1. Summary of Key Points
- Take legal advice before starting a contract if you have any doubts whether it could be classed as an employment contract.
- Anyone who operates as self-employed who is later deemed to have been employed is likely to face a big tax bill.
- “Umbrella companies” offer reduced admin. hassle but are unlikely to save tax following changes to the law.
- If you are classed as employed, there will be up to 20% more tax to pay and more restricted rules on allowable expenses.
- It’s very unlikely that operating a limited company will save you tax if you are classed as employed.
2. Background
There are considerable differences in the tax and National Insurance treatment of self-employed people compared to employees. Consider the example of an IT technician earning £30,000 per year. One is employed, the other self-employed.
- The employee will take home 60% to 65% as net pay – from £18,000 to £19,500.
- The self-employed one will take home 75% to 80% – from £22,500 to £24,000.
This difference is reasonable compensation for the commercial and other risks – no paid holiday, no paid pension – self-employed people are generally running compared to employees. However, over the past 20 years many people who believed they were self-employed have faced large tax and NI bills because Her Majesty’s Revenue and Customs (HMRC) have ruled that they were employees and not self-employed. This is known as false self-employment. Certain fields of work have been especially targeted because the proportion of workers claiming to be self-employed is much higher – up to 3 times higher – than average:
- The construction industry has become the subject of a whole new set of rules – the Construction Industry Scheme. This is dealt with in a separate note because these rules are unique to that sector.
- IT consultants and contractors.
- Butlers and nannies and other “personal service” contractors who often work for the same client for several years.
This note is a summary of the key issues for determining whether someone is self-employed or not. This is one of the most complex areas of UK employment law and this note is by no means intended as a cast-iron guide to any given person’s legal employment status.
3. The Key Tests of Employment
Beware of anyone offering you an “IR35-proof” contract. Various cases from 2008 to 2010 have resulted in such advisors coming unstuck – if your contract has words which are not being borne out by your actions, the contract will not stand scrutiny.
Overall it is the intention and reality of the relationship which matters. HMRC will apply the following tests. The more of the following questions which are answered “Yes”, the more likely it is that HMRC will rule that false self-employment applies:
- Is the customer offering work, and the contractor accepting it, on an ongoing basis?
- Does the customer have control over the hours being worked and the tasks undertaken?
- Does the customer require the contractor to do the work personally? (i.e. he or she cannot send a substitute)
The first three tests are the prime tests Courts and Tribunals have applied between 2008 and 2010. There are other tests which have lesser stature:
- Does the customer provide all the equipment needed to carry out the contract?
- Does the customer require the contractor to do the work personally? (i.e. he or she cannot send a substitute)
- Is the contractor free from any financial risk or painshare?
- Is the customer paying by the hour or day – as opposed to fixed price or lump sum contracts for specified tasks undertaken?
- Is the customer providing sick pay, holiday pay and other similar benefits?
- Is there an intended employment relationship – as opposed to a stated intent in the contract not to have such a relationship?
- Is the contractor spending the vast majority of his or her time on this customer’s contract?
- Does the contract provide for a fixed notice period?
A number of companies who should know better are currently – November 2009 – advertising “IR35 proof solutions” and similar. This is very dangerous. the reason is that HMRC and the Courts are taking a case by case approach in this area. So anyone offering a “one size fits all” approach to their clients in this field cannot possibly be acting in the best interests of their clients. Some of their clients will be fine. Others will find that far from being “IR35 proof”, the “solution” has in fact brought them firmly to the attention of the HMRC.
At best an HMRC investigation will take up a lot of management time better spent winning and executing work. At worst it will take up a lot of time and the contractor will finish up with a hefty tax bill to boot.
4. Whose Problem is this?
After all the above complexities, we get to a simple answer – yours! If you set up a limited company or other business and run a contract or contracts through it on the basis of being self-employed, but it is later determined that it was false self-employment, you are liable for all the PAYE and employee’s NI which you’d have paid as an employee. Strictly under IR35 – the Inland Revenue regulation dealing with this area – you’ll get a 5% deduction from the invoiced value to cover admin. expenses, but if you’ve been taking home 20% more cash than you’d have done as an employee, there could still be a big bill to pay.
5. Managed Service Companies (Umbrella Companies)
This little wheeze made it easy for individuals to operate their self-employed contracts with minimal admin. hassle until the Government introduced new laws in 2007 which put a stop to it. Each company would have many self-employed contractors working through them – but not so many that the umbrella company was too big to claim the reduced rate of corporation tax smaller companies pay.
The rule now is simple – these companies must account for PAYE and NI in full for everyone on their books, as if they are employees. So the only benefits they now offer are reduced admin. hassle. Some will claim they have dispensations to also save tax on expenses such as travel and subsistence. However, it is advisable to steer clear of companies making these claims – many have found that HMRC have clamped down on their dispensations once they started “abusing” them. By definition such dispensations are at HMRC’s discretion so if they are revoked and back taxes claimed no legal challenge is possible.
6. Business Expenses for Contractors within IR35
The rule for the self-employed here is that expenses “wholly and exclusively incurred” for business purposes can be deducted from revenue to arrive at taxable income. This means that a wide range of expenses can be deducted.
For people deemed to be employed the expenses must be “wholly, exclusively and necessarily incurred in the course of the employee’s duties”. This is much more restrictive as follows:
- Invoiced cost of meals whilst at a temporary workplace.
- 40 pence per mile for the first 10,000 miles driven, then 25p thereafter.
- Invoiced cost of hotels and the reasonable costs of evening meals.
- Training which is directly relevant to your contract duties.
- Pension – still a big tax break as you save tax and NI if the company pays a pension contribution.
- Subscriptions to a professional body which is on the HMRC approved list.
As an example, if a self-employed contractor decides to go on a training course, there will be no problem with the deduction for tax purposes. But if an IR35 contractor goes on the same course, they probably cannot claim tax relief for the costs incurred – unless going on such courses is part of the contract terms.
7. Is Going Limited Worth It if I am within IR35?
Running a limited company costs about £400 per year in legal and professional fees. The tax savings start to outweigh these costs when taxable profits are greater than £12,000 per year or so. However, once your company is caught within IR35 you’ll pay the extra fees but still be taxed as if you were an employee – it’s almost certainly not worth it to be limited any more.
8. Why People Fail IR35
Traps people fall into which contribute to them failing the IR35 test:
- Hours are set by the client.
- Tasks are vague instead of there being a clear contractual scope of works.
- A named individual in the contract instead of a trading company.
- No right of substitution for the “employee” – instead it’s up to the client to find a substitute in cases of illness or holiday.
- An obligation for the client to find and offer work and for the “employee” to accept it.
- An exclusivity clause preventing the “employee” from working for other clients.
- A right to “employee” benefits such as paid holiday or pension.
- The “employee” takes on roles in the client organistion such as fire warden or union rep.