In this context, "disguised employees" refers to workers who receive payments from a client via an intermediary and whose relationship with their client is such that had they been paid directly they would be employees of the client.
Before IR35 was introduced workers who owned their own companies were allowed to receive payments from clients direct to the company and to use the company revenue as would any small company. Company profits could be distributed as dividends, which are not subject to NICs. Workers could also save tax by splitting ownership of the company with family members in order to place income in lower tax bands.
In 1999, as part of the Budget, the UK's then Chancellor, Gordon Brown, announced new measures to counter tax avoidance by the use of PSCs. Properly titled the "Intermediaries Legislation" it is commonly known by the number of the press release in which it was announced, IR35, and came into force throughout the UK in April 2000.
The stated aim of IR35 was to prevent workers from setting up
limited companies via which they would work effectively as
employees but pay less tax than a conventionally employed
worker. The so-called "Friday to Monday" scenario, where it
was possible for a worker to leave a job on Friday and return on
Monday to be doing the same work for the same company, but as a
contractor via their own limited company and paying a lot less tax,
was cited in the press release as the anomaly being corrected by
the legislation. In such a scenario
HMRC would be allowed to "look through" the contractual arrangement
between the worker's company and the client company and formulate a
"hypothetical contract" which showed that the worker was a
"disguised employee". The fee paid to the worker's company would
then be taxed as a salary.
IR35 only applies if the individual is
working for a client under circumstances where if it were not for
the presence of a limited company or partnership (known as the
"intermediary") it would be one of standard employment. The HMRC
argues that in these cases the individual is deemed a "disguised
employee". Anyone working via an intermediary will be caught
by the new rules if they fail the 'IR35 test'. This test
determines whether the person would be an employee if they were
contracting directly with the 'client', rather than using this
intermediary. If their terms and conditions or working
practices are of employment then they will be 'caught' by
detailed explanation of IR35
IR35 - is it still relevant?
IR35 - how will I know if I am caught?
IR35 and the law of unintended consequences
IR35 - so let's use "control" to our advantage