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They think it’s all over

Category Technical Articles
AuthorTechnical Department
Francesca Lagerberg considers where the rules in relation to IR35 now stand after the judicial review case. Francesca is the National Tax Director at Smith & Williamson, Chartered Accountants. She was previously the Senior Consultant to the Tax Faculty of the ICAEW. Article published in the March 2002 issue of Tax Adviser. An Inland Revenue press release issued after they successfully withstood a judicial review appeal on IR35 said: ‘The uncertainty caused by this case can now come to an end’ – with more than a hint of pique. But it is not the end of the IR35 story. Many aspects continue to causing concern and confusion for taxpayers and advisers who are struggling with rules affecting intermediaries.

IR35 – what we know

The rules affecting the provision of personal services via an intermediary (more commonly known as IR35) have now been in place for one complete tax cycle. They came into effect from 6 April 2000 and most taxpayers affected would have been required to consider, as at 5 April 2001, if any deemed payments were due under the rules. Due to the inherent difficulties of the related computation, a concession ensured that taxpayers had until the end of January 2002 to put in finalised figures relating to any IR35 payments. This means that it will have taken until this year for the full extent of those affected by IR35, and the sums of tax and National Insurance Contributions (NICs) involved, to be known.

Consider what we do know so far. The legislation itself is clear in its intent. The income tax rules are set out predominantly in Finance Act 2000 (FA 2000), Sch. 12 and the NICs rules are in, Welfare Reform & Pensions Act 1999, s. 75 and the NIC Regulations – The Social Security Contributions (Intermediaries) Regulations 2000, (SI 2000/727). The rules state that anyone supplying their services through an intermediary, such as a company or partnership, could be within the IR35 rules. The aim is to reduce the opportunities available to use an intermediary to avoid PAYE and NIC by such methods as paying profits in the form of a dividend.

If an individual ‘worker’ is within IR35 he or she will have to account for a minimum amount of tax and NICs on a deemed payment. The deemed payment is taken to occur as at 5 April (the tax year-end). If salary has been paid throughout the year or prior to the year-end, there may be little or no tax and NICs left to pay.

To determine the deemed payment calculation involves a nine-step process. This is set out in the legislation and the Revenue provided guidance on how it views each step in the Revenue’s Tax Bulletin, dated February 2001.

Are the rules valid?

There have been many complaints aimed at the way the IR35 rules operate but the Professional Contractors Group (PCG) sought to challenge the rules via a judicial review case. The case was based on a threefold approach. Firstly, it was argued that the rules breached human rights. Secondly, that the rules constituted illegal state aid to the competitors of personal service companies, as the former did not have to be concerned with IR35, and thirdly that the rules made the United Kingdom (UK) a less attractive place to work which infringed various European rules. All three arguments were rejected by the High Court in April 2001 (see R (on the application of Professional Contractors Group Ltd and others) v IR Commrs [2001] BTC 240). The PCG appealed this decision mainly concentrating on the European law arguments, but the Court of Appeal rejected its appeal in December 2001.

This PCG has decided not to appeal the decision to the next stage of the legal process and therefore this element of the IR35 story has come to an end. The Revenue’s view in relation to anyone who has been holding off complying with IR35 obligations in the hope that the rules would be overturned is quite clear – they should wait no longer. In its press release following the Court of Appeal decision it notes that:

‘Workers affected by the legislation will need to make sure they have paid all tax and National Insurance Contributions due under this legislation by 31 January 2002. If they do not do so, they may incur penalties.’

Those who have not met their obligations on time will also have been incurring interest on any tax due as from the due date.

Status issues

Despite the end of the judicial review case the situation relating to IR35 is anything but finalised. There are a number of outstanding issues – not least the thorny question of who is actually within IR35 in the first place.

In determining who is within and who is outside the rules one has to take a leap of imagination and consider a hypothetical contract between the worker and the client, thus removing the intermediary from the equation. The question is then: ‘if such a hypothetical contract existed would the worker be an employee or self employed in relation to the client?’ If the answer is ‘an employee’ then IR35 is applicable. This brings into play the status rules that have been the subject matter for numerous case law decisions over the last few decades.

The question of whether someone falls with Sch. E or Sch. D is neither straightforward nor easily explained to a client. So many factors can come into play. Just some of the issues that may point towards someone being self employed include:

  • whether they are in business on their own account;
  • the financial risk they take on in their work;
  • whether they can provide a substitute; and
  • the intention of the parties.
It is not possible to take a check-list approach to determining who is within the rules and you need to consider the ‘big picture’, taking all relevant factors into consideration.

