The Ultimate Guide to IR35

IR35, or the “off-payroll working rules,” is UK tax legislation designed to determine whether a contractor is genuinely self-employed or operating as a “disguised employee”. It applies when a contractor works through a limited company but their working arrangements resemble those of an employee.

Background to IR35

Permanent employees and contractors are treated differently under UK law. If a contractor provides services through their own limited company, they may take some of their pay in dividends instead of taxable salary. They can also offset several business expenses against Corporation Tax and pay less in National Insurance Contributions. This lower tax burden reflects the more significant financial risk of being self-employed.

HMRC introduced IR35 (or the ‘off-payroll working rules’) in 2000 to tackle ‘disguised’ employment. When a contractor is a ‘disguised’ employee, they take advantage of the tax efficiency of working through a limited company despite being treated and working as though they are an employee by the end client.

HMRC views these disguised employees as avoiding tax by taking advantage of the reward with none of the corresponding risks. The benefit for employers is that they don’t have to pay employers’ National Insurance Contributions or give the contractors employee benefits. The benefit for contractors is that they can pay themselves through their limited company to minimise their tax burden.

What does ‘IR35’ mean?

‘IR35’ was the reference given to the press release which first announced the off-payroll working rules, it was the Inland Revenue’s (IR) 35th (35) press release. IR35 is used to determine whether a contract points towards employment or self-employment, combating tax avoidance by closing loopholes and ensuring contractors working the same way as permanent employees pay the same taxes.

If a contract is ‘Inside IR35’, it points towards employment. The working arrangements are similar to those of a permanent employee, so HMRC imposes broadly the same Income Tax and National Insurance liabilities. Working Inside IR35 is usually done via an umbrella company that handles the administrative burden of paying the correct taxes.

If a contract is ‘Outside IR35’, it points towards self-employment, and you can enjoy the tax efficiency that self-employment brings (as well as all the associated risks). Working Outside IR35 is usually done via a personal service company (‘PSC’). A PSC is a limited company set up by a contractor to provide their services; they are usually the sole shareholder and company director.

How does IR35 work?

IR35 applies on a contract-by-contract basis; it does not apply once to your entire company. For each contract, the relevant ‘decision-maker’ (usually the end client) prepares a Status Determination Assessment (‘SDS’). The SDS looks at the engagement contract’s wording and the contractor’s day-to-day working practices and decides whether IR35 applies.

HMRC offers detailed guidance notes and an online tool to help decision-makers determine whether IR35 is relevant. Third parties also specialise in performing these assessments and providing insurance against a potentially incorrect determination.

Who does IR35 apply to?

Any contractor that is a UK resident for tax purposes has the potential to be impacted by IR35, although the party responsible for performing the SDS can vary. This is a point that often confuses contractors. They mistakenly believe that if a potential client is overseas, then IR35 doesn’t apply. Instead, they become responsible for the SDS, decide whether they are Inside IR35, and hold the liability should this decision be wrong.

If you are a contractor paying tax in the UK, you need to consider IR35.

If a contract is found to be ‘Inside IR35’ it means the working arrangements are similar to that of an employee, as opposed to that of a self-employed individual. As a result, the contractor must pay the same taxes as an employee (Income Tax and National Insurance), usually via an umbrella company.

Implications of being Inside IR35

Working Inside IR35 means that you have been caught by the IR35 rules, and HMRC regards the service you provide to be one of employment. You are considered an employee for tax purposes rather than a self-employed individual running their own business.

If you work Inside IR35, you are subject to the same Income Tax and National Insurance Contributions as a permanent employee. You cannot make use of the salary and dividend structure in the same way you can while working Outside IR35 via a limited company. Instead, you are paid via PAYE.

Paying a contractor via PAYE requires a fee-payer to run payroll. Most clients do not want to take contractors onto their payroll directly; instead, they prefer to engage contractors via an intermediary such as an umbrella company.

If you are a permanent employee considering contracting for the first time, accepting an Inside IR35 contract is more straightforward than working Outside IR35 via a limited company. You do not need to incorporate a limited company, hire an accountant, or submit a self-assessment tax return.

Once you have chosen an umbrella company, all you need to do is submit your timesheets. The umbrella company will handle the administrative tasks of running payroll and paying the relevant taxes to HMRC.

The situation is more complicated if you are an existing contractor considering switching from working Outside IR35 to working Inside IR35, as you need to decide what to do with your limited company. Do you keep it going, make it dormant, or close it completely?

