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What is the financial impact of IR35 on IT contractors?

There is a considerable difference in the tax and national insurance liabilities of a contractor caught by IR35, and another who falls outside the IR35 net.

In a nutshell, IR35 was created 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’.

Outside IR35

An IT contractor who works via his own limited company and whose contracts fall outside IR35, would typically pay himself a small salary (often attracting no PAYE tax, or National Insurance liabilities), and derive the most of his income from company dividends.

Inside IR35

On the other hand, an IT contractor whose contracts fall within IR35 will draw down 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.

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 large difference in the take-home pay of contractors inside and outside IR35. Most studies carried out since the legislation was first introduced suggest that a typical contractor on £300 per day would be £10,000 per year worse off if caught by the rules.

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.

For obvious reasons, you should always seek professional advice before signing a contract, and ensure that both their contracts and their working practices both demonstrate that they fall outside the IR35 net.

Last updated: 1st November 2014