Our guide shows you how to structure your working arrangements so as to avoid falling into IR35
For small business owners and freelancers who have just started out, staying on top of your business finances and documents can be daunting. Here’s where our article comes in, so you can quickly get a grip on the basics.
A balance sheet provides a snapshot of the financial condition of a company, showing how much it owns (assets), owes (liabilities) and the amount that is left over for its owners (owners’ equity) at a specific point in time.
The balance sheet is typically completed at the end of a month or a financial year. It is comprised of three main elements:
The balance sheet is divided into two sections: the left side shows the assets of the company, while the right side shows the liabilities and shareholders’ equity.
Assets are listed in order of liquidity. For example, cash or inventory are listed above less liquid assets like property or equipment.
Liabilities are listed in order of maturity; current liabilities, which will come due within a year are listed above long-term liabilities. The latter refers to liabilities that will remain outstanding for longer than one year.
The total sum of all assets, less a business’ total liabilities is equivalent to the owners’ equity. This represents the amount that would be available for a business owner to draw out.
The balance sheet lets a business owner and investors see what the company owns and owes, and to understand its net worth. It also indicates the financial health of a business.
For example, a balance sheet that shows a negative balance in owners’ equity indicates that liabilities exceed assets. This can be a warning sign that the company is in a bad financial situation, and should prompt business owners to dive deeper, and uncover the causes for the negative balance.
A balance sheet can also be used to calculate important financial ratios. One example would be the working capital ratio, which is obtained by dividing the current assets by current liabilities. This ratio measures a business’ efficiency, and shows how well it is able to meet its short-term obligations.
And for small business owners seeking external financing, the balance sheet —along with financial statements like your cash flow and P&L—are required documents when you apply for a bank loan.
The profit and loss account (P&L) is a financial report that shows the revenue, expenses and profit or loss of your company over a specific accounting period.
This period can be a month, a quarter or a year. A P&L is also commonly referred to by other terms, such as the income statement, statement of operations, financial results statement and earnings statement.
A P&L is comprised of the following key elements:
The P&L is a key financial statement in a business plan, as it quickly shows how much money your business has made or lost.
What’s important is to compare your P&L across different accounting periods. In doing so, you’ll be able to identify business cycles and trends—such as the peak and trough periods that occur across the year, or aspects of your business that generate the most profit or costs.
You may also identify changes that are not immediately apparent, such as periods where your expenses are growing at a faster rate compared to your revenue. With these insights, you’ll be better-positioned to make improved business and financial decisions.
And lastly, information from your P&L can also be used to calculate metrics that are important indicators of your company’s financial health. These include the operating ratio, gross profit margin and net profit margin.
IR35 is a piece of legislation which allows HMRC to treat private contractors as if they were employees. It was introduced to combat the problem of “disguised employment”, where employees offer their services via limited companies to pay less tax and National Insurance.
IR35 is usually a threat to your income only if you are self-employed and provide your services via a limited company.
HMRC may decide that you should, in fact, be paying tax and NI contributions as if you were an employee.
If your contract is found to fall within IR35 then the difference in take-home pay usually amounts to around 20%.
But that’s not all. HMRC may choose to investigate previous contracts going back at least 6 years to see if they should also have come under IR35. So this could mean a higher tax bill and a bulk payment for previous unpaid tax, plus penalties and interest.
You need to structure your contracts and working arrangements in such a way that they fall outside IR35.
Your objective is to stop any enquiry by HMRC before it has a chance to get off the ground. This is usually not that difficult to do but the process is technical and a bit complicated.
If you are a legitimate contractor trying to make your way through a busy year without falling foul of HMRC’s complicated IR35 legislation and obscure assessment process there is a clear and straightforward action plan [anchor link] below.
Let’s start with the basics: why is IR35 so complicated and so ambiguous?
It’s complicated because there is no simple checklist of things HMRC looks for to make their assessment. But they will look at many different details in your contract and will also look at your working practices in fine detail. Here is the full list of what HMRC will look through when assessing IR35.
It’s ambiguous because HMRC will not make their assessment on the basis of those details directly but on the basis of an “overall picture” which emerges from those details. As the saying about beauty and the eye of the beholder implies: not everyone ascribes value in the same way.