Trading while Inside IR35

Once a project is found to be Inside IR35, an intermediary must be chosen. Although umbrella companies are by far the most common trading solution, they are not the only option available to contractors:

Umbrella Company

An umbrella company acts as an intermediary between the contractor and the end client, charging a small margin to handle the administrative task of running PAYE. The contractor submits a timesheet, and the umbrella company invoices the client. Once the client pays the invoice, the umbrella company deducts Income Tax, National Insurance, and employer costs (employer’s National Insurance, apprenticeship levy, and umbrella margin). The net amount is then paid directly into the contractor’s personal bank account.

Agency PAYE

With agency PAYE, the contractor is enrolled into the recruitment agency’s PAYE system and effectively becomes their employee for the duration of the contract. The agency pays the contractor a fixed rate while charging the client an uplifted amount to cover their fee and administrative costs. The agency deducts Income Tax and National Insurance from the contractor’s rate and pays the net amount into their personal bank account. There are rarely additional costs to the contractor as the agency factors administrative and employer costs into what they charge the end client.

Although this may make it seem like Agency PAYE is better than operating through an umbrella company, a contractor’s net take home is usually the same. End clients should offer inflated rates for umbrella company contractors to reflect that they pay the employer’s costs directly. However, how accurately rates are inflated has been a point of contention since the IR35 rules emerged.

Limited Company

Most contractors are unaware that you can technically continue working through your limited company while working Inside IR35. In reality, very few contractors work this way as most end clients refuse to work with contractors on an Inside IR35 basis unless it is via an umbrella company or agency PAYE.

Fixed-Term Contracts

Contractors working on fixed-term contracts are employed directly by the end client for a specific period. As the contractor is an employee, there is no intermediary, and the IR35 rules do not apply. By law, the employer treats the contractor the same way they treat other employees on a permanent basis. The contractor receives equal treatment to other employees for the contract duration. They have unfair dismissal and redundancy rights, receive the same pay, and pay the same taxes.

It’s worth noting that, although there are technically many options available to Inside IR35 contractors, recruitment agencies and end clients frequently specify that they will only accept contractors working through an umbrella company.

Outside IR35 means a contractor is considered self-employed for tax purposes, allowing them to work through a limited company and benefit from tax efficiencies (such as the salary/dividend split). This classification reflects genuine business-to-business engagements, where contractors assume the financial risks and responsibilities of self-employment.

Implications of being Outside IR35

Being ‘Outside IR35’ means that you are running a genuine business and, therefore, operating outside of the IR35 rules. As an Outside IR35 contractor, you are a limited company director, invoicing your client directly and using the company revenues and profits in a way that suits you, just like any other small business owner.

Financially speaking, working Outside IR35 means taxes are not deducted at source, and you are not subject to direct PAYE. Instead, the client pays the entire fee amount (plus VAT if applicable) to your limited company as revenue. This revenue is subject to Corporation Tax and a mixture of Income Tax and Dividend Tax, depending upon how it is withdrawn.

As you are not subject to PAYE, you must ensure you pay the right amount of tax by submitting a self-assessment tax return at the end of the year. Most contractors working Outside IR35 employ the services of a specialist contractor accountant, as the nuances of running a limited company can be tricky.

Trading while Outside IR35

Choosing a legal structure is one of the most important decisions Outside IR35 contractors must make. There are several options available:

Limited Company

Almost all Outside IR35 contractors choose to operate via a personal service company (PSC). A PSC is a limited company set up by a contractor to provide their services; they are usually the sole shareholder and company director. As a limited company is a distinct legal identity, the contractor’s personal assets are not at risk should the company face financial hardship.

Sole Trader

A sole trader is a self-employed individual who is the sole owner of their business. As a sole trader, there is no distinction between yourself and the business; you are considered the same entity. You have absolute control over how the business is run and are entitled to keep 100% of the profits. Although technically possible, Outside IR35 contractors rarely work as sole traders. Most end-hirers won’t work with them as there is a risk that the sole trader could seek to claim employment rights from the hirer (as is common in the construction industry).

From a contractor’s point of view, not only are there financial benefits involved with working through a limited company, but sole traders also face virtually unlimited liability. Their personal assets could be at risk in the face of litigious clients.

