IR35 is considered to be the main piece of legislation affecting contractors and freelancers as its implications affect the way in which they are paid and the amount of tax they pay.  The following article explains the rationale, scope and implications of the legislation.

Disguised employment example

An employee leaves his employment on a Friday afternoon and returns to work the following Monday to do the same job but not as an employee of the original employer.  Instead he is employed by a company of which he is a controlling shareholder and/or a director.  His services are supplied to the original employer. His company invoices the original employer for these services and receives a gross payment.  By making these arrangements, the original employer would avoid paying Class 1 National Insurance Contributions (“NIC”) at up to 13.8% and the former employee could arrange his payments between salary and dividends from his company to minimise his tax and NIC liabilities.  

The government, therefore, introduced anti-avoidance legislation, known as IR35, in April 2000 with the purpose of countering this problem.


The IR35 legislation applies to individuals who provide their services through an intermediary (usually a personal service company) where the income received for performing the services would have been treated as employment income had the

individual contracted directly with the customer (that is without the intermediary).  

 So does IR35 apply or not?

The legislation does not define what is employment ( a contract of service) and what is self employment (a contract for services). 

 Common law principles, which means mainly past court cases, are used  to establish the factors which are relevant in deciding whether a contractor is self employed or not.  These factors are applied to both the:

  • contract under which the services are provided, and
  • working practises of the contractor.

 Case law has shown that a contract will not protect a contractor if the working practices are not consistent with it.  Key indicators include, but are not limited to the following:

Direction and Control

The amount of direction and control by the end client must be considered.  

  • What is performed – if a client can move the contractor to different areas of higher priorities then this will be an indicator of employment.
  • When it is performed – control over when the work is done may be an indicator of employment.
  • Where it is performed – when the contractor is required to work at the client’s premises this can be an indicator of control, although if the work can only be done at the client premises, this may not be a factor.
  • How it is performed – this is a strong indicator of employment; it permits the client to prescribe the way in which the work is to be carried out.  However, the absence of this level of control does not necessarily indicate self-employment, it is unusual for someone of a particular skill to be told how to do their work, but this does not mean they are self-employed.

 Right of Substitution

Personal service is an essential element of a contract of employment.  A person who has the freedom to choose whether to do the task themselves or hire somebody else to do it (on a reasonably unfettered basis) for them, is probably self employed.

 Mutuality of Obligation (“MOO”)

This tests if any obligation exists between the client and the contractor.  MOO would normally feature in all contracts, e.g.. an obligation on each party to provide something.  The internal guides for HMRC staff suggests that they ignore this test when considering the IR35 status of a contract.  This is quite a complex test but the courts have criticised HMRC’s instruction to ignore it

 The expectation for continuous work to be provided to a person and the expectation for all work provided to be completed indicates an employment relationship.   If there is a clause contained in a contract setting out an obligation for the client to offer further work and for the contractor to accept it, there would be a MOO in the contract and it would be caught by the IR35 legislation.   ‘Rolling contracts’ or indeed contracts that are continually renewed could fail this test.  If the client simply pays the contractor or agency for services then it may be that MOO does not exist and so this is not an “employment” situation.  Contractors should be careful or avoid if possible referring to repeat or renewing work so as to not evidence a MOO.

Provision of Equipment

A contractor engaged to undertake a specific piece of work using their own tools and equipment will be a pointer to self-employment.  If the contractor is provided with basic equipment this would be an indication of employment.

Financial risk

An individual who risks their own money, such as buying assets, bearing running costs and paying for overheads, is evidencing self-employment.  The risk of not being paid for an invoice is insufficient to satisfy the test.  Financial risk could also take the form of quoting a fixed price for a job, with the risk that the contractor would bear the additional costs if the job overruns.  Working for a fixed price, agreeing to correct defective work (at the contractors cost) and providing your own insurance cover will support a case for self employment.

Basis of payment

Employees tend to be paid by fixed rates, paid weekly, monthly etc. and may also be paid for overtime. Self-employed contractors tend to be paid a fixed sum for a particular job. 