To quote from HMRC’s guidance to determining IR35 status:
“The object of the exercise is to paint a picture from the accumulation of detail. The overall effect can only be appreciated by standing back from the detailed picture which has been painted, by viewing it from a distance and by making an informed, considered, qualitative appreciation of the whole. It is a matter of evaluation of the overall effect of the detail, which is not necessarily the same as the sum total of the individual details.”
You will make HMRC’s job much easier if you understand how they go about formulating their assessment. This enables you to give them the evidence they require in a way that is unlikely to be misinterpreted or misunderstood.
One of the easiest ways to avoid misunderstandings is to ensure that both your contract and your working practices are saying the same thing.
Always remember that HMRC will be looking at both your contract and your working practices.
If your contract is deemed not to be comprehensive then HMRC will build what they deem to be a properly comprehensive picture by including relevant details from your working practices.
According to case law and legal precedent, if HMRC believes your contract to be both genuine and comprehensive then they are required to base their decision on the contract alone. In reality, they also always look at your working practices first to ensure your contract is not a sham.
What this means is that if your working practices are characteristic of employment then you will be included within IR35 on that basis, whatever your contract might say.
However, if your working practices are an accurate and true reflection of your contract terms (and hence your contract is not a sham) then you still cannot relax: you may still fall within IR35 on the basis of legal technicalities contained within or omitted from your contract.
Although IR35 is both complicated and ambiguous its essence is simple: you need to look like a private company and not like an employee.
The first thing to do is to move into place the factors able to influence your case the most.These are 4 things you can do right now which are easy, powerful and will set you on the right path.
Substitution means you can send someone else in to do your work, at your own decision and expense.
Provided the right of substitution is clearly and tightly defined as laying in the contractor’s hands, then the legal precedents make it a very effective defence. Your client cannot exercise any significant control (such as right of approval) over who you choose to replace you for this defence to work well.
Ensure that you have a right of substitution clause included in your contract. Even better, actually use this right during your contract’s duration.
HMRC may deem your contract or working practices to be ambiguous. You look like a private company but you also do some things in a way that makes it look like you are an employee. You might fall within IR35 or you might not.
If you include a “statement of intention” in your contract then, when there is ambiguity, you will not be included within IR35.
Without such a statement of intention in your contract HMRC is required to interpret the ambiguity in your case as it deems most correct.
This is not an effective defence if your contract or working practices are unambiguous and you clearly look like an employee.
In all IR35 cases the courts have made it clear that they require evidence from the client
The value of a confirmation of arrangements letter has been very well established. Provided it is correctly structured you can use it to very quickly close down any enquiry into your IR35 status by HMRC.
A confirmation of arrangements letter can also be used if you work for an agency and are unsure if the agency-client contract itself (which it is unlikely you will get to see) is IR35 compliant. Or you may have already signed a contract which could be interpreted as ambiguous.
A confirmation of arrangements letter should clearly state why your working arrangements fall outside of IR35. It should also record that every party in the contractual chain agrees on the IR35 status of the contractor.
This is an area where it is worth paying for professional advice. [CTA]
You have to be certain that your contract does not contain mistakes, inconsistencies or omissions which could inadvertently land you inside IR35.
If you have to provide your own contract then at the very least use a professional template and submit your final version for professional review. If your client provides the contract then make sure to have it professionally reviewed sufficiently early to allow time for negotiations.
IR35 is a complex area of case law and an ordinary solicitor is unlikely to have the expert knowledge needed to identify and resolve potential issues. Only hire someone who specializes in dealing with IR35 issues in the contracting sector.
Whilst professional advice is essential when drafting your paperwork, you also need to personally understand what is involved and how to approach it. This enables you to be consistent in your working practices.
Knowing what to look for in a proposed contract also enables you to recognise whether you need to negotiate different terms.
Here’s what you always have to keep in mind, starting with the most important factor: control.
Control used to be the defining factor for determining whether someone was an employee or genuinely in business on their own account. Even today, most other factors in your contract will be interpreted through the lens of control.
If the only controls that your client can exercise over you are that the work must be completed by a certain deadline and to a sufficient standard, then it is likely you will be classified as an independent contractor.
It can also help you to be classified as falling outside of IR35 if you are:
Examine the other terms in your contract and ensure that they do not give your client a level of control over you that could be interpreted as an employer/employee relationship.
