IR35 – Deemed Payment and the treatment of expenses

The main purpose of IR35 is to remove the tax advantage of taking income as dividends where, in practice, the contractor is working more like an employee than a genuinely independent business.

If your contract is caught by IR35 and your limited company is responsible for operating the rules, most of the income from that engagement may need to be treated as employment income.

Scroll down for important information on the Off-Payroll rules and when the 5% allowance is available.

Expenses under IR35 – the 5% allowance

If your contract falls within IR35 and your company is still responsible for the deemed payment calculation, you can deduct a flat-rate 5% allowance from the relevant contract income.

The allowance is intended to cover the general cost of running the intermediary and you do not need receipts or an itemised breakdown.

You may also be able to deduct certain expenses when calculating the deemed payment. These are not the same as ordinary limited company business expenses. In general, they must be expenses you could have claimed against employment income if you had been employed directly by the client.

Employer pension contributions can also be deducted separately as part of the deemed payment calculation.

For a full explanation of how the allowance works and when it applies, see our guide: IR35: the 5% allowance explained.

Off-Payroll: when the 5% allowance no longer applies

Since April 2017 in the public sector and April 2021 for most private-sector engagements, the Off-Payroll Working rules can move responsibility for determining IR35 status away from the contractor’s company and onto the client.

If your client is a medium or large organisation and the contract is inside IR35, the fee-payer will normally deduct PAYE tax and National Insurance from the relevant payment. In this case, the 5% allowance is not available.

The allowance can still apply where the end client is a small private-sector client, or where the client is wholly overseas and the Chapter 10 rules do not apply.

For more details, read: Off-Payroll IR35 rules – what is the small companies exemption?

IR35 deemed payment calculation

If Chapter 8 applies and your company receives gross income from an inside-IR35 engagement, it may need to calculate a deemed employment payment at the end of the tax year.

The calculation broadly follows these steps:

1. Start with the income your company received during the tax year from engagements caught by Chapter 8.
2. Deduct the 5% general expenses allowance.
3. Add any relevant payments or benefits made directly to you by the client which have not already been taxed.
4. Deduct qualifying expenses and capital allowances allowed under the deemed payment rules.
5. Deduct qualifying employer pension contributions made by the company.
6. Deduct Employer National Insurance already paid by the company on salary or benefits provided to you.
7. Deduct salary and benefits already taxed as employment income.
8. Calculate the Employer National Insurance due on the remaining amount and deduct this to arrive at the final deemed employment payment.

If the income has already been taxed under the Chapter 10 Off-Payroll rules, your company does not carry out this Chapter 8 deemed payment calculation for that income.

HMRC provides a worked example here: ESM8150 – deemed payment example.

Speak to your accountant

IR35 and deemed payment calculations can become complicated, especially where there are several contracts, different types of expenses or payments made at different points in the tax year.

If you are unsure how the rules apply to your company, ask your accountant or an IR35 specialist to check the calculation.