UNDERSTANDING THE OFF-PAYROLL WORKING (IR35) RULES

Introduction:

The Off Payroll Working (IR35) Rules are detailed and complex. This article is designed to provide a summary of the main provisions to ensure that our existing clients are well informed, and provide some comfort that our firm, as a responsible accounting and taxation services provider for the SME sector, understands the basis on which these rules are applied and has taken steps to ensure compliance.

WHAT ARE THE OFF-PAYROLL WORKING OR IR35 RULES?

The off payroll working or IR35 rules are designed to ensure that a worker (often referred to as: a Freelancer, or Limited Company Contractor) who provides their services to an end client via an intermediary, pays the same Income Tax and National Insurance Contributions (NICs) as if they had been employed.

Within this context the intermediary can be a: Limited Company, Partnership, or other individual.

WHO DETERMINED WHETHER THE RULES APPLY?

Originally it was the responsibility of the freelancer / contractor intermediary to make an accurate determination of whether the rules apply based on their working practices and the contractual terms of engagement which exist between the intermediary and the end client.

However, over the last 10 years these rules have been subject to significant revision and the party who determines whether or not the rules apply now depends upon the nature of the end client.  And specifically: the sector in which they operate, their size, and whether they are based in the UK, as follows:

• Public Sector – It is the responsibility of the end client to make a determination.
• Private Sector, Medium / Large Sized End Client – It is the responsibility of the end client to make a determination.
• Overseas End Client – Providing that the end client does NOT have a UK base, it is the responsibility of the freelancer / contractor intermediary to make a determination.
• Private Sector, Small Sized End Client – It is the responsibility of the freelancer / contractor intermediary to make a determination.

For the purposes of determining whether a private sector end client is “Small”, they need to NOT satisfy two or more of the following three criteria:

• Annual Turnover – Less than or equal to £15m (prior to April 26 – £10m)
• Balance Sheet Total – Less than or equal to £7.5m (prior to April 26 – £5.1m)
• Average Employees – Less than or equal to 50

For end clients who are NOT limited companies, LLPs, or unregistered charities a simplified test applying only the Annual Turnover rule can be applied.

WHAT IS THE BASIS FOR MAKING THE DETERMINATION?

HMRC have provided their own tool (CEST) for making determinations, and a separate determination must be made for each contract for each worker.

There are also a number of specialist consultants in the marketplace that can assist both end clients and freelancer and contractor intermediaries in making an accurate IR35 determination.  Certainly, where there is any doubt about whether the rules apply to a particular engagement then it is prudent to always seek advice from a specialist at the outset to ensure compliance.

In those instances where the end client is responsible for making the determination, they must provide a status determination statement (SDS) including the reasons applied for their determination to the freelancer / contractor intermediary.  The intermediary typically has the right to appeal this decision if they feel that the determination does not accurately reflect the working practices and nature of the agreement between the parties, but ultimately the determination is the end client’s responsibility and decision.

In those instances where the rules are deemed to apply, often referred to as being “inside IR35”, it is the responsibility of the party making the determination to deduct employment taxes at source and pay these to HMRC.

Note – Umbrella companies are unlikely to be required to apply the rules as a result of the fact that workers employed via an umbrella company are normally subject to full employment taxes, and claim expenses under the employment (rather than self-employed) basis.

LIMITED COMPANY ACCOUNTING FOR INSIDE IR35 CONTRACTS WHERE THE END CLIENT MAKES THE DETERMINATION

Where the intermediary opts to use a limited company structure for an inside IR35 contract then the following general accounting rules would apply:

• Invoicing – Invoices are raised as normal at the rate agreed with the end client.
• VAT – Will continue to be applied as normal for the total invoiced value, where the client opts for VAT registration, or where Turnover levels exceed the VAT registration threshold.
• Income Tax and NIC – The end client will be treated as a “deemed employer” and deduct income tax and NIC at source.  They will also submit RTI submissions on behalf of the worker and pay these taxes to HMRC as if the worker had been directly employed.
• Expenses – The worker will be eligible to reclaim “employment” expenses from the end client at source as if he had been directly employed.
• Invoice Payment – Payment of invoices to the intermediary company will be made NET of employment taxes paid at source.
• Trade Debtors, Directors Remuneration, and Directors Loan Account – The remaining unpaid balance within Trade Debtors (difference between GROSS invoiced and NET paid values) is cleared by recognising Directors Remuneration in the P&L at the same gross value of Sales, and posting the difference to the Director Loan Account (available as an after-tax withdrawal).
• Withdrawal of Funds – As all funds are after-tax, and now recorded as Director Loan Account balances in the Director’s favour, they can be withdrawn at will without the need to pay additional taxes.
• Non-Allowable Expenses – Unless the intermediary operates other outside IR35 contracts then other business expenses (such as Accountancy Fees) are typically not allowable for tax purposes.
• Allowable Expenses – Company pension contributions are still allowable for tax purposes, but tax relief for these can only be obtained within the workers self-assessment tax return, unless the intermediary operates other outside IR35 contracts to allow potential offset.
• Self-Assessment – The worker must submit a self-assessment personal tax return in the normal way at the end of the tax year reporting the gross income earned under the inside IR35 contract and also any tax paid at source.

The fact that the tax deductibility of other business expenses (such as Accountancy Fees) is limited where an intermediary only operates inside IR35 contracts reduces the attractiveness of this option when compared to for instance:

• An employment position with the end client – Often it is not possible to accept an employment position with the end client because they are looking for part-time contract resource without the added responsibility of also providing associated employment rights and benefits.  But where an employment position is available then this should be strongly considered to take advantage of these associated rights and benefits.
• The use an umbrella company – Where an employment position is not available, then the worker also has the option of considering umbrella company services.  These companies typically use limited companies, termed as “umbrella companies”, to account for contractors / freelancers as if they were employed for tax purposes within the umbrella company.  They generally do not offer the same level of employment rights and benefits offered by the end client, but they are required by law to provide a base level of services, such as the provision of payroll and holiday pay services.  In addition, the fees paid to the umbrella company are allowable as pre-tax deductions, which makes them more attractive than using an intermediary limited company unless the intermediary operates other outside IR35 contracts, or has the future prospect of doing so.

LIMITED COMPANY ACCOUNTING FOR INSIDE IR35 CONTRACTS WHERE THE INTERMEDIARY MAKES THE DETERMINATION

In most cases the process outlined above applies equally where the intermediary makes the determination.  Except that in these instances it is also possible to deduct a “deemed employment payment” equivalent to 5% of total invoiced value in respect of general business expenses (such as Accountancy Fees).

ACCOUNTING FOR OUTSIDE IR35 CONTRACTS

Where a contract has been determined to be outside IR35 (by either party), and providing that the intermediary has taken appropriate steps to ensure that they are also compliant from an MSC legislation perspective, then there are some clearly definable benefits to operating via a limited company.

Where the intermediary opts to use a Limited Company structure for an outside IR35 contract then the following general accounting rules would apply:

• Invoicing – Invoices are raised as normal at the rate agreed with the end client.
• VAT – Will continue to be applied as normal for the total invoiced value, where the client opts for VAT registration, or where Turnover levels exceed the VAT registration threshold.
• Income Tax and NIC – The intermediary itself is the employer.  But the Director has the flexibility to determine both the value of salary that will be paid and also the timing of these payments.  There is therefore flexibility to retain funds within the company on a pre-employment tax basis.  As the employer the intermediary must process payroll, making RTI submissions, and paying employment taxes (PAYE, Employee NIC, Employers NIC) to HMRC.
• Invoice Payment – Payment of invoices to the intermediary company will be made GROSS.
• Allowable Expenses – There is greater scope for the deduction of business expenses as the self-employment test of “wholly and exclusively” is applied in comparison to the employment test of “wholly, exclusively, and necessarily”.
• Corporation Tax – Unlike inside IR35 contracts the company will typically have profitability (unless all income is paid as a salary) which will be subject to Corporation Tax at the current rates.
• Dividends – The Director has the flexibility to elect to pay any retained after corporation tax profits as dividends subject to dividend tax at the current rates, or retain these funds within the company, to be used to grow the business or withdraw them at a future date.
• Self-Assessment – The worker must submit a self-assessment personal tax return in the normal way at the end of the tax year reporting the salary and dividends received in the tax year and any employment taxes paid at source.

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