What is IR35, and what does it mean for your business?

The UK recently introduced new legislation to close a tax liability loophole and redefine certain relationships between companies and contractors operating in the UK. If you employ workers or have contractors in the UK (or if your company is based in the UK), you are required to know how the new IR35 rules could affect your business.

IR35 has significant implications for businesses and temporary workers in the UK alike. Misclassifying contractors or failing to demonstrate compliance with IR35 mandates can have severe repercussions for companies unfamiliar with the legal ecosystem in the UK.

Remote's Contractor Management platform presents an easy option for companies that want to remove the guesswork from compliant contractor relationships.

This comprehensive guide covers the intended purpose of the law, key rules, and how IR35 affects contract work arrangements in the UK. Whether you’re a business owner or manager, this article offers a clear understanding of IR35 and its impact on engaging with UK team members.

Read on to learn how to navigate the complex landscape of IR35 and make informed hiring decisions.

What is IR35?

Inland Revenue 35, also known as IR35 or the “Intermediaries Legislation,” is a set of off-payroll working rules for companies, intermediaries, and independent contractors in the UK. It aims to determine whether a contractor is truly self-employed or should be classified as an employee for tax purposes.

The public sector reforms apply to workers who provide their services through an intermediary, such as a limited company (LC) or personal service company (PSC). The purpose of IR35 is to ensure that off-payroll workers pay roughly the same income tax and National Insurance as standard employees.

IR35 examines factors like control, substitution, and mutuality of obligation within the working relationship to determine if the contractor should be subject to employment taxes and insurance payments.

These laws establish whether an off-payroll contractor should really be considered an employee. The legislation has significant implications for businesses, contractors, and the way they engage with each other.

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The UK implemented IR35 in response to a large number of contractors evading income tax and national insurance payments through “deemed employment” loopholes that allowed them to self-classify as independent contractors. Referred to as “disguised employees,” these workers paid less in taxes and national insurance contributions by operating as LC contractors.

After the UK applied IR35 to the private sector in April 2021, determining a contractor’s IR35 status shifted from the contractor to their client. This resulted in a 35% reduction in self-employed contractors and a significant drop in pay for 80% of those who continued working inside IR35 contract arrangements.

Who is affected by IR35?

The IR35 legislation affects both companies dealing with contractors and the contractors themselves.

UK contractors paid less in taxes by setting up an LC structure to accept client payments. The UK government believed some of these workers were exploiting the tax system by operating as contractors when they should have been classified as employees. Anyone who would meet the definition of “employee” without the existence of the limited company (also known as a PSC) is now termed a “deemed employee” and therefore is subject to employment and income taxes.

Some small businesses are exempted from the new rules, which apply primarily to medium- and large-sized private-sector businesses and all public-sector clients. A small business must meet two of the following criteria to qualify for this exception:

• Annual turnover of less than £10.1 million

• Gross assets of less than £5.1 million on the balance sheet

• Fewer than 50 employees

All businesses that do not meet the small business criteria are subject to IR35 legislation.

Does IR35 apply to non-UK companies?

IR35 can apply to non-UK companies in certain circumstances. The legislation lists off-payroll working rules for contractors providing services in the UK, regardless of their nationality or the location of their employer, although there are potentially complicated gray areas.

Contractors who are UK tax residents fall under IR35, and their medium- or large-sized companies are required to determine their status as either a contractor or an employee. Non-UK contractors working in the UK, however, are not subject to IR35 if they don’t have tax residency.

Reciprocal agreements (RAs) between the UK and other countries add another layer to consider. While each arrangement depends on the specific RA, workers in the UK are generally required to pay social security contributions in their client’s country and can only retain their national insurance for a set number of years. The RA with the US, for example, sets the limit at five years.

If a non-UK private-sector client engages with contractors or has a presence in the UK, such as an office or branch, it may be subject to IR35 rules and therefore needs to comply with the tax obligations associated with engaging UK workers.

It’s important for non-UK companies to understand and comply with the relevant tax laws and regulations when operating within the UK, as this will help them avoid potential penalties and legal issues related to IR35. Blanket assessments are not recommended; instead, each contractor’s IR35 status should be established individually.

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When should you convert a contractor to an employee?

