What is IR35 and how does off-payroll work? Dave Chaplin, CEO of tax compliance firm IR35 Shield, investigates and explains the two schemes’ key differences.

The new off-payroll legislation took effect on 6 April 2017, for the entire public sector and was then extended to the private sector in April 2021, but only for medium and large firms. The original Intermediaries Legislation remains in force where contractors work for a small client.

So, what is IR35? As you read on, we’ll explore:

  • How to navigate the new IR35 world.
  • Why it is crucial to understand IR35, off-payroll legislation and which one applies to you.
  • The key differences between the two.
  • How to defend your status if the original legislation still applies.

IR35 or off-payroll – which one applies to you?

The IR35 reform’s original intention was to be a wholesale replacement of the longstanding Intermediaries Legislation, which is Chapter 8 of the Income Tax (Earnings and Pensions Act) 2003. This original legislation, commonly referred to as IR35, has been in force since April 2000.

However, following consultations, parliament considered the pressure on small companies (as defined by the Companies Act) would be too onerous, so it introduced a small companies exemption.

Whilst designed to ease the burden on small businesses, it has added considerable complexity, because the original legislation remains in place but only applies to contractors working for those small companies.

So, we now have both the new off-payroll working (OPW) legislation (Chapter 10 of ITEPA 2003), which applies to all of the public sector and to private sector companies that are medium or large. Both are somewhat confusingly referred to as IR35, and all parties need to understand the differences to avoid accidental exposure.

The criteria used for small, medium and large can be found in the Companies Act 2006. The Act sets out the following parameters for a small company to operate within:

  • Annualised turnover of up to £10.2m.
  • Balance sheet assets of up to £5.1m.
  • Average number of employees of up to 50.

To qualify for the small companies' exemption, a company must meet two or more of the above criteria.

Should the company qualify, the original Intermediaries Legislation applies and the contractor would then assume responsibility for assessing their IR35 status and taxing themselves accordingly.

Many medium and large hiring firms are now fully outsourcing some of their projects to small, niche consultancies so that the new legislation does not come into play. An advantage arises because the consultancy will be considered the client in OPW terms; because the consultancy is small, so the exemption applies.

The rules then revert to the original legislation whereby the contractor retains responsibility for the assessment and the accompanying tax risk.

The exemption is not a tax loophole. Firms need to be cautious, meaning that the consultancy is likely to still assess the engagements and issue Status Determination Statements as a robust compliance measure.

Tip #1: Make sure you know which version of IR35 applies to your engagement.

What is IR35 and how does the new off-payroll differ?

When the new legislation applies, the contractor loses control over assessing their tax status, which becomes the client's responsibility. The client needs to determine the IR35 status of the engagement to establish whether it is one of deemed employment (inside IR35) or not (outside IR35). The client also takes on the responsibility of the entire tax risk.

The client is expected to create a Status Determination Statement (SDS), which outlines their view on the status and reasons for the conclusion they reached. The SDS is then passed down the supply chain and onto the worker. Its original intention was designed to ensure tax is correctly paid and help contractors receive fairness, but it's not quite worked as HMRC intended.

Navigating the off-payroll legislation landscape hasn't been easy for the contingent labour market, and contractors have suffered at the hands of confused hirers and recruiters, many of whom have taken the path of least resistance and initially started by blanket banning all limited company contractors. Despite the fallout for all parties, it was the most sensible and least-worst option for some firms.

OPW is complex for all parties and arguably unfair for all parties, although slightly different. Because of a yet-to-be resolved anomaly highlighted by the National Audit Office in its February 2022 audit, if HMRC successfully overturns an outside assessment, the client pays all of the tax and the contractor pays none at all – this is because HMRC has failed to address an issue with tax offsets.

Likewise, there is inbuilt unfairness for contractors. Many clients will understandably take a risk-averse approach. If they determine an engagement is likely to be inside IR35, they will offer the engagement as PAYE only.

This means the contractor cannot exercise their legislative right to dispute the clients' determination. And, even where clients are issuing Inside IR35 statements and considering disputes, they are marking their own homework – and there is no external right for the contractor to appeal to a tribunal, thereby denying them access to natural justice.

Tip #2: If off-payroll working applies, then the clients' decision is likely to be final, leaving the only option for the contractor to attempt a rate renegotiation or vote with their feet.

Evidence an 'outside IR35' contract

'Outside IR35' contracts do still exist and once you have secured work on that basis, the key is for both parties to work collaboratively to sustain the IR35 status and ensure the working practices continue to reaffirm this.

If you are working under the original IR35 legislation, you must maintain tax investigation insurance because the cost of successfully defending yourself against HMRC will rise above £50,000.

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It's important to understand that HMRC can form an opinion that is binding on you to pay the tax they think is owed, and the only option to overturn that decision is to appeal to the tax tribunal.

The appeal will require you to discharge your burden of proof – which means you will need to rely on the client helping you to garner the corroborated evidence required. When it comes to court, good quality evidence is critical. Otherwise, you will lose.

The same strategy is necessary for clients under the new rules. Therefore, clients will be seeking to reinforce outside IR35 status assessments with strong corroborating evidence gathered before and during the engagement. It's your job to assist with this.

Whilst much of the contracting market suffered from a knee-jerk reaction fuelled by fear, the reality is that under the new off-payroll legislation, provided the client and contractor work together to create an evidence-based defendable position, it's practically impossible for HMRC to claim otherwise.

Tip #3: Work collaboratively with the client on IR35 status and ensure you build an evidence trail to help protect your position.

Calculate rate renegotiations

If you're considering an inside IR35 engagement, you need to understand the off-payroll rules' financial impact on your income. Working inside IR35 under the new regime will impose an additional employment tax liability on the end client or agency and a tax hike, so knowing how much to increase your rate by for an inside IR35 engagement to be net income-neutral is essential.

But bear in mind that hirers will want to renegotiate too and pass their new tax bill onto you by a rate reduction. The usual rules of supply and demand apply – and no one owes you a living!

Some clients and contractors face the impact of the withdrawal of tax relief on expenses previously claimable. For a contractor who travels and lives in accommodation near the client site during the week, if deemed 'inside IR35', they may need to increase their rate by up to 40% to maintain the same level of take-home pay, thereby making the hire completely untenable.

Tip #4: Calculate two rates, one for inside IR35 and the other for outside IR35 – but don't always expect to get what you want.

Beware of dodgy pay schemes

Contractors should also tread with caution when considering using payroll companies – as it is an unregulated market. If you get scammed, you are responsible for any non-payment of tax. Be wary of the indicators of non-compliant schemes, such as dubious payment terms or a lack of transparency over payment illustrations.

HMRC has some excellent guidance on the Government website about umbrella companies. If you are unsure and can see no advantage, the safest route is being on the client or agency payroll.

Tip #5: If you are unsure how payroll schemes work, insist on agency payroll. Read HMRC's guidance on umbrella companies.

Always seek expert help

If you are responsible for your assessments, seek outside help. The IR35 case law is notoriously complex, and even HMRC takes 3-5 years to train its inspectors.

Gaining a good understanding of how the two different parts of IR35 work will enable you to navigate the terrain successfully and maintain your long term contracting career.

About the author

Dave Chaplin is CEO and founder of IR35 compliance solution IR35 Shield and author of IR35 & Off-Payroll Explained.