A press release numbered IR35 announced the Chancellor's intention to tackle the avoidance of tax and national insurance contributions (NICs) through the use of intermediaries such as service companies or partnerships.

The proposals and subsequent rules have since become commonly referred to as IR35.

The proposals targeted circumstances where a worker would be treated as an employee of the client, if it were not for the existence of the intermediary. Where this was a limited company, the worker was able to take money out in the form of dividends instead of salary.

Dividends are not liable to NICs so the worker would pay less in NICs than either a conventional employee or a self-employed person.

The IR35 test

A worker will be caught be the rules if he/she fails the 'IR35 test'. This test determines whether the worker would be an employee of the client if the intermediary (e.g. the limited company) did not exist.

The test aims to 'look through' the circumstances
surrounding the work carried out and determine whether the worker is really a 'disguised employee' (IR35 applies) or is in fact independently contracting with the client through a company (IR35 does not apply).

Scope of the Rules

The IR35 rules apply to income earned in respect of work done under contracts which would have been contracts of employment if the worker had been working direct for the client ('relevant engagements').

They do not introduce any statutory definition of employment or self-employment, so the existing case law still applies to decide employment status.

Workers with up to 5% share in the intermediary (taking into account the holdings of family and domestic partners) are not subject to the rules, unless they receive payments or benefits which are not taxable as employment income.

Calculations

If you are caught by the IR35 rules, you are treated as receiving a notional salary on the last day of the tax year (5 April) equal to the company's gross income from relevant engagements less certain specified deductions.

You will have to pay over PAYE and NICs on this notional salary by 19 April and include it on the year end return P35 by 19 May.

It is evident that there is very little time to process the calculations, and H M Revenue & Customs will not penalise the use of provisional payments and calculations in order to meet the deadlines.

The deductions cover expenses that would normally be available to direct employees, contributions to registered pension schemes and the actual salary and employer’s NIC plus the employer's NIC on the deemed salary.

Also allowed is a 5% flat rate deduction to cover the company's running costs.

Apportionment

Where a company has relevant engagements and other business which does not fall within the new rules, allowable expenses will have to be apportioned. Likewise, if a payment for a relevant engagement covers more than one worker, the payment can be apportioned between them on a just and reasonable basis.

Other Taxes

Corporation Tax is computed in the normal way, including the deemed salary and associated employers' NIC as allowable expenses. VAT operates regardless of any IR35 adjustments.

Dividends and Other Payments

Nothing in the legislation prevents a service company from paying money to the worker or others in the form of dividends, or retaining cash in the company. It will simply mean that an extra payment of PAYE tax and NICs will be calculated on 5 April. Dividends which are reclassified as deemed salary are relieved from tax so the PAYE takes priority, thus preventing double taxation of the payment.

Amending Contracts

Workers who think they may be subject to the new proposals should consider their position carefully, and should seriously think about renegotiating contracts so that they are no longer relevant engagements. Particular items to cover are:

• getting away from payment at hourly rates and ensuring that the contract is 'project based'

• ensuring that the client will accept a capable substitute worker

• creating freedom in the way the work is carried out

• providing major items of equipment

• ensuring that there is no 'mutuality of obligation' - i.e. that the client is not obliged to provide work, nor the worker to carry it out

It is, of course, essential that the contracts should actually operate within the scope of the written terms.

Managed Service Companies (MSCs)

New legislation introduced by the 2007 Finance Bill will deem income received by individuals providing their services through a MSC to be employment income if not
already treated as such. This means that MSCs will be required to operate PAYE (from 6 April 2007) and Class 1 National Insurance Contributions (from a date to be
specified after Royal Assent) on all payments received by individuals for services provided through such companies. If the MSC rules apply the IR35 rules are disapplied.

Please note: This guide is intended to provide basic information only. Where specific advice is required, we recommend that you seek proper professional help; either from this firm or other suitably qualified person or practice.