If contractors cannot charge a fixed fee, they should issue their own invoices rather than relying on timesheets.  There should be no references to “overtime” and ideally any expenses should be included in the fixed fee for the job. If expenses must be claimed, then contractors should not use the client’s claim forms. 

Length of Engagement

Long periods working for one client may be typical of an employment but not conclusive.  Regular working for the same client may also indicate that there is a single and continuing contract of employment.

Period of notice

A period of notice in the contract is more typical of employment contracts, so an absence of a notice period would point towards self-employment.

Contractors should ensure that the contract does not contain any clauses that prevent them from working for other clients at the same time.  The contract should be able to be terminated early with a short notice period or no notice at all.  A clear end date is also desirable.   An exception to this could be where the contract was for a specific, clearly defined task.

Business Set Up

To show if a person carries out business on their own account, it is necessary to take account of all aspects of the business from an overall view.  If the business looks like a real business then this will strengthen the argument for self employment.  Other indications that the contractor is running a genuine business include having business insurance, own equipment, working on more than one client at a time, a business telephone number, company stationery, other sources of income etc.

Part and Parcel of the Organisation

The contractor should not be seen to be an integrated part of the organisation as this can weaken the case for self-employment status.  The contractor should not use any benefits provided to the client’s employees such as subsidised canteens, gyms, invitations or attendance at company Christmas parties etc.

Working practices

The contractual indicators should not be examined in isolation and the existence of a single indicator is not necessarily conclusive.  In addition, the actual working practices should be examined along with the contract under with the person is engaged.  It is vital that the actual working practices of the contractor are reflected in the contract.  HMRC are increasingly overlooking the contract and placing reliance on the working practices to determine the IR35 status.  We recommended that each contract is reviewed to ensure that the obligations of IR35 do not apply and can help our clients achieve that.

What happens if the contract is caught by IR35?  If, after a review of the contract and working practices, the engagement falls within the scope of IR35, HMRC sets out specific rules on how to calculate the tax that will be payable. You are required to pay the majority of your income (less a few qualifying deductions) as salary – this is referred to as their IR35 ‘deemed salary’  calculated as follows:

Turnover (net) from relevant engagements (cash basis)      

Less:  5% Allowance (of the above)

Less:  Qualifying Expenses (see below)

The 5% allowance is the amount of profit that the company would make assuming that the company incurs only qualifying expenses.

Qualifying Expenses

The following expenses are qualifying deductions in calculating an employee’s deemed IR35 salary:

  • Travel, Mileage, Accommodation and Subsistence costs covered under Section 336 ITEPA 2003;
  • Childcare;
  • Employer contributions to an approved pension scheme;
  • Employer National Insurance contributions;
  • Approved professional subscriptions;
  • Professional indemnity insurance.

 Any other expenses incurred by the company will not be offset against the salary but will still be an allowable deduction from the profits made by the company which are subject to corporation tax.  

 What happens if your employment status is successfully challenged?

If an engagement is found by HMRC to have fallen within the scope of IR35 and the payments have not been treated in the above manner, HMRC would perform calculations on the income received by the intermediary in the relevant years.  The individual would be assessed liable to additional tax and NIC and penalties and interest might also be charged.  The determination of penalties is dictated by whether the individual under investigation has taken reasonable care to prepare returns appropriately.  If a contractor was found to be caught by the legislation and had used a professional to have their contract reviewed then the penalty levied on the contractor could be significantly lower than if the individual did not use a specialist to review the contract under investigation.

 Is using an Umbrella Company a worthwhile option?

Whilst the overall tax paid on an IR35 caught contract will be higher, it is still more tax efficient to operate through a limited company, rather than an umbrella company, the reasons for this include:

  • Ability to benefit from the VAT Flat Rate Scheme
  • Lower administration fees
  • 5% of the income is not subject to PAYE and NIC
  • Expenses prohibited by umbrella’s such as mobile phone and internet can be claimed.
  • One less company handling your money, after a series of umbrella companies becoming bankrupt this can be perhaps the most compelling reason.

