IR35: recording income received from contracts where the client’s customer deducts Income Tax and National Insurance
This article explains how FreeAgent supports IR35 rules for public and private sector contracts where the client’s customer deducts Income Tax and National Insurance (NI) contributions from the amount that the client invoices. For other types of private sector contracts, please read the guidance on how FreeAgent supports IR35 when your client’s company is required to make a deemed payment.
Before you start
If your client expects to work on a contract where their customer will deduct Income Tax and NI from their invoice, you or your client should create a new income category in FreeAgent for tax and NI deducted at source through IR35 rules.
Select 'Settings' from the drop-down menu in the top-right corner of the screen, select 'Accounting Categories' and complete the required information.
You or your client should then complete the steps outlined below every time they undertake a piece of work for a customer who will deduct Income Tax and NI from your client’s invoices under IR35 rules. If a project is created in FreeAgent for these contracts, do not tick the IR35 checkbox as this only relates to contracts where your client’s company is required to make a deemed payment.
1. Create the invoice
When your client completes a piece of work for a contract where their customer will deduct Income Tax and NI from their invoice, you or your client should create the invoice in FreeAgent and select ‘Sales’ as the income category. Don't select the category that you or your client created for tax and NI deducted at source.
When your client’s customer pays the invoice, they will deduct Income Tax and NI contributions from the invoice amount and will pay this to HMRC on your client’s behalf. The amount your client receives will be the amount of the invoice minus the value of these Income Tax and NI contributions.
For example, if your client completes work for a total of £1,200, their customer will be deducting Tax and NI before paying them, so your client will still create and send them an invoice for £1,200.
2. Split the bank transaction for charges deducted
Once the invoice has been paid and the corresponding bank transaction has appeared in your client’s FreeAgent account (minus the Income Tax and NI contributions deducted by their customer), you or your client need to split the bank transaction to explain the amount that their customer deducted from the invoice.
To do this, you or your client should navigate to ‘Banking’ from the menu at the top of the screen and select ‘Bank Accounts’ from the drop-down menu. Navigate to the relevant bank account in the client's FreeAgent account and select the payment received from the customer. Choose ‘More Options’ and then edit the amount to reflect the full value of the invoice that was raised. Explain the transaction as an ‘Invoice Receipt’ and save the changes.
Doing this will generate a ‘Money Out’ transaction for the amount of the Income Tax and NI that your client’s customer deducted at source (i.e. the difference between the amount that your client invoiced and the amount that their customer paid them). Select this transaction and then choose ‘Sales Refund’ from the transaction 'Type' drop-down menu. Select the new income category you or your client created for tax and NI deducted at source from the ‘Category’ drop-down menu and set the VAT rate to 'Out of Scope'. Select 'Explain Transaction' to complete the process.
Following on from the previous example, once your client has invoiced their customer for £1,200 and received payment for £1,000, you or your client will need to mark that the invoice has been paid in full in FreeAgent. To do this, navigate to the relevant bank transaction in FreeAgent, select ‘More Options’ and change the value to £1,200. This will create a new ‘Money Out’ transaction with a value of £200 to reflect the amount of tax and NI their customer deducted from the invoice.
Next, you or your client will need to explain the £200 as ‘Type: Sales Refund’, ‘VAT: Out of Scope’, and choose the category you or your client created to record IR35 deductions.
3. Report the amount that your client received to HMRC through RTI
If your client chooses to take this money out of their company as part of their salary, the final part of the process is reporting the information to HMRC through FreeAgent’s payroll.
To do this, you or your client should prepare payroll for the relevant month as normal in order to generate a payslip for that month. Select the ‘Edit’ button next to the payslip and then enter the amount that your client's company received from their customer, excluding VAT and the amount of Income Tax and NI that the customer deducted, in the ‘Pay Not Subject to Tax or NI’ field. This would be £1,000 in the example above. Your client will pay the VAT to HMRC through their VAT return as usual.
The 'Basic Pay' field would only be needed if your client was taking a salary from the company separately from the money your client's customer is paying them. For example, if your client was taking £1900 a month from the company and the client's customer paid them £1000 under IR35, the payslip would contain £1900 basic pay and £1000 tax/NI free pay, which would be £2,900 in total. However, if your client wasn't taking £1900 a month from the company, the payslip would only contain the £1000 tax/NI free pay. Please note that the payslip that your client's customer sends them will have different year-to-date figures as their payslip will include all the deductions.
Alternatively, if your client expects to receive the same amount every month from contracts where the customer deducts Income Tax and NI from the client's invoices, you or your client can edit their payroll profile and enter this information in the ‘Pay Not Subject to Tax or NI’ field of the ‘Monthly Pay’ area.
4. Include this income on your Self Assessment Tax Return
HMRC have said that income earned in this way should be included on the individual's tax return as if it were employment income paid to them by their customer.
FreeAgent won’t do this automatically, so you or your client will need to add a new set of Employment pages to their tax return and include the total income they invoiced in the tax year, excluding VAT, in box 1.
Then, include the income tax (not the National Insurance) that your client's customer deducted from their invoices in box 2.
Select 'Yes' in box 8 to show that the income was earned through an off-payroll working arrangement.