Umbrella Company

An Outside IR35 contractor can, in theory, decide to work through an umbrella company. As with an Inside IR35 contract, the umbrella company would invoice the client and then deduct all relevant taxes before paying the contractor net. In practice, this is rarely done as it removes any ability to distribute earnings tax-efficiently. The only time Outside IR35 contractors consider working through an umbrella company is if the contract is short or if they are considering moving to a permanent position. In these cases, they may not want the administrative burden of setting up and later closing down a limited company.

Since IR35 was first introduced, contractors have tried to ensure they operate as a genuine business Outside IR35. Operating in this way ensures they can pay themselves a tax-efficient salary and dividend split. By doing so they minimise Income Tax exposure and both employer and employee National Insurance Contributions. But what happens to those contractors that are caught by the IR35 rules? What is the cost of IR35?

We’ve attempted to quantify the impact of IR35 by comparing various scenarios for two contractors, Jack and Jill. Both charge a daily rate of ??500; however, Jack works Inside IR35 via an umbrella company, while Jill works Outside IR35 via a limited company. The following calculations use our Inside IR35 Calculator and Outside IR35 Calculator, assuming 230 working days and using the tax rates from 2024/2025.

Comparison of ??500 per day

At a daily rate of ??500, the financial outcomes for Jack and Jill differ significantly based on their IR35 status. Jack, who works Inside IR35 via an umbrella company, has annual taxable earnings of ??106,705, pays ??33,388 in taxes, and takes home ??67,317 (??3,609 per month). Jill, working Outside IR35 via a limited company, has lower taxable earnings of ??91,254 but only pays ??16,956 in taxes and takes home ??74,298 (??5,192 per month).

This results in Jill taking home almost ??7,000 more per year than Jack, a 9% higher take-home. To match Jill’s take-home pay, Jack would need to charge a daily rate of ??530, an 18% increase over his current rate. The cost of being caught by IR35 is clearly substantial.

Key drivers of the disparity

The primary reason for this disparity lies in the different types of taxes each contractor pays. Jack’s income is taxed at source through PAYE, resulting in Income Tax and employee National Insurance Contributions. On the other hand, Jill’s income is structured through her limited company, allowing her to pay Corporation Tax and Dividend Tax, which are generally lower than PAYE taxes.

Additionally, Jack faces a significant burden of employer National Insurance Contributions, paying ??12,641 annually compared to Jill’s ??473. This discrepancy highlights a common frustration with IR35: contractors classified as employees for tax purposes often bear the costs typically associated with employers.

Impact of changing daily rates

The financial disparity between Inside and Outside IR35 contractors varies with daily rates. At ??300 per day, Jack’s annual take-home pay is ??44,116 compared to Jill’s ??51,899, a difference of 15%. At ??700 per day, Jack takes home ??95,772, while Jill’s take-home is ??91,058, narrowing the gap to 6%.

Although the inequality appears to decrease the higher the daily rate charged, this isn’t beneficial. It simply reflects that the difference between the dividend and Income Tax rates reduces the more you earn. Higher earners pay higher tax rates on the income that falls into the respective bracket, so key takeout working Outside IR35 via a limited company is so attractive. It facilitates effective tax planning.

Impact of effective tax planning

The above calculations assume that Jill withdraws all cash from her limited company in the year it was earned and has no allowable expenses. While this above us to identify a general parallel between Inside IR35 and Outside IR35 take “home” rates, it does not reflect reality.

In truth, working Outside IR35 through a limited company allows Jill to choose how she withdraws her money from the business. She can select from several different strategies to minimise her tax liabilities effectively.

Allowable expenses reduce the Corporation Tax liability, delaying payment of a dividend to the following tax year reduces the amount captured by higher rate tax brackets, and leaving revenue in the company as retained earnings enables claiming Business Asset Disposal Relief (BADR) upon winding up.

BADR is the most effective way contractors can reduce their tax bill. BADR turns a dividend into a capital payment instead of paying the relevant Dividend Tax rate, contractors and investors see a reduced capital gains rate on qualifying disposals of 14%.

When considering tax planning, the disparity between Inside IR35 and outside IR3 take-home increases significantly. Take the ??500 per day example above. If Jill decides to leave 25% of her net profit in the company as retained earnings, and can claim BADR upon closing the company.

This results in a total capital gain of ??78,970: ??61,266 from standard take-home, and ??17,704 from BADR. That is an increase of ??16,653 per year to Jack’s take-home, or 15%. To earn an equivalent take-home while working Inside IR35, Jack must charge a daily rate of ??640, a 28% increase from what he currently earns.

