whatever means, from the client, less our salary and any other allowances. If this figure is more than nothing (potentially it could be negative) then we have to calculate any extra tax and NI payments that we might owe on that payment. The remaining 5% goes to the company as administration expenses


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