This blog goes slightly off the beaten track compared to my other finance-related blogs. But IR35, the so-called ‘intermediaries legislation’, is an important topic for freelancers. It doesn’t seem to go away, and influences the way we do business.
The idea is to present this freelancer’s understanding of the contentious HMRC rule.
To illustrate it in practice, I reveal the defences I would put up if, hypothetically, the HMRC were to argue that Prism-Clarity should be within the IR35 net.
Not much of this is original. It borrows heavily from other sources including a helpful account at freelancesupermarket.com. The only truly original material in this blog is the illustrative defence relating to Prism-Clarity.
Please note: this blog does not represent advice. This is a contentious topic. If in any doubt, consult your accountant or a professional Human Resources adviser.
How it came up
In Prism-Clarity’s case my accountants drew my attention to IR35 before I even started doing business or had any clients or engagements. And rightly so. It was important to be aware of it upfront, given it applies at the level of an individual engagement or contract.
Where it really came into question, though, was when a client expressed a hypothetical interest in extending our freelance arrangement into a more in-depth relationship. This might have involved more regular hours, a retainer, and perhaps more ‘direction and control’. I will talk more about that later.
I was hesitant to do this for a few reasons, but sensitivity about IR35 was one of them. So far the extension hasn’t transpired – and won’t – unless we can arrange it in a way which presents no danger of breaching the parameters I describe in this blog.
Background on IR35
There is plenty of information available on IR35 so I won’t waste too much time explaining the background. Perhaps the safest and best source is the official authoritative one, namely
HMRC’s own webpages, but there are also numerous calculator websites available, including this one from contractorcalculator.co.uk.
IR35 is the short name used for the tax rules that apply if you work for a client through an intermediary company. Hence the term ‘intermediaries legislation’. This could be either a limited company or a personal service company, which is how some contractors prefer to operate.
If your company is within the legislation, so-called ‘in IR35’, this could result in a large tax charge; namely the difference between corporate tax rates and your applicable marginal personal income tax rate. For some companies/individuals this could easily be the highest personal tax bracket. So it could be a large and costly difference, and if you had any choice in the matter you’d want to ensure that your company was not caught.
Of course, you might be caught because the structure of your company and your business deserves to be. In that case, it’s hard to argue that you shouldn’t be paying the higher (personal) tax rate.
But it’s not always obvious or definitive. Despite IR35 having been in force since 1999, the tax advisory and business communities have roundly criticised it as poorly conceived, badly implemented and causing unnecessary costs and hardships for genuine small businesses.
The logic behind this blog is to try to ascertain, against this background of uncertainty, that a particular company – mine – isn’t and shouldn’t be ‘in IR35’.
The case for the defence part one: generic
There are two elements to consider in considering your defence against your business being ‘in IR35’: a generic element and an assignment-specific element.
Am I genuinely ‘in business’, as opposed to ‘in employment’? Is my business genuinely open for business, open to take on multiple new clients and not directly beholden to any of them?
Are my business assignments ad hoc or repetitive?
Do I generally work from home (or from my own business premises) or from client premises?
Generally, do I use my own equipment or client equipment?
Does my business have the standard elements which indicate that it’s a genuine company, open for new business? A corporate bank account? Website? Business cards? Company stationery?
Do I have an active marketing approach, always on the look-out for new clients?
The case for the defence part two: assignment-specific
This is where it gets more complex, because the true test of IR35 applicability is not the generic one offered above. Those considerations may be relevant at the margin but, in effect, the true definition of an employee has been determined by case law over the years.
It comes down to three key concepts which apply assignment-by-assignment. These apply whether or not there is a written contract, hence my use of the word ‘assignment’ rather than ‘contract’. They are direction and control, mutuality of obligation and right of substitution.
Direction and control (DC)
This means the client can tell you what to do, especially if they can tell you to do anything that’s not directly relevant to delivering your assignment. If the client can do this, they are exerting direction and control, and increasing the risk that your company is ‘in IR35’. Of course most freelance assignments involve an objective, some conditions or constraints around the quality of the deliverable, and a timeline. Those are natural features of a freelance assignment. But in themselves they don’t represent direction and control, since you as the freelancer are free to deliver in the best way you see fit, including where, when and how.
Mutuality of obligation (MO)
This is more complicated but, at its simplest, involves the following criteria. Does the client have to offer you work? Do you have to accept it if they do? Can you charge when there is no work to do? Typically a simple test of ‘no work, no pay’ will suffice as the key test for this one.
Right of substitution (RS)
This one is more clear cut: can you send someone else to do the work? Employees can’t do that, so if you can, you are not an employee. As a sole practitioner, even operating within a company structure, this one can be hard to disprove: usually as a sole practitioner it is either you or nobody.
Passing any one of the above criteria should be enough to take you outside IR35. Ideally all three would apply. But it’s worth noting that the conditions have to exist in reality as well as in the contract. One company lost a case (i.e. the HMRC deemed it ‘in IR35’) partly because its client denied they would ever accept a substitute for the worker, despite there being a clause in the contract that substitution was possible.
Prism-Clarity vs the generic tests
Prism-Clarity passes all the generic tests (part one above) which prove that we are genuinely ‘in business’ rather than ‘in employment’. We are genuinely open for new business, and open to take on multiple new clients. We aren’t beholden to any of them.
All business assignments are ad hoc even those that are more regular in nature. There’s no guarantee a client will ask me to do work and, even if they do, no guarantee I will do it, if for example I can’t agree with the client on timing constraints. In fact I have demurred on work for that very reason, that I could not reach agreement with a client on a timeline that suited them, due to competing client work.
I do all my work from home, with only occasional visits to client premises for meetings or pre-assignment briefings. I exclusively use my own equipment, never client equipment. My business has a corporate bank account, a website, business cards and company stationery. I have an active marketing approach, using social media, bilateral and online contacts and numerous subscriptions/corporate memberships which indicate my ongoing freelance availability.
In short, I approach each client and each assignment as an independent business, and never as a temporary employee of the client.
Prism-Clarity vs the assignment-specific tests
Still, while all of the above can help prove you are genuinely ‘in business’, having multiple clients or contracts isn’t a sufficient defence against being ‘in IR35’, since the rules are applied on a per contract basis. This is despite the government at the time of the legislation (Paymaster General Dawn Primarola in 1999) stating clearly that people in business on their own account would be outside the rules.
The fact is that the assignment-specific tests are a bit harder to pass, especially the third one, since, as a sole practitioner, I have no substitute to be able to pass work on to. But the first two assignment-specific tests are easier to pass. I am not under the direction or control of any client, other than in setting assignment-specific criteria, which I then deliver against, however I see fit. There is no mutuality of obligation. No client has to offer me work and often they don’t. And even if they do, I don’t have to accept and sometimes don’t. ‘No work, no pay’ applies.
Still, I now record each assignment formally against the above three criteria (DC, MO, RS) pre-emptively, along with a summary of the contractual terms that apply to that assignment (email, verbal, Non Disclosure Agreement, etc). I hope I will never have to use these records to prove my status outside IR35 to HMRC. But for peace of mind it is valuable to have the evidence to hand.