Impact of pension contributions

As taxes are deducted at source for Inside IR35 contractors, pension contributions are the only tax planning tool available. Maximising pension contributions reduces tax liability, and increases total capital gained (this is different from take-home pay). This is a popular strategy for Outside IR35 contractors to make better use of their earnings.

In our example above, if Jack decides to contribute 50% of his relevant earnings to his SIPP via salary sacrifice, he would have a total capital gain of ??93,915: ??40,203 from standard take-home and ??53,712 from pension contributions. This is a substantial improvement over the ??67,317 take-home achieved with no pension contributions.

Summary

Every contractor’s working arrangements and earning profile differ, so identifying a single figure that can quantify the cost of being caught by IR35 is impossible. It can vary based on days worked, other sources of income, expenses, allowances, tax rates etc.

As such, there are some inherent limitations to the above calculations. For example, they do not consider the impact of allowable expenses Outside IR35 contractors can offset against Corporation Tax. Pension contributions are employed as well; neither contractor has the luxury to view this in-come in sense from a hypothetical tax reduction perspective, many contractors can’t afford to lock away such a high proportion of their income until they retire.

The same can be said about BADR. While it is a fantastic form of tax relief, it is only claimable once a company is wound down (i.e. closed). Until then, the money is stuck in the business and can’t be accessed. It also goes without saying that not everyone’s contracting career is going to a multi-year or multi-industry far tax years.

While the difference between Inside and Outside IR35 take-home pay can be substantial, depending on your daily rate, contracting length, and use of tax reliefs, the vast majority can go some way to reducing the deficit.

IR35 assessments determine whether a contractor operates inside or outside the IR35 legislation. These evaluations examine factors like control, substitution, and mutuality of obligation to establish employment status. Accurate assessments are crucial for ensuring compliance and avoiding tax penalties for both contractors and hiring organisations.

When does IR35 apply?

If you are a UK resident for tax purposes and are considering working as a contractor through an intermediary (such as a limited company), IR35 must always be considered. The only variable is around whose responsibility it is to conduct the IR35 assessment.

This is an important point that often confuses new contractors who believe that working with small businesses or overseas clients exempts them from IR35. They are incorrect. Working with small companies or overseas clients means the contractor is responsible for the IR35 assessment and is liable should HMRC investigate and find it faulty.

Who is responsible for the IR35 assessment?

IR35 applies on a contract-by-contract basis. For each contract, the relevant decision-maker prepares a Status Determination Statement (SDS), which looks at the engagement contract’s wording and the contractor’s day-to-day working practices. The party responsible for preparing the SDS depends on the industry in which the client operates, the size of their business, and the location they’re based.

The decision-maker responsible for the SDS is also the party responsible for the additional tax liabilities, interest payments and penalties should the assessment be wrong.

How is IR35 status determined?

There is no ‘HMRC approved’ template for IR35 assessments. Instead, those responsible must review the contract and the day-to-day working realities against the IR35 rules. HMRC look at both when performing an IR35 investigation.

The responsibility for performing the IR35 assessment lies with the contractor only if you provide services to a private sector client defined as a small company under the Companies Act 2006 or a foreign business classed as ‘wholly overseas’. The end client/fee-payer is responsible for the assessment in all other situations.

Contractors that have to perform their own IR35 status determination should note that there is no specific assessment process. Instead, you need to consider the IR35 rules in conjunction with the written terms of your contract and the day-to-day working arrangements. When performing the assessment, it’s essential to remember that genuine Outside IR35 contracts are business-to-business relationships. The contract will likely be inside IR35 if you ‘look and feel’ like an ’employee’ in your day-to-day working arrangements even if the contract says you are not.

Given the potential costs of getting an assessment wrong, contractors who have to perform the review themselves should opt for professional help in the form of a contract review.

QDOS’ Full IR35 Contract Review service offers a concise assessment of your contract and working practices, providing a comprehensive report of the engagement’s IR35 status with a clause-by-clause analysis and straightforward suggestions for positive changes.

HMRC’s IR35 CEST tool

HMRC claims that their Check Employment Status for Tax (CEST) tool can help determine whether you are ‘inside’ or ‘Outside IR35’ for tax purposes. The tool provides HMRC’s view of a worker’s employment status based on the information provided, although using the CEST tool when making employment status decisions is not compulsory.

