Freelance workers face IR35 tax trap

New IR35 tax rules governing “disguised employment” will hit firms and freelance workers.

Man holding a telephone © Getty Images

There is no definitive answer to the IR35 question
(Image credit: Man holding a telephone © Getty Images)

Freelancers and small business owners face higher tax bills under government plans to extend controversial public-sector procurement rules to the private sector. The off-payroll working rules are likely to result in a change in the tax status of thousands of self-employed workers.

The rules, often described as IR35, are designed to tackle "disguised employment", whereby a company hires freelancers and contractors to undertake work, yet they are effectively operating as employees. The arrangement suits employers, who do not have to pay national insurance contributions for such workers, and the individuals themselves, who often set themselves up as limited companies. As such, they often pay national insurance and income tax at lower rates. Some freelancers and contractors operate as sole traders rather than companies, but this can have tax advantages too.

In theory, HMRC could challenge the status of any worker claiming to be inside the scope of IR35 and therefore entitled to operate as a limited company or sole trader rather than an employee. In practice, the large number of workers operating this way made this very difficult.

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The government therefore changed the rules for the public sector in 2017. An organisation hiring freelancers and contractors now has to take responsibility for determining their tax status. If they decide the worker is not entitled to IR35 status, they must treat them as employees for tax purposes, deducting income tax and national insurance at source.

From April 2020, private-sector organisations will also be required to determine the tax status of every freelancer and contractor they hire, and they too will have to deduct income tax and national insurance before paying them if they decide IR35 doesn't apply. Employers say this imposes a major administrative burden, since they will have to consider the tax status of every third party they hire. A lack of definitive guidance on who exactly is and isn't covered by IR35 makes things worse.

Freelancers and contractors also complain that while their tax status may change under the rules, being treated as employees will not give them any additional benefits. For example, they will have no new rights to claim sick pay or holiday entitlement.

They may also face a large additional tax bill. HMRC estimates that 170,000 workers are affected and will collectively pay £3.1bn more in tax and national insurance between 2020 and 2024.

IR35: the basics

Since HMRC does not publish a definitive guide as to who falls within the IR35 system, both organisations and individuals face considerable uncertainty potentially facing an unexpected tax bill if they make a judgement that the taxman subsequently challenges.

In practice, HMRC depends on three principles to assess whether an individual is a genuine freelancer or contractor, rather than someone who is really an employee of the organisation.

First, it assesses how much control the freelancer has over what work they do, and how, when and where they do it. The more control the freelancer has, the more likely it is that they will qualify for IR35 status.

HMRC also considers substitution: whether the freelancer is providing a personal service, or is able to send a substitute in their place. The latter is helpful in proving IR35 status. Finally, mutuality of obligation is important. Where an employer is obliged to offer work, and the worker is obliged to accept it, it is harder to secure IR35 status.

HMRC itself has an online "check employment status for tax" (CEST) tool that both organisations and individuals can use to get a preliminary idea of their tax status. However, the results are not conclusive and there have been complaints that significant numbers of people get indeterminate guidance from the service.

David Prosser
Business Columnist

David Prosser is a regular MoneyWeek columnist, writing on small business and entrepreneurship, as well as pensions and other forms of tax-efficient savings and investments. David has been a financial journalist for almost 30 years, specialising initially in personal finance, and then in broader business coverage. He has worked for national newspaper groups including The Financial Times, The Guardian and Observer, Express Newspapers and, most recently, The Independent, where he served for more than three years as business editor.