Before IR35 was introduced workers who owned their own companies were allowed to receive payments from clients direct to their business. Company profits could be distributed as dividends, which are not subject to National Insurance contributions (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 that year's Budget, the UK's Chancellor of the Exchequer, Gordon Brown, announced that measures would be introduced to counter tax avoidance by the use of so-called Personal Service Companies (PSCs). Properly known as the "Intermediaries Legislation", it is more commonly referred to by the number of the press release in which it was announced, IR35. It came into force throughout the UK in April 2000. Although it was part of that year's Finance Act and was not law at the start of the Financial Year, the Act backdated its commencement to April 6th 2000. The legislation has been consolidated in the Income Tax (Earnings and Pensions) Act 2003 and in the Statutory Instrument Social Security Contributions (Intermediaries) Regulations 2000, SI 2000/727.
Historically, it had been advantageous for the owners of a small company to take all of their wages in one month, thereby only incurring NICs once (up to the monthly ceiling) instead of every month. This ploy had been circumvented some years prior to the introduction of IR35 by imposing NICs on the total annual income of directors as if it were spread over the year, even if only paid by one payment. The increased usage of dividend payments instead of wages was partly a reaction to this change. An additional sense of grievance felt by those who were driven to incorporate, for whatever reason, was the large disparity between the NIC burden on companies and employees (more than 20 percent if the employer's contribution is included) and that imposed on the self-employed.
The stated aim of the measure was to prevent workers from setting up limited companies via which they would work effectively as employees, but saving on tax. The so-called "Friday to Monday" scenario was cited in the press release as the anomaly being corrected - namely that it was possible for a worker to leave a job on Friday and return on Monday doing the same work for the same company, but, as a contractor via their own limited company paying a lot less tax. In such a scenario, HMRC would be allowed to "look through" the contractual arrangement between the worker's company and the client company and to 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. Normal employment status rules should be applied when considering IR35 status and the view of HMRC can be successfully challenged.
IR35 only applies if the individual is working for a client under circumstances where if it were not for the imposition of the limited company or, partnership (known as the "intermediary"), it would be one of 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 IR35 legislation.