HMRC has pledged to ‘stand by the results of the CEST tool if the information entered is correct; however, contractors should be wary about using it. Data released by HMRC show that of more than 1 million, at least three assessment per year have been made for the tool since 2017 when it was launched, yet only 22 government bodies were fined after failing to correctly assess the employment status of their contractors, with two of the departments using CEST and Safe Harbour arrangements.

Relying on CEST alone isn’t a smart move due to its unreliable nature, and the issues don’t stop there. The tool is too simple and lacks the detail required to assess every contractor accurately. Many contractors find the tool confusing, especially if they are asked about topics that don’t apply to them, which makes the results difficult to trust. Even HMRC Litigation teams have said that CEST tool results are not always accepted in tax tribunals.

The IR35 rules are used to determine the status of a contract engagement by assessing whether the working arrangements resemble employment or self-employment. Factors looked at when assessing a contract include whether the client is able to control the work of the service provider, whether the service provider has the right to provide a substitute, whether there is a mutuality of obligation for an employer to provide work, and the worker to perform said work.

The three key tests that determine IR35 status are set out in employment law and have evolved over the day-to-day working practices against a framework known as the ‘IR35 case’. Against these rules, the assessor must decide whether the engagement would be one of employment or self-employment if there was no limited company in between. Is the contractor running a genuine business, or are they operating as a disguised employee?

Supervision, Direction and Control

Supervision, direction and control refers to the degree the client exercises authority over the contractor. A contractor’s level of control determines whether they work as a genuine independent business or as an employee. It concerns what has to be done, when and where it has to be done, and how it has to be done. If a contractor would have this level of control, this could indicate employment. If this is not the case, this would indicate self-employment and would be Outside IR35.

When considering supervision, direction and control, contractors should ask themselves:

If the client can dictate any aspect of the work conducted in your engagement, the contract is likely to be Inside IR35. Instead of accepting a company complete autonomy over their work, HMRC provides several fictitious examples to help recipients assess their response.

Substitution

Genuine Outside IR35 contracts are business-to-business arrangements. In the engaged limited company should have the right to provide a qualified replacement to perform the role if unable to work. This is called a ‘substitution clause’ and it’s a strong indicator of being Outside IR35.

For the purposes of IR35, a substitute is a short-term resource used to cover the contractor during periods of holiday, illness, or other unexpected absence. A substitute does not necessarily have to be an employee of the limited company. It is perfectly acceptable to engage another contractor if they have an appropriate skill set.

For the purposes of assessing a contract, it’s important that when agreeing the terms of the service, it is a strong indicator of self-employment and being Outside IR35. That said, HMRC do distinguish between genuine right of substitution with ‘helper’ provisions.

A right of substitution is only likely to exist where the client does not care from one day to the next for the duration of the contract who turns up to do the work, provided they whoever turns up possesses the necessary skills and experience. However, a ‘helper’ is unlikely to count.

For a contract to fall Outside IR35, a contractor should be able to provide a suitably qualified substitute to carry out the work without the client’s consent.

Mutuality of Obligation

Mutuality of obligation means an employer has a legal duty to provide work, and the employee has a legal duty to accept and perform the work offered. A contract without mutuality of obligation is perfectly employees, guaranteeing their right to an agreed salary and employment benefits.

A business-to-business relationship, such mutuality of obligation doesn’t exist. Supplies are not engaged to perform a specific task. For contractors, this means that once you’ve completed a project, you’re under no obligation to accept any more work, and the client is not obliged to offer you more work either.

Mutuality of obligation is incredibly ambiguous. HMRC state that without mutuality of obligation, there is no tax employment, though this can be regarded as a ‘general rule’. In the meantime, HMRC have stated that mutuality of obligation is not a standalone factor, and if there is control and no right of substitution, it is difficult to be Outside IR35.

For a contract to fall Outside IR35, mutuality is implied in even one state they can work for, the contract! A likely one of employment and to Inside IR35.

Working practices

Supervision, direction and control, right of substitution and mutuality of obligation are all contractual clauses reviewed during an IR35 determination. However, there is a point in making a statement within a contract and the actual practices that occur during the engagement.

When performing an IR35 enquiry, HMRC reviews both the contract and the contractor’s working practices to establish if the assessment is correct. For assessments via contracts, the clauses must reflect the working practices; essentially, the clauses must be genuine.

HMRC may consider additional criteria when assessing the day-to-day working out IR35 status:

It’s important to note that clauses in taxation, the above points are insufficient to indicate IR35paid employment.

