IR35 - definition and case studies

The history

The attraction of limited companies goes back a long way, ever since the Law Lords heard the case of Salomon v Salomon & Co [1897] AC 22. This was the defining case, which established the fact that a corporate personality is a separate legal person to its members. Mr Salomon was a leather merchant. In 1892 he formed a limited company with his wife, five of his children and Mr Salomon himself making up the seven shareholders (the statutory minimum in the 19th century). He sold the business to the company and used the proceeds to pay off the trade creditors. The proceeds included debentures secured on the business, which were taken by Mr Salomon. 

Unfortunately, the business did not prosper as expected and Mr Salomon was forced to sell his debentures to try to save the business. This was insufficient and the company went into insolvent liquidation. The liquidator alleged that the company was a ‘sham’. The Court of Appeal held that the shareholders should have been a bona fide association, not just seven members of the family in what was effectively a one-man company. The House of Lords disagreed and one-man companies have been with us ever since.

The Finance Act 1972 was instrumental in the explosion in demand for these companies. Suspecting widespread tax evasion in the construction industry, the Treasury produced legislation requiring building contractors to deduct tax before paying sub-contractors, unless they were dealing with a company, when the company could be paid gross.

Shortly afterwards, legislation was introduced in respect of temporary workers, so that they would be treated as employees of the agency ‘employing’ them, unless the agency was contracting with a limited company. Agencies in both construction and other industries preferred not to bother with numerous ‘employees’ starting and leaving and it became almost impossible for an individual to find employment through an agency, other than by working through a limited company.

The attraction was increased by Finance Act 2002, which imposed a starting rate of corporation tax of 0% (previously 10%) for companies whose profits were not more than £10,000. This continued until 2005, when it was abolished.

Against this background, the 1999 Budget Press Release IR35 proposed Intermediaries Legislation designed to prevent individuals avoiding tax and National Insurance through the use of companies. It came into effect from 6 April 2000 and continues to be known as IR35.

However, there remain advantages to trading through a limited company:

  • a contractor can draw a minimum salary and pay the minimum tax and National Insurance, drawing profits as dividend out of post-tax profits of the company; there is no further tax on the distribution, except where the contractor has a liability to higher rate tax;
  • this gives rise to a National Insurance saving (no NI on dividends) and a cash flow advantage, since dividends do not attract PAYE;
  • the rate of corporation tax is substantially lower than the total of income tax and National Insurance;
  • for contractors such as IT and other professionals, there is the opportunity to work from home. This can give rise to substantial cost savings (see below);
  • agencies engaging contractors are saved the cost of employer’s National Insurance.

The aim of IR35 is to seek to prevent contractors avoiding tax and National Insurance by treating them as employees for tax purposes. They do not, however, have the benefits due to employees under employment law, such as sickness benefit, holiday pay, maternity benefit etc.

IR35 tests for employment are different for income tax and National Insurance and may yield different results for the same purpose.

Employment v self-employment

There is no definition of self-employment or trade in statute and we must look to case law for guidance as to employment/self-employment status. From this rich source emerged the 'badges of trade'; the modern equivalents are:

  • extent and degree of control exercised by the client over the worker: a self-employed person would probably have control of the work done: an employee would be subject to control by the employer over the time and method of working;
  • right of substitution: the self-employed may sub-contract work or bring in assistance; it is rare for an employee to have the right to appoint a substitute;
  • mutuality of obligations between worker and client: a contractor may turn down work, or work in his own time, the client is not obliged to offer work and is not paid unless he works; an employee is obliged to be available and cannot turn down work. He is paid even if he is given no work;
  • financial risk: a contractor will quote for a job and may incur a loss or profit from work done; little risk for an employee, except lack of promotion and little expectation of profit, except a bonus;
  • employee right and benefits: not available to a contractor; available to an employee;
  • part and parcel of the organisation: a contractor may become a regular but has no additional responsibilities as a result; an employee is capable of being promoted and managing other staff;
  • length of and right to terminate contract: a contractor may have a short-term contract and no right to terminate unless the other party is in breach; an employee has an open-ended contract and can give notice according to the terms of the contract;
  • mutual intention: a contractor’s stated intention may not reflect the facts; an employee contract would be persuasive.

Each case has to be decided on its own merits and a number of firms specialising in ‘IR35 companies’ emerged, drafting contracts which tracked the relevant case law and arranged their clients’ affairs accordingly. Cases include:


Case studies

Lime-IT Ltd v Justin, SPC2002, [2003] SSCD 15 (SSCD 15 (SP C 342)

Whether or not IR35 applies:

The taxpayer company contracted via an agency to provide IT services on various specific projects to the end-user (M). The projects were expected to take one year to complete.

The company (with F as its only employee) was expected to work an estimated 37 hours per week or such hours as were reasonably requested by M. The contract contained a substitution clause, under which the company could send in an alternative worker. During the contract, the taxpayer worked for four other clients. F worked at one of M’s offices and partly from her office at home, where there was a room containing four computers dedicated to the taxpayer company’s business.

Held: It was necessary to ‘look through’ the intermediary company and establish whether, in the absence of the intermediary company, there would be an employment or self-employment relationship; based on the facts presented the relationship would be one of self-employment.

It is interesting to note that the appellant was unhappy with the Revenue’s handling of the case and Mr Justin (for HMRC) produced a lengthy note saying that he was also unhappy with the way the case had been handled and, with the guidance available, would have handled the case differently. In particular, when he gave his initial opinion that IR35 applied, he was working on new unpopular legislation and guidance that was inadequate.

