Why contractors need IR35 insurance

Why do contractors need IR35 investigations and tax losses insurance?

Despite the April 2021 off-payroll working (IR35) reforms in the private sector, many contractors still have the responsibility and liability for IR35 under Chapter 8 ITEPA 2003 (the original IR35 legislation). So being protected against the often expensive fees to defend your tax position and insured against the potentially damaging tax loss if HMRC win the argument, is part of being a professional contractor who is in the IR35 firing line.

The contractors who should be concerned are those who are engaged by small companies (as defined by the Companies Act 2006) which are exempt from IR35 decision-making and those engaged by wholly overseas companies with no UK presence. In both instances, it is the contractor’s company which is responsible for determining the IR35 status of the engagement. Get it wrong and it is your door that HMRC will be knocking on!

IR35 and the “hypothetical contract” explained

The Inland Revenue (the forerunner of HMRC) announced the introduction of the Intermediaries Legislation via the Budget press release IR35 and the name stuck. The legislation was designed to tackle what the Revenue perceived as disguised employment. I.e. individuals working for end clients in roles which looked very much like employment, but because the individual was working through an intermediary (their own company, usually referred to as a Personal Service Company or PSC), they were gaining tax advantages not available to employees. More importantly, from the taxman’s perspective, they were unable to pursue these cases satisfactorily.

The new legislation introduced the concept of the hypothetical contract as shown below:

This is an example of a typical contractual chain in which the end client’s business is engaging the recruitment agency, which, in turn, is engaging the contractor’s company, which is providing the services of its fee earning director/shareholder; i.e. the worker.

The worker is the one providing services to the end client, but there is no contractual relationship between the individual and the end client. The Intermediaries Legislation therefore requires the creation of the hypothetical contract between the individual and end client to ask the question: “If the worker was engaged directly by the end client, would that relationship look like employment or self-employment?”

In order to do that, effectively the intermediary must be bypassed. Whilst an agency is clearly an intermediary, the intermediary for the purposes of the legislation is the PSC, which is why the concept and approach also apply if the end client was engaging the contractor’s PSC directly.

If the answer is that the engagement looks more like employment, then it is deemed to be “inside” IR35. If the engagement is more akin to self-employment, then it is termed as being “outside” IR35. We will look at the consequences of each below.

What has changed with the off-payroll working reforms?

In terms of how we determine IR35, nothing has changed at all. It’s still about creating the hypothetical contract, which means considering the contractual terms and working practices of each and every engagement.

The off-payroll working reforms (Chapter 10 ITEPA 2003) took place in two stages:

• April 2017 in the public sector - making all public sector bodies responsible for determining the IR35 status of all engagements. This also introduced the concept of the “fee payer”, which is the entity responsible for paying the contractor’s PSC.

• April 2021 in the private sector - after two false starts, the same regime was introduced into the private sector with improvements around transparency of decision-making which now also apply to the public sector.

But it’s who has the decision-making responsibility and the liability which has changed for many engagements. This also impacts who needs insurance to protect their tax position.

Responsibility for IR35 decision-making under Chapter 10

This was the amended legislation introduced in April 2017 for the public sector off-payroll working reforms and then further amended in April 2021 when the private sector reforms were introduced.

In the public sector, all public sector bodies have the responsibility for determining the status of each and every engagement of a limited company contractor (PSC). There are significant fines for getting this wrong as the DWP, MOJ, Home Office and others will attest. By the end of 2022, HMRC had collected over £250 million from various public sector bodies for the incorrect application of IR35.

In the private sector, it becomes a little more complex because only medium and large-sized entities have to make the IR35 decision. Small companies are exempt and that pushes the responsibility down on to the contractor under “Chapter 8” (see below).

However, where the decision-making is under Chapter 10, it is never you who has the responsibility – under off-payroll working, the decision-making takes place with the end client at the top of the contractual chain.