Using your own IT equipment when isn’t premium clients frequently insist that contractors work on their systems and recruitment agencies, you may have no practical reason to have a company accountant, or work solely with one client. Those are appropriate points that might weaken an ‘Outside IR35’ determination if a company is offering working in a manner where there are signs of being solely IR35. Instead, it is usually a prerequisite for ensuring security protocols and limiting breaches.

IR35 compliance requires contractors to ensure their contracts and working practices align with the IR35 rules. Contract reviews, accurate status determinations, and careful alignment of working arrangements with contractual obligations are necessary steps. Contractors facing investigations are encouraged to use professional reviews and insurance for protection.

HMRC IR35 Investigations

If HMRC believes that IR35 should be applied to your contract, they’ll open an IR35 investigation. Contractors who fail to demonstrate their engagements are genuinely self-employed face the financial consequence of paying backdated tax, interest, and penalties, plus the bill for their advisors.

Contractors can also trigger an IR35 enquiry due to exhibiting certain suspicious behaviours. HMRC doesn’t publish their list of indicators, but a well-regarded tax expert confirms that by avoiding high-risk profiling and targeting strategies.

Small works can easily become subject to investigation by considering a range of factors. For example, evidence that a business is not genuinely providing a contractor’s operation can include non-arm’s length transactions. They prioritise individuals for review if they are a vulnerable tax payer, or are deemed to display ‘egregious behaviour’.

HMRC’s systems are likely programmed to look for identifiers as an individual operating through a limited company who is little value director, has a spouse as a shareholder, has misguided someone or deliberately not delivered.

If you are operating as weak, don’t fret, many legitimately Outside IR35 contractors operate this way. Provided that the rest of your working practices meet the Outside IR35 criteria, there is no need to be concerned.

IR35 investigation process

An investigation into IR35 status involves an enquiry; the letter can be sent in multiple ways to conclude. Broadly, though, the investigation can be split into three main steps:

You have the right to appeal HMRC’s decision, a process that involves a review of the case by an independent tribunal.

Consequences of getting IR35 wrong

Being investigated by HMRC does not automatically mean you are a disguised employee. If you take the investigation seriously, correctly determine yourself to be classified as ‘Outside IR35’, and have a valid argument (and ideally, contract review), HMRC may close the investigation without financial implications.

However, if HMRC determines your status assessment is wrong and you have incorrectly been working Outside IR35, a total Income Tax and National Insurance bill for backdated periods is passed. At the end of the investigation, an assessment will be raised for any PAYE due.

The severity of the penalty is based on the reason for the inaccurate determination. If HMRC deems the misclassification was due to:

The consequences of getting IR35 wrong can potentially be crippling. Legal fees, taxes, interest, and penalties can all follow an HMRC investigation. Although the recent reforms place responsibility on the fee payer in most circumstances, there is still a significant downside for contractors involved in an IR35 investigation.

Who is responsible?

The personal and limited company that supplies the professional tax liabilities, see interest, and penalties is the same party responsible for performing the original Status Determination Assessment. This depends on the client’s industry, size of the business, and the jurisdiction of the end client.

In summary, the liability lies with you as a contractor if you provide services to a client on the private sector deemed small and overseas are considered as ‘wholly overseas’.

How to maintain IR35 compliance

Beyond using a clean contracts alone will not eliminate the possibility of an HMRC investigation altogether. There is always the chance that you receive that dreaded letter. Aside from ensuring your working practices are aligned with the obligations in your contract, there are a few measures you can take to prevent an investigation or dispute:

Under IR35, contractors can only claim expenses if they are approved by the client and reimbursed on top of the agreed rate. The 5% general expense allowance is now limited to contracts with small private companies. Contractors Outside IR35 have more flexibility to claim business expenses via limited companies.

What expenses can be claimed while Inside IR35?

In 2016, legislation came into effect restricting what could be claimed by contractors working Inside IR35. While expenses can still be paid, they must be agreed with the end client and paid in addition to your standard contract rate. Unlike limited company contractors working Outside IR35, expenses cannot be offset against earnings.

The easiest way to think about IR35 expenses is to think of yourself as a permanent employee of the end client. If a permanent employee can seek reimbursement for an expense, it is likely you can as well. If they can’t, you can’t. All expense claims must be submitted, approved, and reimbursed on top of regular income.

With regards to what expenses are allowable while working Inside IR35:

Travel Expenses

Under the new provisions that came into effect in 2016, any travel and subsistence while working Inside IR35 will be treated as if the engager employed the contractor directly. No relief is given for home-to-work travel costs and associated subsistence.??

