IR35 came in to effect in 2000.

In the late 1980’s HMRC introduced a new rulemaking any recruitment company engaging self-employed workers liable for any unpaid tax if they failed to deduct full PAYE prior to payment to the contractor.

Almost overnight every recruitment company refused to deal with self-employed contractors; as they saw the risks and potential costs as too great, forcing contractors to set themselves up through their own limited companies. (The recruitment companies did not hold any liability for unpaid taxes where they dealt with a limited company)

Contractors quickly became familiar with this new way of working and recognized the additional opportunities it represented in maximizing their returns.

HMRC, shortly after making these changes, realized that their tax takes from the market had reduced significantly as a result of contractors maximizing their returns and, in an attempt to regain some of these losses, they introduced new legislation in 2000:  IR35; also known as the intermediaries Legislation.

At the time of introducing the legislation the contracting market had experienced significant growth and HMRC suggested that IR35 was being introduced to protect the workers. Their perception was that employers were forcing workers to engage through contracts as a way of avoiding many of their employer’s responsibilities and costs.

The idea behind IR35 was to attempt to establish the true employment status of the contractor. In simple terms; it was to examine the relationship between the contractor and the end user to establish whether it was one of ‘disguised employment’ or a genuine business to business relationship.

The resulting legislation prescribes that where the relationship is considered to be similar to a traditional employee – employer it would be categorized as deemed employed for tax purposes.  It was also made clear that deemed employed for tax purposes was just that – for tax purposes, and did not provide any employment rights or associated benefits to the worker.   Furthermore, where a relationship was seen as that of deemed employed a special set of tax rules would be applied closing many of the traditional benefits open to those operating through their own limited company.

Contractors who were deemed employed now had to pay all their income under the traditional PAYE rules, the most tax inefficient payment structure, although they were provided with a standard 5% allowance that could be paid gross to cover the expenses incurred in running a limited company.   The only other expenses allowed were those that could have been claimed by full time employees; effectively disallowing the majority of expenses contractors were claiming at that time.

This was seen by HMRC as a major disincentive to individuals who were considering setting up as contractors; as if they were caught by the IR35 rules they would have to pay tax as if they were employees without any of the benefits provided to employees such as; sick pay, holiday pay etc.