Liability for incorrect IR35 decision-making under Chapter 10

As with all things related to tax, the answer is, it depends on the circumstances. We need to consider three scenarios:

1. End client fails to take reasonable care in its decision-making; e.g. making blanket decisions about engagements or making decisions without considering the contractual terms and the working practices. In this situation, the liability rests with the public sector body or the private sector medium or large-sized entity.

2. End client is both decision-maker and fee payer: If the end client is engaging the PSC directly, then they are also the entity paying the contractor’s company. They are therefore liable as fee payer, irrespective of whether they have taken reasonable care.

3. Where there is an agency in the chain: Another party is the fee payer. In a chain such as End client → Recruitment agency → PSC, the end client still makes the IR35 decisions, but if those decisions are taken with reasonable care, then the liability falls to the entity paying the contractor’s company – here it’s the agency.

Responsibility and liability under Chapter 8 ITEPA 2003

Chapter 8 (or “Old” IR35) is the original Intermediaries Legislation which made the contractor the IR35 decision-maker and also gave individual contractors the tax liability if they got their IR35 decision wrong. 

In most cases, the off-payroll working reforms under Chapter 10 have superseded the original legislation and removed the responsibility and liability away from the individual contractor. However, two types of engagement still require you to determine your IR35 status:

• Your end client is a wholly overseas entity with no UK presence
• Your end client is a small company (entity)

A ‘small company' is defined by the Companies Act 2006 as one which meets two of the following requirements:

• Net turnover below £10.2 million
• Balance sheet totalling less than £5.1 million
• Fewer than 50 employees

If your client is a small company or one based wholly overseas (with no UK presence and irrespective of company size), then you need to take action and demonstrate that you have researched your IR35 position. Ideally, you can do this by taking independent, specialist advice and having a contract review.

What does being inside IR35 mean?

It means two slightly different things, depending upon whether you are engaged under Chapter 8 (by a small company or one based wholly overseas and without a UK presence) or Chapter 10 (all public sector bodies and all medium or large-sized private sector entities).

Chapter 8 (ITEPA 2003) and the deemed employment calculation

If an engagement is deemed inside, you must apply a 5% flat-rate deduction to your fee income for the tax year. This is effectively a ‘notional deduction’ for general expenses incurred in running your business (i.e. you are not claiming for specific expenses incurred).

However, from the remaining 95%, you can claim deductions allowable for any employee, such as subscriptions, protective clothing, training your business has paid for and any pension contributions.

Once you have accounted for these deductions, Employer National Insurance Contributions (NICs) and Pay As You Earn (PAYE) must be deducted and paid across to HMRC. The process has nine steps and HMRC have provided a calculator which you should use to be compliant.

What is definitely the case, is that financially, you will be around 30% worse off than if your engagement was outside of IR35.

Inside engagements under Chapter 10

Under Chapter 10, it is the fee-payer which must deduct PAYE, Employers’ NICs and, where applicable, the Apprenticeship Levy at source from the amount paid to the contractor. The mechanics are that your PSC is added as an employee to the fee payer’s payroll (but for tax purposes only).

However, the off-payroll rules under Chapter 10 will make you financially worse off because you lose the 5% notional expense deduction of the deemed employment calculation. Your company will be paid a net amount after all tax deductions have been made, and if you have been engaged on inside IR35 engagements for a whole tax year, this means that your company will have no profit against which to deduct any expenses.

As a result, the running costs of your business effectively come out of your own pocket; which means that if all engagements in a tax year are deemed to be inside IR35, why would you use your PSC? This is one reason why so many contractors wound up their companies for staff jobs or were engaged through an umbrella company, which also means that you are taxed under PAYE.

This wasn’t the only reason why contractors have not wanted to engage through their own PSC. In many cases, contract opportunities dried up because of uncertainty around the COVID-19 pandemic, but also end clients were unwilling to engage with the legislation and only offering PAYE opportunities. However, these end clients then found that to attract and retain the best talent, they had to up their day rates to compensate contractors for the additional tax they were paying, which, of course, increased end client costs.

On balance, if your engagements are likely to be permanently inside IR35 under Chapter 10, then having a secure job with decent employment benefits may well serve you best.