You are likely to be classified as falling within IR35 if your contract gives your client the right to:
More flexibility exists as regards when and where the work is done but you still need to be careful. For example, the inclusion of lunch break times and duration in a contract would be indicative of an employment relationship.
Generally speaking, the greater the control, the more likely it is that HMRC will view the contract as one of employment.
This is a key test but case law has shown that HMRC is prone to misinterpreting or misunderstanding what is involved. As such it is not worth making this factor a main part of your argument.
Keep it simple: you want to ensure that you are not obliged to accept contracts and that your client is not obliged to offer them.
If work is repeatedly offered and repeatedly accepted then HMRC may take the view that an employment contract has been created “by custom and habit”. In practice, this is most easily offset by securing contracts from several different clients.
If your contract explicitly states that you are not allowed to provide your services to other clients then you will likely fail assessment. Clauses can however be included to preclude you from working for competitors or where another conflict of interest would be created.
Creating risk and uncertainty around how you are paid can be a convincing indicator of self-employment.
Relying on a single, stable paymaster is characteristic of ordinary employment.
Contractors are usually paid on completion of a contract, employees at regular intervals.
Contractors also usually issue an invoice for their services. Be careful though: this factor is often inconclusive and should not be relied upon as the main feature of your argument.
An independent contractor should have all the trappings of a normal business: a registered limited company, a business bank account, VAT registration, expenses for things like office equipment and advertising and so on.
You need to provide and use your own equipment where practical. If there are good reasons as to why you need to use your client’s equipment, such as safety or security concerns, then this factor will not normally cause you to fail an assessment.
You need to keep your distance from your client’s organisational structure and only fulfil the obligations which are in your contract. Also, do not use facilities normally reserved for staff such as a staff car park, gym or canteen.
If you start appearing on telephone lists and organisational charts then you may be classified as “part and parcel” of your client’s organisation. In which case you would fall inside IR35 no matter what your contract says.
This is an easy IR35 test to fail and you need to be careful with your working practices on this score.
If you appraise personnel within your client’s organisation or allow yourself to be appraised, then you will likely be viewed as part and parcel of your client’s organisation. Appraisal is for employees, not contractors.
Even if you get everything on point in terms of both your contract and your working practices, HMRC may still assess you as falling within IR35.
This is because if the client organisation you are working for as a contractor has previously been found to have used “disguised employees” then HMRC can insist that all future contractors be automatically treated as employees.
In such an instance neither your contract nor your working practices will make any difference. The only way to dispute such a decision is through court proceedings.
To repeat, HMRC does not even have to look at your contract in this instance.
None of the assessment criteria for determining whether a contract is located within IR35 will change in April 2020. All of the recommendations given above will still hold.
The name of the game will remain making sure you look like a limited company rather than like an employed individual. And it will still be the overall picture of your activities that you have to watch out for.
Public sector organizations are already responsible for determining the IR35 status of individuals who work for them through their own limited company.
This change is being extended to large and medium organizations in the private sector, that is to say to companies with more than 50 employees or a turnover greater than £10million.
Unless you work exclusively for small businesses, after April 2020 it will be the organization buying your services which decides your IR35 status for you.
Follow the IR35 advice as given above. We have already decoded HMRC’s process for you, and that works no matter who is taking the decision.
Whoever takes the decision will still be contracting for your services via your limited company. You still need to structure your contract terms intelligently and with an eye to IR35 legislation. You still need to ensure your working practices are in alignment with those contract terms.
What does change is the value of a Confirmation of Arrangements letter from your client. You can even secure this before you agree to take on the contract.
The government does have plans to introduce a statutory, client-led “status disagreement process” to enable contractors to challenge an organization’s decision on their IR35 status. Prevention is better than cure, however.
You then need to treat the income from that contract as ordinary employment income, taxable under Schedule E and subject to Class 1 NICs.
Your income from other contracts which do not fall within IR35 is still assessable under Schedule D and subject to Class 2/4 NICs.
Just because one of your contracts does fall within IR35 does not mean that they all will. If it is located within IR35 then you have to treat as such.
Not attracting HMRC’s attention in the first place is even better than having a good defence. For the same reason ensure you do not file any late tax returns and consider employing an accountant to submit your paperwork for you.