Off-payroll (IR35) and the Small Companies Exemption - Explained


Small firms, particularly consultancies, who have mastered the legislative nuances and differences between the IR35 and Off-payroll working legislation have a competitive advantage over their larger competitors. But, the benefits seen by consultancies and clients requires careful navigation to avoid later perils.

The advantage arises because if a hiring firm fully contracts out services to a small consultancy, the rules revert to the original legislation whereby the contractor holds the tax risk and not the hiring firm.

It's important to stress that this is not a tax loophole, and firms utilising consultancies that qualify for the small companies exemption should have due diligence processes to avoid potential risk.

How did the small companies exemption arise?

The original intention of the new Off-payroll legislation (Chapter 10 of ITEPA 2003), which rolled out to the private sector in April 2021, was to be a wholesale replacement of the longstanding Intermediaries Legislation (Chapter 8 of ITEPA 2003) from 2000, commonly referred to as "IR35".

However, following consultations, Parliament felt the onus on small companies (as defined by the Companies Act) would be too much, so it introduced a "small companies exemption". Whilst designed to ease the burden on small businesses it has added considerable complexity because the original legislation remains in place but only applies to contractors working for those small companies.

The newer version of Off-payroll applies to the public sector and private sector companies that are medium or large. Both are somewhat confusingly referred to as "IR35", and firms need to understand the differences to avoid accidental exposure.

What qualifies as a small company?

Under the private sector Off-Payroll legislation, small companies are classified via the same criteria used in the Companies Act 2006. The Act sets out the following parameters for a small company to operate within:

  • Annualised turnover of up to £10.2m
  • Balance sheet assets of up to £5.1m
  • Average number of employees of up to 50

To qualify for the small companies' exemption, a company must meet two or more of the above criteria.

Should the company qualify, the original Intermediaries Legislation applies, and the contractor would then assume responsibility for assessing their IR35 status and taxing themselves accordingly.

How does the tax risk shift?

The common element in both the original and newer legislation is the need to assess whether the relationship between the contractor and hiring firm may be "deemed employment", colloquially referred to as their "IR35 status".

The contractor must assess their status in the original legislation, and their company bears the entire tax risk. Their client has hired them "clean", with no longer-term potential balance sheet tax risk.

However, the new Off-payroll legislation is a different beast. Medium and large companies have to conduct the assessments and hold the tax risk. And if HMRC investigates and disagrees with the status, they can issue a determination to the client, with multiple contractors targeted.

The total tax risk is two lots of national insurance contributions and Income tax, equally roughly 50% of the gross payments made. At the time of writing, there is no clear path to reverse any offsets of tax the contractor has already paid.

Therefore, medium and large clients may prefer to outsource work to a consultancy that can leverage the small companies exemption. Contractors may also rather work for small consultancies to keep them within the original IR35 regime and have a greater chance of receiving fair tax treatment.

Where are the dangers?

Firstly, just because small companies can leverage the exemption doesn't mean they can ignore the IR35 legislation, nor can the contractors. While the contractors are legally liable for the tax and self-assessments, procurement departments expect these consultancies to conduct assessments to help protect all parties in the supply chain.

The larger hiring firm's other concern is related to a fault-line in the Off-payroll legislation. If the hiring firm did not correctly conclude that the consultancy provided a fully contracted out service instead of just warm bodies, the new legislation would come into play. The consultancy would no longer be the "client" in legislative terms, and the exemption would not apply.

In that instance, because the hiring firm hasn't conducted assessments and hadn't passed a Status Determination Statement ("SDS") to the worker, they may be liable for the unpaid tax and not the consultancy. The belt-and-braces approach to protect against this is to conduct assessments for all contractors, which isn't expensive.

There is much discussion about the reasonable care requirements in the new legislation, but, alas, there is no statutory reasonable care provision that protects the hiring firm who reasonably decided the consultancy was the "client" and not them.

That said, providing firms have the proper contractual paperwork in place that demonstrates the provision of services, not people, is the reality, then courts should support that position.

What should firms do?

Firms should robustly stress test their procedures around evaluating whether the consultancy they are engaging is providing fully contracted out services or whether they are simply providing labour as an agency does.

The contractual paperwork and working arrangements need to be examined to ensure they are water-tight. And the small consultancy should be tasked with also implementing a robust assessment regime.

Dave Chaplin

Dave Chaplin is a former IT contractor, founder and CEO of IR35 Shield. He is also the author of "Contractors' Handbook" and "IR35 and Off-Payroll Explained".