 Court Cases

The following cases illustrate how HMRC has sought to challenge employment status.

 Dragonfly Limited

Dragonfly concluded with an unsuccessful High Court Appeal by the contractor in September 2008 resulting in a £99,000 tax bill and a review of the HMRC guidance on IR35.  The main factors affecting the court’s decision against Dragonfly were:

  • The contractor had a succession of contracts with the AA over a number of years (suggesting the existence of a mutuality of obligation), when contracts were extended they were modified to be more IR35 friendly – indicating that the clauses existed specifically for the purpose of avoiding IR35;
  • Dragonfly was found to have only a ‘limited’ right of substitution as any substitute for the contractor would have to be first approved by the AA;

The work carried out by Dragonfly was subject to the supervision and quality control procedures of the AA and the contractor himself also had regular performance appraisals by the AA.

 MBF Design Services Limited

The contractor has succeeded with this case heard in 2010.  The ruling in this case was a sign that the courts were taking a more pragmatic approach in the determination of the IR35 status of a contract. It tested the reality of the relationship between the contractor and the client and was therefore a significant ruling for contractors. The key factors in this case were as follows:

  •  The absence in reality of a right of substitution was not inconsistent with being engaged as a professional man whose personal expertise was valued;
  • The fact that design work was checked and approved was considered a necessity given that the contract involved the design/building of aircraft, the safety of which was subject to approval by external aviation authorities;

 The fact that the contractor was required to work at the client’s site was not a conclusive indicator of employment.  The reality of the situation was that due to the nature of the work undertaken by the contractor, it would have been impossible to carry out the relevant services in any other location than at the client’s own premises.

 ECR Consulting Ltd

This case concluded in May 2011 after a 4 year debate with HMRC and represented important victory for freelancers. HMRC sought additional tax and NICs for the tax years 2002/03 to 2004/05 totalling approximately £44,500. HMRC’s argument for IR35 to apply to ECR Consulting was similar to their other cases and rested on what HMRC perceived to be a fettered substitution clause, a lack of control and a high level of integration between the client and the worker.  In the judge’s summary of the decision, it was stated that the contract was considered to be a contract for services for the following reasons:

  •  the client negotiated for the best price at the time of entering into a contract, at the time of the first contract this was £600 per day, at the time of the second contract this was reduced to £350 per day.  The judge concluded that it would not be possible to control employees in such a manner;
  • despite the contractor having submitted invoices for 37.5 hours per week, the judge did not believe this to reflect the reality of the situation as records showed that the hours worked varied from week to week and that the payment was therefore consistent with the contract being at an agreed price.

 ECR was considered to be a genuine business and therefore not a target of the IR35 legislation.  The judge stated “ECR is in business on its own account.  Elaine [the freelancer concerned] produced to the Tribunal copy business cards and company stationery.  ECR operates from a dedicated business area at her home.  It has company domain and website. ECR advertises its services and is a member of the PCG.  It has retained reserves and invested in development and has over the years taken on fixed price work for a variety of clients.”

 There are obvious actions that contractors should take from this case to support their employment status.

 Marlen Ltd

This is another recent case which has gone to tribunal and resulted in another victory for the contractor. The judgement stated “We have considered two factors – mutuality of obligation and control. These are the two factors which make up the irreducible minimum required to demonstrate a contract of employment” and went on to say “It is our conclusion that there is no mutuality of obligation and the degree of control which would have been needed to establish a contract of employment just did not exist.”

 So what do these IR35 cases tell us?

In each of the above cases, HMRC have challenged the IR35 status of each contractor based on

  • substitution
  • control
  • mutuality of obligation, and
  • the working practises in each situation


The distinguishing thing about Dragonfly is that the contractor repeatedly amended his contract to bring it into line with IR35 legislation however there was no corresponding change the working practices and as such HMRC looked through the contract changes.  In conclusion, your contracts and your behaviour need to support your status.

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