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Inside vs Outside IR35

If a contract falls inside IR35, it means that the contractor is deemed to be an employee for tax purposes and must pay income tax and National Insurance contributions (NICs) similar to a permanent employee. Conversely, being outside IR35 means that the contractor is genuinely operating as a business and can benefit from tax efficiencies associated with running a limited company.

Inside IR35

When a contract is deemed inside IR35, HMRC considers that, were it not for the presence of the intermediary (PSC), the contractor would be an employee of the client. As a result, the contractor:

• Pays tax like an employee – subject to PAYE and NICs.
• Loses access to tax efficiencies – such as dividends and allowable expenses.
• May receive some employment benefits – if engaged through an umbrella company, such as statutory sick pay and holiday pay, but this depends on the engagement model.

Key Implications of Inside IR35

• Increased tax liability: Contractors inside IR35 typically take home less pay due to PAYE deductions.
• Employer's National Insurance: If the contract is in the private sector, the fee payer (end-client or agency) must deduct Employer’s NICs, which may lead to reduced rates for the contractor.
• Limited expense claims: Unlike outside IR35 engagements, contractors inside IR35 cannot claim travel and subsistence expenses in the same way.
• Lack of employment rights: Contractors inside IR35 do not receive statutory employment benefits, unless working through an umbrella company.

Outside IR35

What Does Outside IR35 Mean?

A contract that is outside IR35 signifies that the contractor is genuinely in business on their own account. This means they:

• Have control over their working arrangements – deciding how, when, and where they work.
• Bear financial risk – they may have to rectify work at their own cost.
• Can substitute themselves – a crucial indicator of true self-employment.

Key Implications of Outside IR35

• Favourable tax position: Contractors operating outside IR35 can pay themselves via dividends, which are taxed at a lower rate than salary.
• Greater autonomy: They have control over how they provide their services, including taking on multiple clients.
• Full expense claims: They can claim business expenses, such as travel, training, and equipment, reducing tax liability.

Determining IR35 Status: Key Tests

To assess whether a contract is inside or outside IR35, HMRC and tribunals apply key employment status tests:

1. Supervision, Direction, and Control (SDC)

• Does the client control how the contractor performs their work?
• Can the contractor work independently without micromanagement?
• If there is significant control, the contract is more likely inside IR35.

2. Right of Substitution

• Can the contractor send a qualified substitute to perform the work?
• A genuine right of substitution is a strong indicator of being outside IR35.

3. Mutuality of Obligation (MOO)

• Does the client have an obligation to provide work, and is the contractor obligated to accept it?
• A true business-to-business relationship should not have ongoing work expectations.

4. Financial Risk

• Does the contractor bear the risk of errors and additional costs?
• Contractors outside IR35 often operate with business insurance and may need to correct mistakes at their own expense.

5. Integration into the Client's Organisation

• Does the contractor use the client’s equipment, email address, or participate in staff meetings?
• Contractors who are fully integrated may be seen as employees, increasing the risk of being inside IR35.

Impact of the IR35 Reforms

Public Sector (2017)

The off-payroll rules were first applied to the public sector in April 2017, shifting the responsibility for determining IR35 status from contractors to public sector clients. As a result, many contracts were blanket-assessed as inside IR35, leading contractors to either accept permanent roles, move to umbrella companies, or increase their rates to compensate for tax deductions.

Private Sector (2021)

From April 2021, similar reforms were introduced to the private sector for medium and large businesses. The key changes included:

• End-clients became responsible for determining IR35 status (for non-small businesses).
• The fee payer (client or agency) became liable for deducting PAYE and NICs.
• Increased risk aversion – Many clients chose blanket inside IR35 determinations to avoid compliance risks.

Impact on Contractors

• Reduced take-home pay for those inside IR35.
• Many businesses ceased engaging PSCs, instead offering fixed-term contracts or engaging through umbrella companies.
• Some contractors increased their rates to offset the tax burden.
• Rise in umbrella companies offering PAYE solutions.

Strategies for Contractors Facing IR35 Challenges

• Review and Adjust Contracts: Work with IR35 experts to ensure contracts align with outside IR35 principles.
• Seek Independent Assessments: Tools like CEST (Check Employment Status for Tax) can be used, but expert-led IR35 reviews are often more reliable.
• Negotiate Higher Rates: If forced inside IR35, consider negotiating a higher contract rate.
• Consider an Umbrella Company: While not tax-efficient, it may be the simplest way to remain compliant.
• Diversify Income Streams: Running multiple contracts and ensuring genuine business activities strengthen an outside IR35 stance.
• Understand Client Approaches: Some businesses remain IR35-friendly, while others impose strict policies.

The Future of the Inside vs Outside IR35 Debate

The IR35 debate continues as contractors, businesses, and HMRC grapple with its implications. While the off-payroll rules aim to close tax loopholes, they have led to:

• Talent shortages in sectors like IT and engineering.
• Legal disputes over wrongful IR35 determinations.
• Increased use of offshore and alternative engagement models.

With ongoing scrutiny and discussions about tax simplification, the IR35 landscape may evolve. Contractors must stay informed and proactive in managing their engagement structures.

Final Thoughts

Understanding whether you are inside or outside IR35 is critical for tax efficiency and compliance. Contractors should seek professional advice, assess their working arrangements carefully, and ensure their contracts reflect genuine self-employment where applicable. The IR35 debate is far from over, and its impact on the contracting industry will continue to unfold in the years to come.

Disclaimer: This article is for informational purposes only and should not be considered tax or legal advice. Contractors should consult a qualified IR35 specialist or tax advisor for personalised guidance.