This is a question that has been debated by many contractors working through their own personal service companies ever since the IR35 legislation was introduced in April 2000, and to this day most of them still do not know the answer. For many of them it is probably just as well, as it means that so far they have escaped a Revenue enquiry. Of course, the main reason why the issue is so clouded is that the IR35 rules were so badly drafted in the first place and rely inevitably upon legal interpretations for each individual case.
According to the legislation, IR35 only applies if the following conditions are met:
||income is received by an intermediary;
||PAYE has not been operated on that income in full;
||the income relates to services performed personally for someone else; and
||the worker providing those services would be regarded as an employee of that person if the intermediary did not exist.
The first three of these conditions are not normally in dispute. It is the last condition that causes all the arguments. Basically it boils down to whether or not the contractor should be regarded as self-employed. For this purpose it is necessary under the legislation to construct a hypothetical contract to describe the relationship that would exist between the worker and the engager if the intermediary did not exist. This will be based on all the circumstances relevant to the engagement such as the terms and conditions of relevant contracts and the actual substance of the arrangements between the parties.
If the hypothetical contract is regarded as being of an employment nature, then the IR35 rules will apply and it will be necessary to calculate a Deemed Payment in respect of all income received under that contract during the tax year. The Deemed Payment will then be subject to PAYE in the normal way.
In order to determine whether the hypothetical contract is of an employment nature, it is necessary to apply standard criteria for deciding whether someone is employed or self-employed. These are not laid down by statute but are a series of pointers that have been established by the courts over many years in dealing with cases of this nature. You can see a list of these on our information sheet headed Are You Really Self-Employed?
For most contractors affected by IR35, probably the most important of these criteria are the following:
a) do you have control of the work?
b) is there any mutuality of obligation?
c) can you sub-contract the work to others?
It is the last of these that often causes the most dispute. Commonly known as a right of substitution clause, it has been established by the courts that they are only operative if the client would actually accept them in practice. This can be quite difficult to prove, as most clients tend to hire a company because they want the services of a particular individual. If that individual should attempt to send someone else in his or her place, even for a day or so, it would probably be met with some resistance by the client unless it had been approved by them in advance, which would probably only be after a lengthy recruitment process involving interviews and references.
Mutuality of obligation is normally easier to prove for most contractors. Does the contractor have an obligation to give personal service to the client and does the client have to pay the contractor for that service? It should be noted here that we are referring to a contract of service rather than a contract for services. The former is in the nature of an employment relationship, the latter is more typical of self-employment. It usually boils down to whether or not there are agreed working hours or a fixed contract period during which the contractor must work and for which the client must pay. If the contractor can come and go as he or she pleases, or the client does not have to provide work and pay for it throughout the duration of the contract, then there will be no mutuality of obligation.
Control of the work is another thorny issue. Even the most senior employees are usually subject to some degree of control over their work, such as the manner in which it is done or when to do certain tasks. A self-employed person will normally be allowed to do the work as he or she sees fit. Yet even self-employed persons do not usually have complete autonomy over their work. For example, a landscape gardener will have to work according to the specifications of his customer. So where do we draw the line? It usually boils down to whether or not the contractor has a line manager who regularly allocates or supervises his work. Mere monitoring of the work would not be enough to prove that the contractor lacks that vital element of control. Also, it is the right of control that matters, not merely whether it happens to be exercised or not.
The other factors such as provision of own equipment and financial risk tend to be of less relevance in most contracts for knowledge-based services but can still point towards self-employment where they do exist. For example, a contractor who invests a lot of time and money in training for a particular assignment, or who works at home using his own computer and infrastructure would go a long way towards avoiding IR35. And if a contractor worked for a number of other clients at the same time and profits depended on how well he or she managed the workload, it is unlikely that IR35 would even be an issue.
Probably the best advice for contractors faced with a potential IR35 situation is to make sure the client is on-side from the outset. It is no use simply putting a right of substitution clause or a right of control clause in your contract and getting the client to sign it on a verbal assurance that it would probably never be exercised. The Revenue has been known to wheel out client staff at tax tribunals who then say they would never accept such conditions in practice. As you can imagine, such a scenario could totally undermine your case. It is far better to discuss all this with a client at the start of a contract and agree protocols for certain situations, such as the recruitment and vetting of replacement or supporting staff.
It is also important to make sure that your actual working arrangements agree with the contract. For instance, if your contract states that the work will be done as and when necessary and that there are no set working hours, you should follow this in practice and not end up coming in every day and having to ask permission whenever you want to take a holiday. The same goes for control of the work. If your contracts states that you will have control of the work within performance standards determined by the client, this should be reflected in how you actually do the work.
Agency contracts are another potential banana skin. Many agencies are quick to state that their end-user contracts are IR35-proof when in fact they haven't been changed for a hundred years. Take these with a pinch of salt and try to get a sight of them if you can, although they shouldn't matter too much if you get your working arrangements with the client right.
In conclusion, IR35 needn't be a lost cause provided you get your contract and working relationship right. It needs a bit of foresight and planning, not to mention the co-operation of the client, but for most high-level engagements it should be possible to work out something that will keep you on the right side of the IR35 rules.