Synaptek v Young CH D 2003, 75 TC 51; [2003] STC 543 [2003] EWHC645(CH)

As in the Lime-IT case, a contract was set up through an agency to provide the services of an IT consultant to an end-user, D. The minimum hours to be worked were broadly equivalent to a normal working week. It was observed that the only risk borne by Synaptek was the possibility of D becoming insolvent. The duration of the contract was for a fixed period of six months and the worker had a line manager and was required to comply with the engaging company’s instructions.

Held: IR35 should apply.

Tilbury Consulting Ltd v Gittins (NO 2), SP C 2003, [2004] SSCD 72 (SP C 390)

Tilbury Consulting Ltd (TC) provided the services of its principal director (T) to another company (C), which in turn provided them to Ford. The Revenue issued a ruling that the arrangement was within IR35; T appealed. The Special Commissioner reviewed the evidence in detail and allowed the appeal, finding: ‘the facts show that C and not Ford had been engaged as principal. It equipped itself with its own specialised personnel to discharge its own obligation to Ford, either by employing then directly or by engaging outside contractors, such as TC. F did not exercise control over the manner in which the C personnel carried out their duties. To the extent that control was exercisable over the performance of T’s services; that lay with C. Ford accepted suitable substitutes from C and TC. T was never a part of Ford’s business or undertaking’.

Held: The facts were inconsistent with an employer/employee relationship and IR35 did not apply.

The existence of a substitution clause was starting to emerge as a key consideration in establishing whether IR35 should apply, which was further reinforced in other cases, of which Ansell Computer Services Ltd v Richardson Sp C, [2004] SSCD 472 (Sp C 425) was one.

Novasoft Ltd v HMRC [2010] 

This is a defining case, which would indicate that IR35 is untenable. 

Working from home

One of the attractions of a personal service company is the ability to base your business at home. If one or more rooms are used for the purposes of business, there is an opportunity to charge some of the additional cost of services. If any part of the home is used exclusively for business, it may restrict the principal private residence relief under Section 224(1) TCGA 1992.

Provided the contractor can establish that the business really is based at home, a proportion of travel expenses to clients/customers will be allowable under section 34(2) if it is not exclusively for business. HMRC challenged the base of business in the case of Horton v Young Ca 1971, 47 TC 60; [1972] Ch157; [1971] 3 All ER 412.

Mr Horton was a self-employed bricklayer who travelled daily between his house and building sites. There was no office on the sites and his contracts were all verbal. He wrote up his books and kept his tools at home. The Court of Appeal held that he ‘had no place which you could call his place of business except his home’.

In the case of an employee, this is specifically disallowed under section 338, ITEPA 2003, although there are exceptions when the employee is based at home or travels to a temporary workplace. These are explained in the employment Income Manual at EIM32000 to EIM32154.


Another line of attack used by HMRC is the settlements legislation contained in sections 619 to 629 Income Tax (Trading and Other Income) Act 2005 (ITTOIA 2005). The well-known Arctic Systems case - Garnett v Jones HL2007, 78 TC597; [2007] STC 1536; [2007] UKHL35;[2007] 3 All ER 857 - was seen as a victory for husband and wife companies.

Mr and Mrs Jones established an IT company and they were each issued one share. Mr Jones was a director and Mrs Jones was company secretary. Both worked in the business and were paid a nominal salary for some years. When the company became profitable, they paid a dividend. HMRC sought to tax Mr Jones on the dividends on both shares, claiming that Mr Jones had made a settlement on Mrs Jones. The High Court agreed, but the decision was overturned at the Court of Appeal and the House of Lords. 

Consequences if IR35 applies

When IR35 applies, the intermediary (not the customer) is deemed to be the employer and the worker is treated as the employee of the intermediary. The customer is not affected. The income under the contract is subject to PAYE and National Insurance and the intermediary must account to HMRC for the deductions. As mentioned earlier, IR35 has no effect on employment law, so the deemed employee acquires no employment rights.

IR35 applies to companies where:

  • the worker or his family controls more than 5% of the ordinary shares of the company
  • the worker or his family is entitled to receive more than 5% of any dividends from the company
  • the worker received, or could receive, payments or benefits from the company which are not salary, but could reasonably be taken to represent payment for the services provided to clients.

IR35 applies to partnerships when:

  • the worker or his family is entitled to 60% or more of the partnership’s profits
  • most of the partnership profits come from work for a single client
  • where a partner’s share of profits is based on his income from relevant contracts
  • a ’family’ includes blood relatives and civil partners.


The intermediary must assess whether he is within the IR35 deemed payment rules. This is not an easy task since, as the case law shows, it can be difficult to ascertain and the guidance is unclear. The intermediary is obliged to calculate a deemed salary payment in order to calculate how much PAYE and National Insurance is due. He runs the risk of penalties if he gets it wrong. He can deduct 5% of his salary in respect of expenses of running the company. Other expenses can be claimed only if they would be deductible by an employed person.

IR35 - success or failure

It is no exaggeration to say that IR35 is not at all popular with contractors. It is equally true that it is disliked by their advisors, principally because of the uncertainty as to whether their clients are caught or not. Given the strict penalty regime for getting things wrong, it is understandable that it makes a lot of people very nervous.

When IR35 was introduced, the government estimated that it would generate £900m per annum in additional tax revenues. However, IR35 has actually only raised less than £2m a year in tax revenues! This is dwarfed by the cost of setting up and administering the scheme and, consequently, has actually cost the taxpaying public heavily, as well as the heartache caused for contractors and their advisors.

A survey of the Professional Contractors’ Group established that of the 1,500 of their members investigated by HMRC, only 7% were found to be within IR35.