IR35 refers to the off-payroll working rules that determine whether a contractor working through an intermediary (typically a personal service company or PSC) should be taxed as an employee for income tax and National Insurance purposes. Since April 2021, medium and large private sector businesses and all public sector organisations are responsible for determining the employment status of contractors they engage and, where IR35 applies, operating PAYE on the payments made.
For the broader legal framework, see the full IR35 guide. This article focuses on the payroll mechanics when a contractor falls inside IR35.
Who Is Responsible for the Status Determination
Medium and Large Businesses
The end client (the organisation receiving the contractor’s services) must make the Status Determination Statement (SDS) if they meet two or more of the following thresholds:
| Threshold | Amount |
|---|---|
| Annual turnover | Above the Companies Act small company limit |
| Balance sheet total | Above the Companies Act small company limit |
| Number of employees | More than 50 |
The Companies Act turnover and balance sheet limits were raised to £15 million and £7.5 million for financial years beginning on or after 6 April 2025. The off-payroll rules apply the higher limits with a delay, so check on GOV.UK which limits apply to the client’s financial year.
Small Companies
If the end client qualifies as a small company under the Companies Act 2006 (below all three thresholds), the responsibility for determining status and paying the correct tax remains with the contractor’s PSC, as it did under the original IR35 rules.
Public Sector
All public sector bodies are treated as medium/large regardless of size and must make the determination.
The Status Determination Statement
The end client must:
- Assess the contractor’s employment status using HMRC’s Check Employment Status for Tax (CEST) tool or other reasonable methods
- Issue a Status Determination Statement to the contractor and the next party in the chain (typically the recruitment agency or fee-payer)
- Include reasons for the determination within the SDS
- Maintain a process for handling disagreements — the contractor has a right to challenge the determination
The SDS must be issued before the contractor starts work or before the first payment is made.
Payroll Obligations When IR35 Applies
When a contractor is determined to be inside IR35, the fee-payer (the party directly paying the contractor’s PSC) must operate PAYE on the payments. In many engagements, the fee-payer is a recruitment agency; if there is no agency, the end client becomes the fee-payer.
Deemed Payment Calculation
The fee-payer calculates the deemed employment payment from the fees paid to the PSC:
| Step | Detail |
|---|---|
| 1. Start with gross fee | The amount invoiced by the PSC (excluding VAT) |
| 2. Deduct direct costs | Materials and expenses the contractor has incurred (if evidenced) |
| 3. Deduct employer NIC | Calculate employer NICs on the net amount |
| 4. Result | Deemed employment income subject to PAYE and employee NICs |
PAYE Deductions
The fee-payer must deduct from each payment:
- Income tax through PAYE using the contractor’s tax code
- Employee National Insurance at the standard Class 1 rates
- Student loan deductions if applicable
- Employer National Insurance — paid by the fee-payer on top of the deemed payment
The Apprenticeship Levy may also apply if the fee-payer’s annual pay bill exceeds £3 million.
RTI Reporting
Each payment to an inside-IR35 contractor must be reported through Real Time Information in the same way as a standard employee payment. The fee-payer submits a Full Payment Submission (FPS) and includes the contractor on the payroll.
Practical Payroll Considerations
Tax Code
The fee-payer must obtain the contractor’s tax code from HMRC. If no code is available, the fee-payer should use the 0T code on a week 1/month 1 basis until HMRC issues a coding notice.
Employment Rights
An inside-IR35 determination for tax purposes does not automatically grant the contractor employment rights (such as holiday pay, sick pay or unfair dismissal protection). Employment status for tax and employment status for employment law are assessed separately.
Multiple Engagements
A contractor may work for several end clients simultaneously. Each engagement is assessed individually. The contractor may be inside IR35 for one client and outside for another.
Record-Keeping
The end client must retain:
- Copies of all Status Determination Statements issued
- Evidence supporting each determination (e.g. CEST results, contractual terms, working practices questionnaires)
- Records of any disagreement process correspondence
- Documentation for at least 6 years (in line with HMRC compliance check time limits)
The fee-payer must retain standard payroll records for each inside-IR35 worker, including payslips, tax calculations and RTI submissions.
Penalties for Non-Compliance
| Failure | Consequence |
|---|---|
| End client fails to make SDS | Responsibility and liability transfer to the end client — they become the fee-payer |
| Fee-payer fails to operate PAYE | HMRC can recover unpaid tax, NICs and penalties from the fee-payer |
| Failure to take reasonable care | Liability can be transferred up the supply chain to the end client |
| Deliberate non-compliance | Penalties of up to 100% of the tax due, plus interest |
HMRC has confirmed that it will focus compliance activity on businesses, not individual contractors, under the reformed off-payroll rules.
IR35 and Payroll Software
When processing inside-IR35 contractors through PAYE payroll, payroll software should be configured to:
- Set up the contractor as an off-payroll worker (separate from regular employees)
- Apply the correct NIC category letter (typically letter A)
- Calculate the deemed payment automatically from the gross fee
- Submit the payment via RTI with the correct indicator for off-payroll workers
- Issue payslips showing the PAYE and NIC deductions
Most modern payroll systems have specific fields for off-payroll workers to ensure compliant reporting.