Inside IR35, contractors can only seek reimbursement for travel and subsistence expenses if they relate to the performance of their duties or travel to a ‘temporary’ workplace. These expenses must be approved by the client and paid in addition to the standard contract rate.

No relief is available for ordinary commuting, which is travel between home (or a place that is not a workplace) and a ‘permanent workplace’. HMRC outline several criteria for identifying what constitutes a permanent workplace.

Accommodation Expenses

The 2016 changes to travel and subsistence allowances also impact accommodation expenses. Inside IR35 contractors can no longer claim costs such as hotels unless approved and reimbursed by the fee payer.

Pension Contributions

Contractors working Inside IR35 can continue to claim tax relief on pension contributions, regardless of whether they work in the public or private sector.

IR35 and the 5% rule

Prior to April 2021, contractors working Inside IR35 were entitled to claim a 5% general expense allowance. This 5% was a flat rate, calculated on the gross fees receivable, and was designed to cover administration costs such as insurance, working from home, accountancy and training.

Since April 2021, new rules have significantly curtailed who can claim the 5% allowance. For all public sector and most private sector contracts, the 5% allowance no longer exists. The only exception is if the contract sits within the private sector and the client is deemed a ‘small company’.

Outside IR35 expenses

Contracts that fall outside of the scope of IR35 allow contractors to work via limited companies, claiming all allowable expenses. ??As a limited company owner, business expenses reduce profits before tax. This, in turn, reduces the amount of Corporation Tax owed to HMRC. More allowable expenses mean less taxable profit and a lower tax liability.

For an expense claim to be ‘allowable’, it must be incurred ‘wholly and exclusively’ for the purposes of business.??The terms’ wholly’ and ‘exclusively’ are designed to prohibit expenditure that serves a dual purpose, a business purpose, and a non-business purpose.

IR35 does apply to UK-based contractors working with foreign companies. If the client is wholly overseas without a UK presence, the contractor is responsible for determining the IR35 status and is liable for the additional tax and penalties should the HMRC investigate and find the assessment to be incorrect.

IR35 and overseas clients

International markets can provide lucrative opportunities for UK contractors willing to work with overseas clients. Historically, the jurisdiction of the end client had minimal impact on a contractor’s IR35 status, as a contractor’s UK tax obligations were their responsibility only. However, the changes to the IR35 rules in April 2021 mean that contractors are no longer responsible for determining their IR35 status. Most of the time, the responsibility now lies with the end client or agency that pays the contractor.

Many overseas clients are unaware of the UK’s IR35 legislation or are uninterested in the time-consuming process of providing a status determination assessment. HMRC have no jurisdiction over non-UK-based companies and cannot force compliance with the IR35 rules.

If you are a UK resident contractor working for an overseas client, then IR35 still applies. Just because you work for a foreign company outside the UK or are paid in a foreign currency does not mean you can ignore IR35. This confuses a lot of contractors who think IR35 no longer applies if their client is not based in the UK. This is incorrect.

How this impacts UK contractors

The UK government sought to clarify the confusion around IR35 and foreign companies in the Finance Bill 2020. Organisations without a UK presence, considered ‘wholly overseas’, are removed from the IR35 responsibility chain.

Instead, where a client is wholly overseas, the pre-April 2021 rules will apply, and it will be up to the contractor themselves to determine IR35 status. The responsibility and, most importantly, the liability is returned to the contractor.

It is up to the contractor to evaluate their own IR35??status and, if they assess themselves as Inside IR35,??make the relevant Income Tax and National Insurance payments. Should HMRC conduct an IR35 investigation, any additional tax and penalties arising from an incorrect assessment will be payable by the contractor.

What does ‘wholly overseas’ mean?

According to the gov.uk website, “an organisation is classed as overseas if it does not have a UK connection”. HMRC consider the definition of having ‘no UK connection’ to be where:

A permanent establishment in the UK is usually a branch or a local office. If the client is??based overseas but has a branch or local office in the UK, no matter how small,??the second test is not passed. The business is not wholly overseas, and they retain responsibility for determining IR35 status. They are liable for any additional taxes or penalties arising from an incorrect assessment, and HMRC will pursue any outstanding obligations through the UK establishment.

IR35 does not apply when you have no liability to tax or National Insurance Contributions in the UK. Therefore, if you are a contractor based overseas and you qualify as a non-UK resident via the Statutory Residence Test, the IR35 legislation does not apply.

