When is a personal services company a contractor and when an employee? It
seems to depend on each project
IR35 was an Inland Revenue press release focusing on "personal service
companies" (PSCs) ie, generally one-person outfits that charge out the
services of the service contractor to clients. The client then pays a fee to
that company and the contractor then takes a (possibly small) salary from which
National Insurance contributions, PAYE and income tax are deducted. After
deducting any expenses incurred by the PSC, the contractor can then pay himself
remaining profits as a large dividend on which no NICs have to be paid, and
income tax does not become payable until the dividend is declared.
The tax advantages to the service contractor are clear but there are also
benefits to clients in that they can find specialised assistance without
entering into employment relationships.
In 2000, IR35 was given legislative effect and essentially curbed the use of
PSCs for tax avoidance. It re-entered the limelight again recently when an
association of contractors asked the courts for a declaration that the rules
could not lawfully be applied. They lost but the judge criticised some Inland
Revenue guidelines that accompany IR35.
IR35 means that contractors operating as if they were the client’s employees
will have to pay the same tax and NICs as employees. The IR stressed that it
did not want to deter genuine users of PSCs. The tests to determine the level
of taxation and NICs are therefore applied to individual projects, depending on
whether the employment test is satisfied.
IR35 applies where two things happen. First, the worker provides services to
a client through an "intermediary company" – a PSC. This happens
where he has a "material interest" in it which, basically, means he
owns at least 5 per cent of the shares or that he receives a dividend from the
PSC, which really appears to be remuneration for services.
Second, it must be shown that the contractor provided the services as if he
were an employee of the client. The contractor has to figure out whether he
falls into that category. Various tests from employment law must be used to
answer this question, and for guidance he must look at the terms of the PSC’s
contract with the client as well as the surrounding circumstances.
If IR35 applies and the contractor is deemed an employee of the client, any
fees the PSC receives will be deemed the salary of the contractor, even if not
paid out to the contractor by his PSC, with the result that Schedule E tax and
NICs are payable.
The judge had a few things to say about the IR’s guidelines accompanying the
legislation, such as that the guidelines cause uncertainty over when IR35
applies to contractors, but this was not so grave as to infringe human rights.
The IR also believes that any issue of "mutuality of obligation"
between client and contractor is irrelevant in deter- mining if there is
The judge was also concerned about guidelines on the right of substituting
one worker for another on a task. It remains to be seen if the guidelines on
employment will be changed but adjustments are being made elsewhere in the wake
of the case, such as a new IR35 concession for construction service companies.
– The contractors lost the case. The legislation stands but with some
criticism of its guidelines.
– Contractors have to determine, for each project, whether they fall within
the "employee" description. Legal advice may be needed here.
– Contractors might now re-write their terms of business with clients, to
make them seem less like employees and less likely to be caught by IR35.
– The IR can obtain such contracts but can take account of circumstances,
not just paperwork, in deciding tax liability.
By Linda Farrell, partner at Bristows