What does outside IR35 mean?

When your engagements are outside IR35, the tax advantages are such that you will be financially better off than on inside engagements or being paid under PAYE as an employee, as follows:

1. Your company’s invoice will be paid gross, so no tax and NICs (or apprenticeship levy) deducted at source by the fee payer.

2. You can pay yourself (after business expenses have been deducted) via a low salary and take the remainder of your income as dividends, which do not attract either employers’ or employees’ NICs. If your company has an additional shareholder – typically spouses/partners – whether the business employs them or not, the tax burden being spread across more than one person, might mean that neither of you is paying higher rate tax.

3. The relevant business expenses you can claim when outside IR35, also include travel costs from your home to the end client’s premises because your company is sending its employee (you) to a temporary workplace; i.e. unlike an employee your cost of commuting is not coming out of your take-home pay.

4. By comparison to an engagement being inside under Chapter 8, you could find yourself with a take-home pay which is perhaps 30% higher.

Protecting  your IR35 position

There are three things you should do:

1. Contract Review – make sure the review considers both the contractual terms and working practices. The review will offer you amendments needed to strengthen the contract (if applicable) and provides you with a clear opinion on your IR35 status.

A contract review is not only the gateway to buying tax losses insurance, but is also a demonstration of taking reasonable care. This means you could be saving yourself from a penalty for not taking reasonable care, which could be between 15% and 30% of the tax due. That’s likely to be 20 times more than the cost of a review.

2. Tax Investigations Insurance – an HMRC enquiry can be a long-drawn out affair, rarely costing less than £3,000 in fees to deal with and usually costing two or three times that sum. If the matter goes to Tribunal, you could be looking at professional fees of £50K to defend your position. Why wouldn’t you insure the defence costs?

3. Tax Investigations Insurance - if HMRC are successful in the IR35 enquiry, you will be pleased that your costs have been met, but you will still have tax, NIC and interest to pay. Depending on the length of the engagement and the level of fees you have earned from the engagement(s) under enquiry, the tax bill could even match the cost of going to Tribunal.

But if you have had the contract(s) reviewed and have the defence costs covered, for a few hundred pounds a year, you ensure that you will have no nasty tax surprise. You can go about your business knowing you have all the angles covered.

What if you are investigated?

If the decision-making is under Chapter 10, then you will not be the focus of an HMRC enquiry. Any such enquiry is likely to start with the end client and the tax liability, if the engagements have been incorrectly classified as outside, will fall either to the end client or the fee payer agency (if there is one).

In comparison, under Chapter 8 you have the responsibility and liability if the outside IR35 decision is incorrect. Typically, HMRC will ask about the latest tax year, but can also look into earlier tax years, technically even going back four (or six) years for failure to take reasonable care.

If you have a Markel Direct policy, an IR35 specialist consultant from Markel Tax will be appointed to work with you on the investigation. The consultant will deal with all the correspondence with HMRC, ensuring that you receive the best defence – all without charge to you or your business. Markel Tax’s consultants have an unrivalled success rate with IR35 enquiries, including winning the first IR35 Tribunal case and many more since, so you will be in safe hands.

Act now to protect your tax position

Contract reviews, tax investigations and tax losses insurance are all costs associated with being a professional contractor when you have responsibility and liability for IR35.

IR35 protection is available to contractors in a number of forms, including Contract Reviews to ensure you know your IR35 status; Legal Expenses Insurance to defend not only your tax position, but also other potential legal challenges and tax losses insurance to meet any potential tax liabilities, interest and penalties you are ordered to pay.

For more information about IR35 concerns, please contact Markel Tax's specialist team on 0345 0660 035.

About the author

Paul Mason is the Head of Tax Partnerships at Markel Tax. Paul joined the Markel Tax team in 1997 and has been closely involved with IR35 since 2001, providing advice on the subject to contractors, end clients and fee-payers.

Paul is a regular speaker on IR35 and works closely with Markel Tax’s investigations specialists to ensure freelancers get the best defence in an IR35 enquiry.