I’m a freelancer – but will my contract pass IR35?

I’m a freelancer – but will my contract pass IR35?
Choose a Name: The name has to be unique, obviously, and not likely to be confused for someone else’s existing name. The best reference point is the Companies House website – www.companieshouse.gov.uk – which has a simple search facility so you can check your chosen version. Also, try to avoid names that are specifically related to your line of work, just in case you want to change careers later: imagine selling cars though a company called Al’s Bakery.
Decide on Share Ownership: Is this just you, or you and your spouse, or you and two or three other people? This is important, because it defines how to allocate the Ordinary Shares In the company. Dividends are paid in direct proportion to numbers of shares held. A husband and wife typically have 50% each, for example, but if one is already earning money, be aware of the impact of the share income on their tax position. Share allocation can be changed after the event. There are several variations on share management; but for anything other than a simple allocation of ordinary shares, get expert advice.
Register at Companies House: There is an online system you use to set up your company and pay the registration fee. It is fairly simple to use. One question it will ask is who the directors are. For a typical small contractor company you only need one but there’s no reason not to have more. Although not strictly necessary any more, it also helps to nominate a Company Secretary: this could be the same person, but it’s more sensible to have someone else, a partner or relative for example.
Register a Memorandum of Association: Something else to do while you are at Companies House. At its simplest this is a document describing what your company is for and how you wish to run it. You can do it yourself, but the document can have legal implications in a tax investigation so do some online research for a suitable template from sites such as www.simply-docs.co.uk or www.clickdocs.co.uk.
Set up a Bank Account: This has to be a business bank account. Banks are increasingly wary of new business accounts, so you will have to answer some detailed questions and it will help if you have some professional references and a signed contact to demonstrate you actually will have an income.
Register for VAT: You have to do this if your annual income is in excess of a set amount (currently £67,000 pa) but it Is advantageous to register anyway. VAT and the Flat Rate Scheme are discussed in more detail elsewhere.
And that’s it. It sounds complicated but is in fact quite straightforward. You can also take the easy way out; either use a company formation agent, or there are several accountants who specialise in contractors who will set up all if the above for you for a small fee, or even for free, as well as providing expert support. Finally keep track of all your various expenses setting the company up, since you can reclaim these once you start trading.

The intention of IR35 is very simply expressed: if you are working as an employee of your client then you should pay the same taxes as an employee of that client. You can’t avoid paying those taxes simply by saying you are a freelance contractor, you have to be able to prove it.

Proving it, though, is not that simple. IR35 does not set hard and fast rules that would allow a clear-cut decision.

Let’s start with the contract. The basis of any IR35 judgement centres on the three key employment indicators, Direction and Control, an irreducible minimum of Mutuality of Obligation and a reasonably unfettered Right of Substitution. In theory, the clear presence of any of those three in a contract would take that contract outside IR35. In practice, they are never that clearly defined unless the contract has been very carefully drafted. Therefore any contract you use must be checked for these factors and if necessary changes made to define them correctly. This requires expert opinion from someone with demonstrable expertise in this field. What you should never do is use HMRC’s own free contract assessment service; that is a guaranteed loser.

However the contract is only part of the story. The final judgement will take account of the totality of the arrangements and the intent of all the parties involved. So you may have a safe Right of Substitution in the contract, but if the client is never going to allow you to invoke it then it has no value as a defence. This was the major conclusion of the Dragonfly case, that the working arrangements and the contract have to be fully aligned.

It is therefore very hard to state categorically that a contract will pass or fail IR35. You should take great care to ensure the contract is properly assessed and amended and you must fully understand the nature of the engagement. Then, if you are challenged by HMRC, you have the tools to mount a decent defence. And because you have taken steps to assure yourself of your IR35 status, if you do lose there won’t be any additional penalties.

That defence, however, requires expert support and guidance. Most if not all of the lost IR35 cases have been where the contractor represented themselves. Make sure you have effective insurance to cover the cost of expert advice and representation. A few hundred pounds will protect you from the average £15,000 costs of a defence. And, more importantly, it will buy a great deal of peace of mind.

© 2009 All rights reserved. Reproduction in whole or in part without permission is prohibited.

Image: yes!_no? by Fernando Takai

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