There is a considerable difference in the tax and national insurance liabilities between an individual caught by IR35, and another who falls outside the IR35 net.
In a nutshell, IR35 (the Intermediaries Legislation) was created in 2000 to clamp down on ‘disguised employment’; to prevent contractors and others who would typically be viewed as ’employed’ by HMRC from being taxed as if they were ‘self-employed’.
For example, a contractor might work for a large consultancy as a permanent employee one day, only to return the following day as a limited company contractor, enjoying the tax advantages of working via a company, despite working in exactly the same way as he did before. According to HMRC, he would be deemed a ‘disguised employee’.
A professional contractor who works via his own limited company and whose contracts fall outside IR35 would typically draw down a small salary (often attracting no PAYE tax or National Insurance liabilities) and derive the majority of his earnings in the form of company dividends.
No NICs are payable on dividends, and although dividend tax rates rose significantly in 2016, there remains a tax advantage to working via a company compared to being an employee.
There are also several tax planning options open to company owners, not employees; such as the ability to divide company shares with a spouse to reduce higher rate tax liabilities, and the opportunity to delay drawing down funds until a future tax year.
Naturally, company owners do not have any of the perks associated with standard employment. The tax advantage they enjoy will often cover the cost of things like insurance, accountancy fees, training, and so on.
On the other hand, a contractor whose contracts fall within IR35 will receive income in the form of a ‘deemed payment‘. He will have to pay income tax and national insurance contributions on the entire amount.
In addition, people caught by IR35 are granted a 5% expense allowance to cover the costs of running a limited company. They can also claim for standard ‘Section 198’ expenses such as pension contributions and business insurance costs.
Unfortunately, this allowance is not available if you work for a public sector body (from April 2017 onwards), or a private sector organisation (from April 2021 onwards).
All limited company contractors should calculate their Corporation Tax and VAT liabilities in the normal way, regardless of whether they are caught by IR35 or not.
What is the financial impact in real terms?
There is a sizeable difference in the take-home pay of contractors inside and outside IR35.
According to the IR35 calculator on our partner site, ITContracting, if you are a contractor earning £400 per day, you will be around £7,500 worse off if your contract work is caught by IR35.
If you’re earning £750 per day, the difference is over £9,500.
These calculations contain various assumptions (e.g. you work for 44 weeks each year).
The vast majority of this tax gap is accounted for by the taxation of dividends. Dividends do not attract National Insurance Contributions, whereas salaries do. The gap has closed by several thousand pounds per year since the introduction of a new dividend tax regime in April 2016, but the difference remains a significant one.
For obvious reasons, you should always seek professional advice before signing a contract, and ensure that both your contracts and working practices both demonstrate that you fall outside the IR35 net.