This does not mean that, as a UK-based contractor, your contract is automatically Inside IR35. All it means is that a Status Determination Assessment must be performed.

Although it is unusual, contractors working Inside IR35 can operate through a limited company. Taxes are deducted at source by the fee-payer, paid into the limited company bank account, with the contractor taking the remaining funds as a tax-free salary. No additional taxes (Corporation Tax, Dividend Tax etc) are owed.

Can I use my limited company while Inside IR35?

While it is not common practice, it is possible to continue working through a limited company if your current contract is determined to be Inside IR35. You don’t have to sign on with an umbrella company immediately. That said, although it is technically possible, most clients will refuse to hire contractors who work through a limited company while Inside IR35. They have preferred methods of engagement, usually via an umbrella.

Contractors that can work via their limited company while Inside IR35 will have taxes deducted at source by the fee payer (usually the client). The fee payer will allocate a tax code and make the relevant deductions for employers’ National Insurance, personal Income Tax and National Insurance.

The remaining amount is then paid to the limited company along with any VAT owed. As the fee payer has already deducted tax from the monies paid to the limited company, the contractor does not need to pay further personal taxes (income, NICs, or dividends), and the company does not need to pay any Corporation Tax on the received amount.

The contractor can take the total amount as a tax-free salary, transferring the money from the limited company directly to their personal bank account with no additional funds owed to HMRC. There is no double taxation. This video explains the process in detail.

Contractors working through a limited company while Inside IR35 should remember to check the amount of Income Tax deducted from the source by the fee payer. The fee payer only has sight of the current contract; they do not have knowledge of any other money the contractor may be earning. For example, a basic rate of 20% of Income Tax may be applied despite the contractor being a higher or additional rate taxpayer. If this occurs, the contractor must pay any outstanding tax through their self-assessment at the end of the year.

When is it viable?

Working Inside IR35 via a limited company may be viable if:

What are the limitations?

The inherent limitation of working via a limited company while Inside IR35 is that many clients will refuse to engage you. They do not want to adopt the additional responsibility of allocating a tax code and making relevant tax deductions. In addition, a lack of clarity regarding the IR35 rules means that clients insist on contractors using an umbrella company. Despite working through a limited company being a perfectly acceptable way to operate, clients do not want to risk being incorrect in their approach and exposing themselves to potential tax liabilities.

It’s also worth noting that, despite working through a limited company, if your contract is Inside IR35, you are still significantly restricted by the expenses you can claim.

What are the alternatives?

One option for a limited company contractor caught by the IR35 legislation is to make their company dormant. The company will have no trading activities, although it will still have ongoing (albeit minimal) filing obligations with both Companies House and HMRC. In this way, the limited company will continue to exist pending its future re-activation when Outside IR35 contract work becomes available.

If making the existing limited company dormant is not desired, the contractor may wish to consider closing it and taking advantage of the significant tax reliefs available.

Outside IR35 and limited companies

If your contract is Outside IR35, you operate as a genuine business-to-business relationship and can work through a limited company. You earn revenue, claim expenses, and can take advantage of efficient tax planning arrangements.

IR35 does not apply to sole traders as they work as self-employed individuals, they do not operate via an intermediary. End clients tend to often avoid sole traders due to potential liability risks and employment rights claims, instead preferring contractors to operating through limited or umbrella companies.

What is a sole trader?

A sole trader is someone who owns 100% of an unincorporated business. As a sole trader, you and your business are legally one entity; you are not distinct in the way a limited company is from its owners.

Does IR35 apply to sole traders?

IR35 does not apply to sole traders as they operate as self-employed individuals. The IR35 legislation only applies to contractors working through intermediaries (such as a limited company). Although??IR35??does not apply to Sole Traders, the issue of employment status for tax purposes remains.

The rules for determining employment status are similar to those for determining IR35 status. Which employment status tax legislation applies to you as a sole trader is determined by whether you’re a direct hire or working via an agency.

Why don’t contractors work as sole traders?

Contractors rarely work as sole traders as they usually don’t have a choice; most agencies and clients will refuse to engage them. They will stipulate that they require a company (limited or umbrella) to act as an intermediary in the chain of services. They do this for two main reasons:

In addition to the above, operating as a sole trader has downsides for the contractors themselves. For a sole trader, there is no distinction between business and individual. You hold personal responsibility for the businesses’ debts and may have to sell off personal assets to meet those debts should something go wrong.