The Off-Payroll Working rules have spurred a lot of confusion among UK businesses since April 2020, when the HMRC’s tax law updates came into effect.
Much of this confusion is about how the Off-Payroll Working rules relate to IR35, a 21-year-old legislation that aims to prevent contractors from avoiding income taxes and National Insurance contributions. It’s also due to new responsibilities imposed on private sector companies in the UK.
In this post, we’ll explain what Off-Payroll Working is all about, as well as what companies can do to stay in compliance.
This article is part of our guide on independent contractor taxes.
What is Off-Payroll Working, or IR35?
Off-payroll working is a set of rules that govern the tax and national insurance that a worker pays when they are providing services to a client through their own intermediary. The idea is to ensure that independent contractors and other off-payroll workers pay the same taxes as an employee would. These rules will apply to contractors who work through their own limited company, via a partnership, or through a separate individual.
In most cases, the client or the business will be responsible for determining if their contractor is performing off-payroll work. HMRC offers the CEST tool, which stands for Check Employment Status for Tax, to support businesses in making this determination. If the worker is deemed to be an employee, the normal rules for employment apply, including deductions for income tax and national insurance.
Off-Payroll Working rules vs. IR35: What’s the difference?
Understanding the difference between IR35 and Off-Payroll Working rules requires a little bit of historical context. Here’s a quick overview.
IR35 is the HMRC’s 2000 tax initiative that aims to counteract tax avoidance among freelancers and contractors who deliver services to companies through an intermediary, often referred to as a Personal Service Company (PSC). It is equivalent to the IRS 1099 NEC form.
Under the law, contractors who were determined to be operating “inside IR35” would be required to pay income taxes and National Insurance contributions as if they were employees. However, they would not get regular employee rights or protections.
Originally, it was the PSC’s responsibility to assess whether IR35 should apply. This involved analyzing the contractor-client relationship and determining whether the contractor would have been deemed an employee if they had provided their services directly to the client (instead of through an intermediary).
Off-Payroll Working rules
According to HMRC, IR35 was largely unsuccessful. In fact, HMRC believes it’s losing nearly £700 million of revenue as a result of contractors working as “disguised employees,” and therefore getting out of income taxes and NICs.
To help remedy this, the agency decided to switch things up. In April 2017, it introduced the Off-Payroll Working rules to the public sector.
Since then, all end clients in the public sector became the ones to assess their relationships with freelancers and contractors, not the PSC. If the client deemed a contractor to be operating inside IR35, the “fee-payer” would need to make the tax deductions and NICs from the worker’s pay, and pay the employer’s NIC.
As of April 6, 2021, the Off-Payroll Working rules would also extend to larger businesses within the private sector.
How Does IR35 Impact Payroll?
If workers are considered to be employees under off-payroll rules, deductions will need to be made from their salary before they are paid each month, including income tax contributions and national insurance payments. This is in contrast to freelancers or independent contractors who are paid their full invoice amount, and handle their own tax separately using a self-assessment form, or pay corporate taxes via their limited company.
If businesses assess their workers as inside IR35, they may end up paying a lot more tax than they did previously. Despite this, they will still not be eligible for benefits such as insurance, pension schemes, or sick days.
Who do the Off-Payroll Working rules apply to today?
Specifically, the Off-Payroll Working rules now apply to all public sector companies that work with contractors through intermediaries, as well as medium and large private sector clients with a UK connection.
To qualify as a medium or large-size company, a business must meet two or more of these criteria:
- Have annual turnover of more than £10.2 million
- Keep a balance sheet of more than £5.1 million
- Have more than 50 employees on its payroll
What happens if you violate the Off-Payroll Working rules?
Even if you don’t intentionally violate the Off-Payroll Working rules, it is dangerously easy to do so by accident. This is because the nature of a client-contractor relationship often changes over time.
Imagine you’ve hired Matt to be a freelance programmer. In the beginning, you assign Matt to work on a new feature, where additional development support is needed. At the same time, he’s providing similar services to two other companies. However, over time, you start giving Matt more and more work, which leads him to quit his other clients and work just for you. Even though he’s not on the payroll, he’s become an indispensable part of your dev team. If he wasn’t working through a PSC, he would otherwise be considered an employee.
According to the Off-Payroll Working rules, if you’re paying Matt via his PSC, you are now responsible for deducting income taxes and NIC from his earnings.
If you fail to do so, you can face a broad range of consequences, such as:
- You could be held responsible for paying the income tax amount and NICs that should have been deducted from the payments to the contractor’s PSC.
- You might be asked to pay backdated taxes, NICs, and penalties.
- You could face a serious tax investigation.
How to stay in compliance with the Off-Payroll Working rules
Here are some tips for keeping track of your work relationships with contractors who work through an intermediary so you can stay in compliance with the Off-Payroll Working rules.
- Use the HMRC assessment tool. The HMRC provides this assessment tool to help businesses determine whether the Off-Payroll Working rules apply to their contractor relationships. By taking the time to use it, you can determine whether you need to deduct income taxes and NICs fairly easily.
- Regularly audit your contractor relationships. As we saw in the example above, contractor relationships can change over time. By periodically assessing your engagements, you can ensure you remain in compliance.
- Consult legal advisors. If your company doesn’t have an in-house legal counsel who is well-versed in IR35 and the Off-Payroll Working rules, it is worth bringing one in for a consultation. Professional guidance can help you build processes and improve freelancer agreements to ensure you remain in compliance.
- Update freelancer contracts. To avoid issues with your contractors that could lead to friction or talent loss, clarify the type of work relationship you are seeking in your freelancer agreement. For example, if your contractor is supposed to take on a full-time role with your team, they should be prepared to have income taxes and NICs withheld from their pay. If they intend to provide limited services, you can state in their contract that they are not to work beyond a predefined amount of hours, and maintain control/autonomy over their work.
Don’t get caught in the dark
The new requirements under the Off-Payroll Working rules present a significant change and challenge for many employers. Not only do companies need to be prepared to assess their relationships with contractors who work via an intermediary, but they must also potentially withhold deductions from these workers’ pay and make NICs.
For many companies, this could mean losing valuable talent on top of added expenses.
To avoid this, your company must do its due diligence to first understand what’s required of it under the tax laws. The next step is communicating transparently with your contractors and freelancers to whom the Off-Payroll Working rules apply, and possibly amending your work relationship.
By taking the necessary steps, you can remain in compliance with the law while keeping top talent in your ranks.
US-based companies should follow the IRS guidelines by submitting form 1099-NEC.