What is IR35?
IR35 was the press release issued by the Inland Revenue at the 1999 budget. Alastair Kendrick, director of PAYE and NI solutions at accountancy firm Ernst and Young explains, "It outlines the Chancellor's proposed changes to the taxation of personal services companies [otherwise know as limited companies]." It becomes law on Friday.
Why do I need to know about it?
If you do contracting work it will impact the structure under which you can operate and the amount you can earn. The purpose of the IR35 legislation is to clamp down on tax avoidance by contractors who work via limited companies.
Before April 5, to set up a limited company contractors appointed themselves as director and became an employee of the firm. They could draw a small salary to avoid paying large amounts of tax and NI and receive dividends from the company which were NI-free.
However, under the IR35 regime this structure is likely to change. Each contract must be tested against the Schedule D self-employment rules to determine the contractor's working status - employed or self-employed.
Barry Roback, managing director of accountancy firm JSA, explains, "If you are deemed to be on a self-employed contract, then nothing has changed. You will be able to operate via a limited company and enjoy all the benefits of dividends."
Contractors deemed to be employed will be treated for tax purposes as PAYE, and subject to income tax and NI. Industry pundits estimate that contractors deemed to be employed, and therefore caught under IR35, will see their income will drop by anything from 10% to 45%, depending on individual circumstances.
How will IR35 change the contracting industry, if at all?
A Freelance Informer survey of 1,000 contractors last autumn revealed that 18% of contractors say they will work overseas if the IR35 legislation is implemented. Threats of contractors working abroad have been abundant, and a "brain-drain" is predicted.
Those that stay may look to go permanent but risk losing half their income. Others are asking for rate increases of around 10% from employers to compensate for income loss.
The IR35-friendly contract has been a much-talked about solution. Julian Howes, senior partner at Gloucestershire-based Graduate and Professional Financial Services, says, "To avoid IR35, future contracts would have to include features such as a fixed price for the whole contract rather than hourly rates, and establish that the contractor has overall responsibility for the work [ie complete control]."
But agencies and industry bodies alike emphasise that the paper contract must reflect a contractor's true working practice.
What are the options?
There are several guises for operation. Contractors can work as sole traders (or self-employed workers) and work directly for an IT company, but they must fulfil the badges of self-employment, such as deciding when and where they work, and by working under their own supervision - for example, consultants who work from home.
Alternatively, agencies predict that the temporary/casual scenario, where contractors become employees of an agency, is likely to be adopted by new contractors. Permanent workers are more cautious about making a total step into contracting from the permanent world and may therefore want a halfway house.
Peter Searle, managing director of recruitment agency Computer People, thinks that there will be more temps/casuals (or "permie contractors") as a result of IR35. Via this method, Searle says, "a contractor receives two-thirds more than they would as a permanent worker." And as an employee of the agency would also receives employment benefits such as holiday pay, sick pay etc.
Another option is to work as part of a management company. Under this regime contractors become employees of the management company, which then invoices the agency and deals with tax and social security payments.
If contractors choose the management company or umbrella option, it is important to establish whether they will receive any dividend income from the company. Not all umbrella companies operate in the same way.
Any contractors that work through a management company that pays them a salary, and they do not receive an income from dividends, will escape the IR35 rules as they are already being paid under PAYE.
However, if they switch to what has been called a composite company, where they receive both salary and dividends, then the IR35 regulations would be applied to each of the contracts.
Which option will earn me the most money?
It is difficult to say. It will depend on the impact of IR35. Kendrick points out, "Some people are saying that if many contractors go overseas to avoid the legislation, then the staff shortage will unveil pots of money to those that stay."
It is a mixed view. Contractors who want to push their rates up to compensate for the legislation may encourage employers to use permies to avoid paying more. It is a case of wait and see.
What are the pros and cons of working for an agency?
Time saving is the main advantage. Agencies find the contract, which saves the contractor hunting around for work. Some agencies also offer training discounts, bonus schemes and even share options.
On the flip side, agencies will take their cut of a contractor's income for services rendered. The burning question, according to Gordon Morrison, partner at accountancy firm Wheawill and Sudworth, is whether agencies will assist with IR35-friendly contracts.
What are the pros and cons of becoming a limited company?
Up until now, by working via a limited company tax advantages were available, but most of these will be outlawed by IR35.
But there are still some plus points even if a contractor is caught under the IR35 regime. If a company falls foul, a contractor will still be allowed to deduct normal expenses (Schedule E), company pension contributions and up to 5% of contract value to cover running costs of the company.
Contractors often shy away from the limited company option because of the amount of administration it involves and the responsibility that goes with it. There are many statutory obligations to uphold. Kendrick says, "The contractor is liable for the work of his company, and he must therefore cover himself with the appropriate indemnity insurance."
Are there any more laws on the cards that will affect contractors?
No, not that the industry is aware of. But Kendrick predicts that the Inland Revenue is aware of contractors' plans to get around IR35 and will attempt to close loopholes in legislation in future.
Will I be hit by the same tax rules if I work abroad?
The IR35 tax rules won't apply if a contractor works abroad, according to Kendrick. "But there are tax rules that may bring you back into a similar position in other countries," he warns.
In Europe, Holland has the best tax levels, followed by Germany and Belgium, according to Patrick Spaight, manager at recruitment agency Volt Europe.
Where can I find out more?
Seek professional financial advice from an accountant, or contact the Inland Revenue. Many of the IR35 Web sites are a good information source to keep updated with the latest movements. Below are some of the most useful sites:
Tina Milton is Web editor on Freelance Informer magazine
This was first published in April 2000