While contractor designations may be appropriate for some business relationships, companies cannot simply pay people as contractors because it’s easier. Contractors and employees fulfill different roles and have distinct legal definitions. Converting a contractor to an employee can protect the employer from penalties, provide a better experience for the employee, and make it simpler for both parties to collaborate.

Is there IR35 in the US?

No, IR35 is a tax legislation that focuses on determining the employment status of contractors for tax purposes in the UK only.

However, any US-based company that has a presence in the UK or pays UK tax will be responsible for determining any UK contractor’s status under IR35.

If, for example, a UK-based web developer accepted a contract position with Microsoft in Seattle, then Microsoft is responsible for determining the worker’s IR35 status since the company is large and has a UK presence. UK contractors are responsible for their own IR35 status when the overseas client is either small or has no presence in the UK.

The US has its own set of regulations to determine whether a worker should be classified as a W2 employee or 1099 contractor, based on IRS guidelines and state-based tests. A worker’s status determines compliance with taxes, benefits, and required documentation.

What does it mean to be subject to IR35 legislation?

In the past, the duty of discovering contractors exploiting tax loopholes fell to HMRC, the UK’s tax authority. Under IR35 legislation, companies subject to the new rules are responsible for determining the IR35 status of their own contractors in the contract of employment. Small businesses are exempt from the rule because of their limited resources, but larger companies working with contractors are now required to vet the IR35 status of their own contract workforces.

IR35 legislation categorizes contractors as “outside IR35” or “inside IR35” for tax treatment purposes:

What does outside IR35 mean?

Contractors who are correctly classified as contractors (and not employees) and pay all relevant taxes are referred to as “outside IR35”.

If the contractor is considered outside IR35, this means the contractor is treated as a genuine business and the payment the contractor receives (“direct deemed payment”) is treated as employment income. The contractor is allowed to pay themselves a salary, treat the remaining income as dividends, and pay taxes as they normally would. This may include working through a limited company as long as the arrangement makes sense and is not misused to avoid paying taxes.

If a contractor works for a public sector entity or in the private sector for a mid- or large-sized company, the client is responsible for determining the “outside IR35” status. This determination can still be investigated by HMRC, but it’s the client’s responsibility to know the compliance rules.

Inside IR35

Contractors who are classified as “inside IR35” are treated as full-time employees for tax purposes. They are required to pay the same income taxes and contribute equal National Insurance Contributions (NICs) as an on-payroll, permanent employee within the same tax bracket — though it’s the company’s responsibility to do so on their behalf by deducting taxes and contributions from their pay.

Contractors working inside IR35 should ensure that their client issues a “deemed payment” at the end of the tax year on their behalf and — if their actual working practices have changed — that their tax status is reassessed for accuracy. An HMRC determination that a contractor has been misclassified as outside IR35 when they are, in fact, inside IR35 can lead to steep fees or fines.

For more information on UK taxes, including employer taxes, see Remote’s UK Country Explorer page.

Does a contractor inside IR35 become a full employee?

No. While contractors found to be inside IR35 must pay taxes on their earnings as if they were employees, and their employing companies must do the same, this does not make them full employees automatically. Laws relating to classification and taxation remain separate at this time. Contractors who become “deemed employees” under IR35 are not automatically entitled to employment benefits such as sick pay and paid time off.

What if a contractor is termed a “deemed employee”?

When a contractor is termed a “deemed employee” under IR35, penalties occur if the contractor was previously classified outside IR35 and not paying the appropriate taxes. A contractor found to be in violation of IR35 (one being paid through an LC who should be classified as an employee inside IR35) must pay all missing back taxes, plus interest and any penalties. HMRC has the power to investigate as far back as six years, so penalties can be severe.

Businesses working with contractors (that is, end clients of contractor services) must also pay penalties and back taxes with interest if found in violation. The UK government announced it would not enforce penalties for accidental offenders taking “reasonable care” in 2021, but it may continue to punish companies deliberately breaking the rules. The government may also publicly criticize companies that fail to comply to encourage more widespread adherence to the new rules.

Use our Contractor Compliance Checklist to avoid misclassification

Work through this checklist to help determine if a new hire should have a contractor or employee relationship.

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How does an SDS help companies comply with IR35 rules?

Companies must submit a Status Determination Statement (SDS) for each contractor. The SDS goes from the end user or end client (the company receiving the service) to the agency (if applicable), then through the PSC/LC, and finally, to the individual contractor. The SDS must include information on the decision the company made regarding the contractor’s status as either inside or outside IR35, plus the reasoning for the decision and evidence of reasonable care in deciding.

