Determining someone’s employment status for tax purposes isn’t always straightforward—especially when they provide services through their own limited company, otherwise known as a Personal service company (PSC). To prevent people from avoiding tax by working as employees in all but name, HMRC introduced the IR35 legislation, also known as the off- payroll working rules.
IR35 is part of HMRC’s wider anti-avoidance strategy. It targets “disguised employment,” where individuals use intermediaries like PSC to pay less tax, even though they work in a way that’s very similar to regular employees. The rules aim to ensure that those who work like employees pay broadly the same tax and National Insurance as those who are employed directly.
This guide breaks down how IR35 works, who it affects, and what steps you need to take to stay compliant and avoid falling foul of the rules.
What is IR35?
IR35, formally known as the off payroll working rules, is UK tax legislation introduced in April 2000. As stated above, it aims to prevent tax avoidance by individuals who supply their services to clients via an intermediary—typically their own limited company but who would be considered employees if they were contracted directly.
Before diving into technical definitions, let’s look at a real-world example to understand why IR35 matters.
Example
Imagine Emma, a graphic designer, who works full-time for a media agency in Manchester. Her role is identical to that of a regular employee, same hours, same responsibilities, same level of control but instead of being hired as an employee, she provides her services through her own limited company, known as a Personal Service Company (PSC).
Let’s compare the tax implications in both cases, assuming Emma earns £40,000 annually.
Scenario 1:
Emma as a Full-Time Employee
Component | Calculation | Amount |
|---|---|---|
Gross Salary | Fixed | £40,000 |
Personal Allowance | First £12,570 tax-free | £12,570 |
Taxable Income | £40,000 - £12,570 | £27,430 |
Income Tax @ 20% | 20% of £27,430 | £5,486 |
Employee NIC | (£40,000 - £12,570) x 8% | £2,194 |
Employer NIC | (£40,000 - £5,000) x 15% | £5,250 |
Total Tax & NIC paid to HMRC | £5,486 + £2,194 + £5,250 | £12,930 |
Note: The employment allowance threshold of £5,000 is ignored in the calculation of Employer NIC.
Scenario 2:
Ema Via PSC (Intermediaries)
Component | Calculation | Amount |
|---|---|---|
Service Fee Charged | Fixed | £40,000 |
Allowable Expenses | Assume negligible (for simplicity) | £0 |
Corporation Tax | £40,000 x 19% | £7,600 |
Employee NIC | Not applicable (no salary drawn) | £0 |
Employer NIC | Not applicable (no salary paid) | £0 |
Total Tax Paid to HMRC | Corporation Tax only | £7,600 |
What's the Issue?
As seen above, the total tax payable to HMRC via PSC is 7,600, which is £5,330 less than when working as an employee, i.e. 12,930. Even though he’s performing the same duties as a permanent employee. This is what HMRC calls “disguised employment.
Purpose of IR35
The primary goal of IR35 is to ensure fairness in the tax system by:
- Preventing "disguised employment"
Where individuals work as employees in all but name, using intermediaries to avoid paying standard employment taxes. - Ensuring equitable tax contributions
Workers operating like employees should pay similar Income Tax and National Insurance Contributions (NICs) as those employed directly.
How IR35 Applies in Practice?
When a contract falls inside IR35, the individual is treated as deemed employee for tax purposes—even though they operate through their own limited company (Personal Service Company, or PSC).
In such cases, the PSC must:
- Treat the income from relevant engagements as if it were paid as salary at the end of the tax year.
- Pay Income Tax and NICs (both employer and employee) on this “notional salary” (see below).
- Account for the taxes to HMRC by 19 April following the end of the tax year.
Example
Notional Salary Calculation
Continuing with the above example, where Emma earns £40,000 from a contract that falls inside IR35. She hasn't drawn a salary, made pension contributions, or paid any Employer NICs yet. She incurred £1,000 in allowable expenses. Assuming the client is a small business, the tax calculation is as follows:
Component | Calculation | Amount |
|---|---|---|
Gross fee received | Fixed | £40,000 |
Less: 5% flat-rate deduction | 5% x £40,000 | (£2,000) |
Less: Allowable expenses | e.g. travel, subscriptions | (£1,000) |
Less: Salary already paid | None | (£0) |
Less: Pension contributions | None | (£0) |
Less: Employer NICs paid | None | (£0) |
Deemed employment income (gross) | £40,000 - £2,000 - £1,000 | £37,000 |
Less: Employer's NIC on above | £37,000 x (15/115) | £4,826 |
Notional salary (taxable income) | £37,000 - £4,826 | £32,174 |
Note
- Employer’s NIC is calculated using the formula:
Deemed gross income × (NIC rate ÷ (100 + NIC rate))
This method is required by HMRC because the notional salary is treated as inclusive of Employer NIC.
