What is IR35?

IR35 Explained

IR35 refers to the UK’s off-payroll working rules, originally introduced in April 2000 through the Intermediaries Legislation (now Chapter 8 of Part 2 of the Income Tax (Earnings and Pensions) Act 2003). The rules are designed to ensure that workers who provide services through an intermediary — typically a personal service company (PSC) — pay broadly the same income tax and National Insurance contributions as employees if the nature of their engagement resembles employment.

The name “IR35” comes from the Inland Revenue press release that first announced the legislation.

Why IR35 Exists

Without IR35, an individual could set up a limited company, contract their services to a client through that company, and extract profits as dividends rather than salary. Dividends are taxed at lower rates than employment income and are not subject to NICs, resulting in a significantly lower tax bill compared to an employee doing the same work.

IR35 closes this gap by deeming the contractor’s income to be employment income when the underlying relationship is one of employment.

Who Determines Employment Status?

The responsibility for determining whether IR35 applies depends on the size of the end client:

Medium and Large Clients (Private Sector from April 2021, Public Sector from April 2017)

For engagements with medium and large private sector businesses and all public sector organisations, the end client is responsible for determining the worker’s employment status. This is known as the off-payroll working rules.

A company is medium or large for these rules when it exceeds at least two of the three small company thresholds in the Companies Act 2006:

• Annual turnover above the small company limit
• Balance sheet total above the small company limit
• More than 50 employees

The turnover and balance sheet limits are raised from time to time (for example, for financial years starting on or after 6 April 2025), so check the current limits against the client’s latest accounts.

The client must:

1. Assess the employment status for each contractor engagement
2. Issue a Status Determination Statement (SDS) setting out the conclusion and reasons
3. Pass the SDS to the contractor and the next party in the labour supply chain (typically an agency)
4. Take reasonable care in making the determination

If the engagement is deemed inside IR35, the fee-payer (the entity paying the PSC) must deduct income tax and NICs before payment.

Small Clients (Private Sector)

For engagements with small private sector companies, the original IR35 rules still apply. The contractor remains responsible for determining their own employment status and accounting for any deemed employment income through their PSC.

The Employment Status Tests

Determining whether a contract falls inside or outside IR35 requires examining the hypothetical contract — what the terms of engagement would be if the worker contracted directly with the client without the intermediary. The key tests established through case law are:

Control

Does the client have the right to control:

• What work is done?
• How the work is done?
• When and where the work is done?

Greater client control indicates employment. Genuine self-employment typically involves the worker having autonomy over their methods and schedule.

Substitution

Does the worker have a genuine right to send a substitute to perform the work? If the worker must perform the services personally with no right of substitution, this points towards employment. A genuine, unfettered right to substitute is a strong indicator of self-employment.

Mutuality of Obligation

Is there an obligation on the client to offer work and on the worker to accept it? In an employment relationship, the employer must provide work (or pay in lieu) and the employee must make themselves available. In genuine self-employment, either party can walk away between projects.

Other Factors

Additional factors considered include:

HMRC’s CEST Tool

HMRC provides the Check Employment Status for Tax (CEST) tool on GOV.UK. This online tool asks a series of questions about the engagement and provides an indication of whether IR35 applies.

While HMRC states it will stand by CEST results (provided the information entered is accurate), the tool has been criticised for not adequately addressing all relevant factors, particularly mutuality of obligation. Many contractors and their advisers prefer to obtain a detailed status review from a specialist.

Tax Consequences When Inside IR35

For Medium/Large Client Engagements

When a determination places the engagement inside IR35, the fee-payer must:

• Deduct income tax through PAYE
• Deduct employee NICs
• Pay employer NICs at the standard employer rate
• The contractor receives reduced net pay

The PSC can deduct a 5% allowance from the deemed payment to cover its running costs.

For Small Client Engagements

Where the contractor self-assesses as inside IR35, they must calculate the deemed employment payment at the end of the tax year and pay income tax and NICs on it through their PSC.

Outside IR35

If the engagement is genuinely outside IR35, the contractor can pay themselves a combination of salary and dividends through their PSC, benefiting from lower overall tax rates. However, they must ensure the working practices genuinely reflect self-employment.

Challenging a Status Determination

When a worker disagrees with a client’s SDS, they can:

1. Raise a dispute with the client, providing reasons for disagreeing
2. The client must respond within 45 days, either confirming or withdrawing the determination
3. If the client does not respond within 45 days, the tax liability transfers to the client

Workers can also apply to HMRC for a formal status determination, though this is a separate process.

Penalties and Compliance

HMRC can investigate IR35 compliance and, where it finds non-compliance:

• Recover unpaid tax, NICs, and interest
• Impose penalties of up to 100% of the unpaid tax for deliberate non-compliance
• Transfer liability up the supply chain if the fee-payer fails to comply

For the first 12 months after the April 2021 private sector reforms, HMRC applied a light touch approach, not charging penalties for inadvertent errors. This period has now ended.

Practical Steps for Contractors

Contractors working through a PSC should:

• Obtain a written contract that reflects the actual working arrangements
• Ensure they have a genuine right of substitution and can demonstrate it
• Avoid working exclusively for one client where possible
• Maintain their own professional indemnity insurance
• Use their own equipment where practical
• Keep evidence of how working practices differ from those of employees

IR35 and Other Tax Considerations

Contractors caught by IR35 face a significantly higher tax burden. Understanding the interplay with tax-deductible expenses and corporation tax is important for managing the financial impact.

Contractors in the construction sector should also be aware of the Construction Industry Scheme, which has its own deduction requirements that interact with IR35.

Maintaining robust accounting records is essential for demonstrating compliance with IR35 rules, particularly when HMRC conducts investigations.