Contractor or employee? Essential facts affecting freelancers and contractors (including IR35)

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Budget on 17 October 2022

The government confirmed on 17 Oct 2022 that these IR35 rules will continue to remain in place, and in their current form, for the foreseeable future. (Liz Truss's government had wanted to remove them in 2023 but this was over-ruled).

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.

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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’.

IR35-friendly contracts

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).

Contract for services: individual consultant, freelancer (sole trader)

Contract for Services: services provided via a consultancy company

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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1. No right of substitution

The hired person does not have the ability to appoint a substitute (someone else) to carry out their contractual duties in their place. Employees do not have this right and instead offer a personal service that's firmly attached to them as individuals. They have no power to get someone else to do their work for them.

Freelancers and contractors should ensure that they're freely empowered to exercise the right of substitution and that their contract does not say that they will be the only individual to carry out the contracted duties.

There are various different kinds of substitution clauses for contracts for services. An absolute one, which essentially says that the freelancer is entirely free to appoint a substitute and the customer will have no say in the choice of appointee is, in reality, unlikely to be palatable to most customers, (though it’s the one most likely to tick the IR35-friendly box).

More common, and generally acceptable, is wording that empowers the freelancer to appoint a substitute and although the customer is allowed a veto right over the identity of that substitute, the wording of the clause makes clear that this veto can only be exercised reasonably, with the objective of ensuring that the substitute has the appropriate technical and professional skills for the contracted work.

The clause should also make clear that the customer’s consent to the substitution will not unreasonably be withheld. So, playing this out, if the freelancer wants to get someone else to perform their contractual duties, and that person is suitably qualified for the work in question, the customer should not be able to reject the arrangement

It can also be helpful (from an IR35 perspective), for freelancers and their customers to agree exactly how a substitution would work. You don’t need to have a substitute in mind, simply agreement on a straightforward procedure for how the freelancer might appoint someone else and what the customer would do in response, assuming that the substitution was agreed.

This detail might cover, for example, how the substitute would be provided with access to any materials, premises, briefings, etc. The details could be appended to the contract for services as an additional annex, or they could be set out in a side letter that runs alongside the agreement and confirms what you both intend to be the practical arrangements that would apply if this situation arises.

This kind of letter is often called a ‘real arrangements’ letter. It is not legally required and neither is it intended to be legally binding of itself. But it is helpful in evidencing the intention to ensure the freelancer’s ability to put in place a substitute a very real and manageable reality within the relationship.

Whether you include this level of detail in an annex to your contract for services, or in a side letter, you can adapt our template letter to substitute a consultant or freelancer to help you cover off what you’d need to action in your particular situation.

You should also ensure that any substitute assigns to you any intellectual property rights that may be generated in the work that they do for you under this arrangement. You can use our short but effective template letter assigning intellectual property generated by an individual consultant/freelancer working on project for these purposes.

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2. Balanced contractual obligations (often called ‘mutuality of obligations’)

Between an employer and employee, there's a mutual set of obligations and it’s generally pretty well balanced: the employer agrees to provide consistent and paid work and the employee personally commits to carry out that work, on an ongoing basis.

Genuine self-employed contractors and IR35-friendly contracts do not follow this pattern. The wording of contracts for services should specify start and end dates, (not indefinite or rolling arrangements), they should be project- or task-specific (not a list of general ongoing duties), and there should be no obligation on either party to offer or to accept the work during the term of the contract – so that if, for example, the customer does not have work for the freelancer on a particular day, there is no obligation for the customer to offer something else or indeed to pay the freelancer for that day.

Equally, if the freelancer has other commitments on a particular day, then generally, they must be free to honour them, provided that this does not render their contracted duties unperformable.

Another thing to note is that employees have a statutory right to a minimum notice period – and so employment contracts normally include a notice period and often a payment in lieu of notice clause. Self-employed tend to be engaged until project is finished but can be dismissed for breach of contract. In addition, a genuine self-employed contract wouldn't have employee rights such as sick pay included.

Often, for genuine freelancers, project work will be done on a fixed-price basis, though potentially with milestone payment stages built into the scope of works, so that the freelancer does not go unpaid for long periods, where the project takes a reasonably long duration. A freelancer’s ability to evidence that they are able to manage their own contract timings, output and delivery risk factors can be very helpful evidence of a genuine arms-length relationship.

  1. The customer is the controlling party in the relationship: actively supervising, directing and calling the shots

If there’s a sense of ‘master and (paid) servant’ about the relationship, there’s a strong risk that this will be an employment contract. This is one of the most significant factors when HMRC determines if an IR35 (employment) situation is present.

Freelancers must have as much control over how they perform their contractual duties as is reasonably possible. If you think about it, they're typically appointed as an expert in what they do, so they should be advising the customer, following receipt of a brief, and not simply following a set of customer instructions, that any employee could be directed to perform.

So, for example, if a client dictates what, when, where and how the work is carried out, it’s very likely that the contract risks being considered one of employment. If a freelancer is provided with broad contractual goals and timescales, e.g. “draft us 5 different blogs on dog-training techniques by the end of the month”, and also broad freedom regarding how they will write and present those blogs, the arrangement is far less likely to raise suspicions under IR35.

By contrast, someone who is instructed to undertake specifically detailed tasks that relate to activities arising daily within the customer’s business, or who is given a very detailed job description reflecting broadly ongoing tasks, it looks far more as though an employment relationship is in place.

Having said that, signing the necessarily exacting terms of confidentiality agreements, abiding by, for example, a customer’s health and safety, data protection, anti-bribery and corruption and bullying and harassment policy rules, plus other security rules, even complying with the customers’ existing brand guidelines, should generally not give rise to any IR35 impact.

If all of these factors are clearly met, the freelancer is most likely an employee and the IR35 penalties will likely apply. Other arguments are likely to carry little weight in dissuading HMRC that this is not in fact an employment contract.

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