As a freelancer or contractor, you’ll typically contract your services by one of two means: by operating as a sole trader and contracting your services in your individual capacity, or by setting up a limited company and contracting your services through your company.
In both cases, it's important to ensure your relationship with your customers maintains an arms-length distance between you, meaning that it's properly a relationship between two fully independent parties that's ‘off-payroll’, not a disguised (or inadvertent) employer-employee relationship.
This might sound obvious and unimportant. But it actually matters a great deal. The UK’s tax regulator, HMRC, penalises trading relationships that should be employer-employee ones but are described as arms-length independent freelancer/contractor arrangements.
What is IR35?
The penalties come on top of obligations to pay the tax that HMRC considers should have been paid, (since employment relationships typically generate more tax for HMRC than arrangements where freelancers contract via their own company or partnership), which is why HMRC is suspicious of any relationship that looks like it could in fact be an employment relationship by another name).
Sole traders pay income tax and National Insurance in a manner very similar to employees and generally are not in a position to reduce their tax liability in the UK.
However, those freelancers providing their services through their own personal limited company pay their tax and National Insurance contributions in a different way.
They can, for example, take a minimum sum as a ‘salary’ on which they pay a National Insurance contribution, and then pay themselves dividends from time to time, on which a lower rate of tax is payable – which reduces, potentially quite substantially, their overall tax liabilities.
This practice is quite legitimate under the UK’s existing laws, provided that it’s not based on a sham set of facts.
It’s well reported that HMRC is not a big fan of this practice, that it scrutinises it carefully and has made very clear that simply running your business through a limited company does not, of itself, prove that you are not an employee of your customer. A number of other factors must be evidenced and this guide explains them in more detail below.
The law that provides HMRC with the rights to investigate and penalise both the ‘freelancer’ and the ‘customer’ in circumstances where the services are provided by a freelancer through a limited company, is commonly referred to as ‘IR35’.
A contract can exist verbally and/or its terms can be legally implied by the parties’ actions, by statute and by the case law of the UK courts. But it's important to remember that not having a contract does not stop IR35 from applying.
Where nothing has been written, HMRC or a court will simply look at what has happened in practice between the freelancer and the client. But this leaves room for a lot of ambiguity and where that happens, HMRC will be entitled to interpret both these activities and the relevant laws to its advantage. So, it is infinitely preferable to put in place written contracts for services, which make the basis on which parties intend to work together very clear.
You can use our template contracts for services as a great starting point to help you put together something clear, robust and that should also help you to demonstrate that there is no employment relationship in your contracting activities, (provided that your actions in practice are consistent with your contract terms of course).
What makes a relationship one of employment?
The main determinative factors
There are 3 principal factors that generally point to a contract being one of employment and not a contract for services...
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