IR35 Primer: Ramifications for Misidentification of Contractors in the Workplace

The underlying issue: The Intermediaries Legislation (IR35) was created in 2000 to clampdown on "disguised employment" and to bust personal service agreements designed to avoid the payment of income taxes and National Insurance contributions by employees misidentified as freelancers or "contractors." 

Since the IR35 legislation was enacted, the finer details of employment law have become a subject of well-deserved interest to both employers and freelancers alike. 

The penalties for violations range from 30% to 100% of the unpaid tax depending on the HMRC-determined level of culpability. 

Come April, 2020, the HMRC will exercise its expanded power over private enterprises to decide the relationships between individual contractors and their suitors. If the relationship is determined to have been mis-identified, the HMRC will seek to recover all income tax and National Insurance contributions (plus penalties) due over the period of the contract affected. This places the onus on freelancers and their employers alike.

Determining whether IR35 applies to your contract is a complex matter. There are three (3) key principles that will determine IR35 violations and culpability:

1.        Supervision, Direction, and Control: What degree of supervision, direction and control does employer have over what, how, when and where the contractor completes her contract and day to day work?

More details pertaining to this element: 

• ‘Supervision’ means the extent to which the employer oversees the contractor's work and how she performs it to a specified standard.
• ‘Direction’ means the employer's direction on how the contractor completes the employer's assignment, by providing instructions, guidance, and advice as to how the work is to be done. The greater the latitude given to the contractor the better.
• ‘Control’ is where the employer is said to have greater say about how the contractor goes about accomplishing the project. This includes the power to move the contractor from task to task as priorities change.

The above terms (seen as restrictions) should never appear in a contract – contractors and freelancers should retain, and actually have, control over when and how they work, not the employer. Contract language placing excess control, direction and supervision over the contractor places the parties in jeopardy of IR35 scrutiny.

Best practice dictates that a contractor will be instructed more vaguely about how the job is to be completed. Job specifications should be outlined as follows:

• The services to be provided
• Where the services are to provided
• The hours in each day over which the services are provided
• The fee for completion of the project (or better yet, an hourly fee)

In sum, the more control retained by the employer over the process to completing the project, the more likely the application of IR35.

2.        Substitution: The underlying question is: Is a specific individual expected to carry out the work herself, or can there be a viable substitute assigned in her place? The key component of this element of the law is who is obliged to perform "personal services." That is, if the contract effectively requires or expects the services of a specific individual to perform, then the employer is arguably in IR35-land. For example, if the company can send another person (a ‘substitute’) to perform the services agreed in the contract, there’s no obligation of personal service and IR35 shouldn’t apply.

It's not uncommon for cagey contractors to exercise linguistic subterfuge: "If I were to substitute myself for a third-party that you don't like, you can terminate the contract." This is not a viable method to argue substitutionability. Indeed, the HMRC can delve into otherwise vacuous contract language which seeks to undermine the legal concept of "substitution."  

If the contract specifies personal exclusivity and states that the contractor must work a certain number of hours per week at a certain rate on an ongoing basis and requires her to take whatever work the company throws at her, then this would suggest the contract should be inside IR35.

3.        Mutuality of Obligation: Is the company obliged to offer the contractor work, and is the contractor obliged to accept it?

An IR35-proof contract must state the employer has no obligation to offer more work; and the contractor has no obligation to take it. This is what is meant by the term "Mutuality of Obligation." Provisions to extend a contract should be avoided for fear that it may be interpreted as an open-ended personal services agreement; or, more poignantly, employment.

Other factors that affect the IR35 status of a contract:

Along with the three key areas highlighted above, parties need to be aware of the following:

• How is the contractor to be paid? A contractor will likely be paid when work is completed, or when project milestones are completed. An employee will usually be paid at regular intervals. Care should be taken that if an employer requires a weekly invoice, the contractor should detail the work completed as well as hours worked and the rate of pay. This sort of invoicing method will serve as proof that the services are based on finite terms and not a promise of non-specific on-going employment.
• Alternative work: If the contractor is contractually obliged to have one client at a time, she's probably an employee, not a contractor.
• Equipment: Unless there’s a sound reason (such as for safety, security or practicality), a contractor should be using her own equipment, rather than equipment supplied by the employer.
• Premises: The contract should specify where the work will be performed.
• Corporate involvement: An employer should avoid placing a contractor on the corporate organization chart or otherwise conferring a formal title. Even the provision of a company business card in the contractor's name can imply employment status.
• Employee-Type Benefits: As benevolent as the company wishes to be, it is not recommended that provisions for holiday, sick pay, pension or other employee-styled benefits should apply to a contractor's agreement.  
• Subordination: A contractor should not be obliged (in writing) to report to staff (or have staff report to them). Employee-like behaviour denotes an excessive degree of "supervision" (see above).
• Intentions of the parties: The contract should always clarify the intentions of the employer to be one of supplier/customer and not employer/employee. The nature of the work should be described accurately. If the intentions of the parties, as expressed in the contract, bear no resemblance to the real intentions of the parties, the written intentions will likely be ignored by HMRC.
• Termination: The contract should state that it will be terminated at the end of the project or if there is a breach of contract. Most IR35 disputes will likely occur when the contractor claims (post-hoc) that she was wrongfully terminated -- thereby implicating IR35 suspect employment. Air-tight contracts can obviate this dilemma.

IR35 penalties can be costly, time consuming and stressful for both freelancers and their employers. Implementing best practices to avoid IR35 violations starts with understanding the relative relationship between your company and the people who work for you. Now you know.