If the contract changes, the company engaging the contractor’s services must create a new SDS to determine whether the relationship with the contractor changed under IR35.

What happens if the contractor disagrees with the SDS the company creates?

Contractors may appeal SDS decisions verbally or in writing within 45 days of receiving the notification. Once the company receives the complaint, the company has an additional 45 days to respond.

Companies in this situation have two options:

1. Uphold the decision and respond to the contractor in writing, citing the reasons why.

2. Change the SDS and issue a new one.

If the company fails to comply with the 45-day limit, the company becomes responsible for taxes and NICs incurred by the contractor for the changed status.

What is “reasonable care” in the eyes of IR35?

HMRC expects companies to collect relevant information via SDS to determine whether contractors lie inside or outside IR35. Due diligence can vary but should include records like:

• Does the contractor have other clients?

• Does the contractor take financial risks, i.e., is the contractor legitimately represented through the PSC/LC?

• What actual work practices does the contractor perform? Are these practices different from those conducted by full employees at the company?

Answering questions like these demonstrates reasonable care that the company attempted to comply with IR35 rules. Companies must maintain these records and document their reasoning for determining contractor status. Under no circumstances should companies make a “blanket” decision about all their contractors’ statuses.

What is the CEST (Check Employment Status for Tax)?

The CEST is an online tool created by HMRC that presents a series of questions to help businesses determine the status of contractors and employees for tax purposes. This tool can be used as part of “reasonable care.”

Businesses can access the CEST on the UK government’s website.

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How to pay contractors and stay compliant in the UK after IR35

With the wealth of talented workers in the UK, businesses should not let IR35 rules scare them away. Highly experienced contractors and employees in a variety of industries live and work in the UK, and these new regulations are intended to close a tax loophole, not make doing business in the country more difficult.

Helpful resources for employing in the UK

We’ve pulled together a collection of information about hiring and paying employees based in the United Kingdom. Use these guides to help your recruitment team understand the unique local requirements for hiring British workers.

• Guide to hiring employees in the UK: Whatever your situation, this guide on hiring employees in the UK can help you get familiar with the basics of UK employment law, payroll practices, common benefits, and more.

• How to pay remote workers in the UK: Paying international employees doesn’t have to be complicated, costly, or time-consuming. This article guides you through the nuances of paying British workers. Remember, the IR35 rules are critical here. To pay employees in the UK, a company based outside the country must either set up a local legal entity or employ their foreign workers through an employer of record, like Remote. Companies may only pay their workers as contractors if the relationship is legitimately contractual. Otherwise, the company could be subject to penalties and fines.

• What does Brexit mean for employers?: Learn more about the specific employment ramifications of Brexit, including visa requirements, work permits, transfer requirements, and taxation changes.

• Overview of the most critical labor laws in the UK: IR35 is just one of a collection of unique employment considerations for teams hiring and managing remote workers in the United Kingdom. This article introduces the most important aspects of the UK’s laws around contractor classification, work permits, union requirements, terminations, and severance pay.

• Benefits to offer employees in the UK: Companies in the UK must offer a specific set of employee benefits to remain compliant with UK labor laws. This is especially important for foreign employers of remote UK workers who may not be familiar with common benefits in the UK (don’t forget that Remote also makes it easy to manage a consistent and competitive benefits program for contractors as well as employees).

The easy way to stay compliant with IR35

Understanding IR35 is essential for both UK companies and global businesses that work with independent contractors in the UK. It’s crucial to carefully assess working arrangements, making sure to consider factors including control, substitution, and mutuality of obligations. Your team can easily build checks to remain compliant with IR35 and mitigate potential risks (this will also help you keep smooth working relationships with contractors).

Remote guides your business through the requirements of staying compliant with local laws and regulations – both in the UK and around the globe. Remote Contractor Management is purpose-built to generate localized contract agreements, guide you to maintain proper contractor classification, and act as your on-hand expert in local compliance practices globally.

Remote’s contractor management services allow companies to balance risk management with flexible, fast, and cost-effective expansion so that you can growth with compliance assured.

If you are interested in working with contractors or employees in the UK, contact Remote and let us know so we can help you start onboarding and paying your remote workers compliantly all over the world.