Already there have been two Special Commissioners decisions in relation to IR35, which have taken an initial look at this issue of who is within the rules. The Revenue have won both. In Battersby v Campbell SpC 287 the unrepresented taxpayer did not advance much in the way of strong legal arguments to help his cause. In the yet unpublished second case there appears to have been more consideration of the issue of status, but again it seems as though some of the crunch issues were not addressed. For example, there are still outstanding questions as to the operation and importance of mutuality of obligation between parties.

The uncertainty in this area of status is a cause for concern. Taxpayers are confused about their legal position and some of the case law is conflicting and unclear. The Revenue appear open to the idea of representative cases being brought which will enable key contentious issues to be considered by a court. The trick will be finding suitable cases which contain the necessary facts without the issues being muddied by other factors.

Other prevailing matters

Assuming that someone falls within IR35 there are other matters which make the operation of IR35 an area littered with pitfalls and traps. The rules are still relatively new and the learning curve is steep. Anecdotal evidence suggests that many taxpayers and their advisers are finding complying with the all the necessary obligations a time-consuming process and that for advisers full recovery of costs incurred is not proving to be easy. Below is a ‘hit-list’ of key areas where difficulties can arise.

Timing issues

(1) Salary after the deemed payments calculation

The deemed payment calculation under IR35 does no more than determine the amount of tax and NIC to be paid by the company to the Revenue. Any subsequent, actual salary payment cannot be ‘franked’ by the tax and NIC paid. Therefore, if an amount is paid as salary after the deemed calculation has been made, it too will be subject to tax and NIC. This means that tax is paid twice on what are essentially the same funds.

The only ways to avoid this double charge are either to distribute the funds as a dividend rather than a salary or to ensure that remuneration is paid before 5 April. Finance Act 2000, Sch. 12, para. 13 prevents a double tax charge where a dividend is paid in the same accounting period or in one subsequent to that to which the IR35 charge relates.

(2) Corporation tax issues

A deduction is given for corporation tax only when the deemed payment is treated as paid (Sch. 12, para. 17(1)). As very few companies have an accounting date which coincides with 5 April, this causes complex timing problems. Assume a company has a 31 March year-end and makes a deemed payment at 5 April following its accounting period. The deduction will not be given for the deemed payment in its 31 March accounts. Therefore, tax is paid on the full accounting profits as if IR35 does not apply. Then tax is paid again on what is effectively the same funds a few days later, on 19 April.

Of course it is true that the IR35 amount is then allowable against profits in the following year. However, if the individual receives further IR35 income in each subsequent year, no relief is ever obtained for the effective double charge at the beginning of the regime.

(3) Cessations

The cessation of a company which is caught under IR35 gives rise to difficult timing problems, which can mean that the deemed payment is ‘made’ too late to be set off against the profits of the final period of trading.

Basis for accounting

IR35 payments are calculated using the cash basis. This was intended to be helpful as it prevents workers being taxed on money not yet received. Unfortunately it also exacerbates the bookkeeping difficulties, as it is necessary to have two sets of books, one on a cash basis and one on an accruals basis.

Training costs

The costs of training allowable as a deduction in the deemed payment calculation are limited to those allowable to an employee under Income and Corporation Taxes Act 1988, (ICTA) 1988, s. 198(1),. This is a very restrictive test.

Although the five per cent flat rate deduction is meant to include such expenses as training costs in the knowledge-based sector in particular, many workers may find it inadequate to take into account the training needs of a contractor.


Many partnerships fall outside the IR35 rules. Nevertheless those which are caught are significantly affected.

The two main problem areas are:

  • the IR35 amount could exceed the profit share of the individual partner; and
  • the profit sharing arrangements can be affected.
NIC/tax divide

Due to the non-alignment of NIC and income tax rules in the UK, it is possible to be within the rules for NIC purposes and not for income tax purposes or vice versa.

Those most likely to be affected in practice are non-executive directors, who will be within the rules for NICs, but may well be outside the tax legislation. An actor, entertainer or lecturer may also be self-employed under the status tests, but a deemed employed earner for NICs purposes and thus within the NICs part of the IR35 rules.


It is apparent that there is still some way to travel before the issues affecting the intermediaries legislation are all resolved. It is, however, arguable that with the high profile case now out of the way it may be possible for all parties affected to take stock and seek to find practical, achievable solutions to some of the remaining areas of concern.

Technical Department
020 7235 9381

March 2002 by


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