- The £5,000 tax-free band for Employer Class 1 cannot be used to reduce Employer NICs on deemed salary under IR35.
Summary
Under IR35, the PSC will:
- Pay Income Tax and Employee NIC on the notional salary of £32,174 (as if paid to Emma).
- Pay Employer NIC of £4,826 separately to HMRC.
- Claim both as deductible expenses when calculating their Corporation Tax liability to avoid the double taxation.
Who is Affected by IR35?
The IR35 (off-payroll working) rules impact on several parties involved in contracting arrangements. Understanding who is affected is essential to ensure proper compliance and tax treatment.
Workers (Contractors/Freelancers)
These are individuals who provide services to clients through an intermediary, usually their own limited company, also known as a Personal Service Company (PSC).
If the nature of their working arrangement resembles that of an employee, IR35 may apply—meaning their income will be taxed in a similar way to that of a regular employee.
Examples
- IT consultants working long-term for a single client under client supervision.
- Engineers, designers, or healthcare professionals operating through their own limited companies.
Clients (End Users of the Services)
Clients are the organisations that receive the workers’ services. Their responsibilities under IR35 depend on their sector (public or private) and size (as defined by the Companies Act 2006).
- In the public sector and for medium or large private-sector clients, the client is responsible for assessing the worker's employment status for tax. If the arrangement falls within IR35, it is the responsibility of the clients to deduct income tax and employee's Class 1 NICs from the payments made to the PSC and pay employer's Class 1 NICs to HMRC.
- For small private-sector clients, the responsibility for determining status remains with the worker’s intermediary. If the arrangement falls outside IR35, the above responsibility is passed to the PSC.
Agencies or Fee-Payers (if involved)
An agency is any third-party entity that supplies the worker’s services to the client. If they are the fee-payer (i.e., the one paying the intermediary), they must:
- Deduct PAYE tax and NICs if the engagement falls inside IR35.
- Report payments to HMRC via Real Time Information (RTI).
- Pay employer NICs and, if applicable, the Apprenticeship Levy.
Determining Employment Status
One of the most important aspects of the IR35 rules is figuring out whether a contractor is effectively working as an employee. This decision—whether a contract falls inside or outside IR35—determines how tax should be paid.
- Inside IR35 means HMRC sees the contractor as an employee for tax purposes, even if they’re working through their own company. In this case, Income Tax and National Insurance must be deducted at source, just like with a regular employee.
- Outside IR35 means the contractor is genuinely self-employed, and their company can continue to receive payments in full, handling taxes separately.
Using HMRC’s CEST Tool
To help with this decision, HMRC has developed the Check Employment Status for Tax (CEST) tool. It asks a series of questions about how the contract works in practice and gives an opinion on whether IR35 applies.
- The tool is not legally binding but is commonly used by clients, agencies, and contractors.
- If used properly and the answers are accurate, HMRC says it will stand by the result.
You can find the tool on HMRC's website and use it for free before signing a new contract or reviewing an existing one.
Factors That influence Status
There’s no single test to decide if a contract is caught by IR35—it’s about looking at the full picture. However, HMRC and the courts often focus on a few key areas:
1. Control
This refers to who decides how, when, and where the work is done.
- If the client sets the working hours, chooses the location, and dictates how the work should be carried out, it suggests that the worker is under their control—much like an employee.
- On the other hand, if the contractor is free to decide how they complete the task and manage their own schedule, it points toward self-employment and being outside IR35.
2. Substitution
This looks at whether the contractor can send someone else to do the job.
- A genuine business relationship allows for substitution, meaning the contractor can appoint another qualified person to carry out the work, without needing the client’s approval.
- If the client insists that only the named contractor can perform the work, this suggests an employment-style relationship (inside IR35).
3. Mutuality of Obligation (MOO)
This examines whether there is an ongoing obligation between the client and the contractor.
- If the client is expected to keep offering work and the contractor is expected to keep accepting it, it indicates mutual obligation similar to a regular job.
- A contractor relationship usually works on a project-by-project basis, with no expectation of further work once the current task is complete.
4. Financial Risk and Equipment
This considers whether the contractor bears financial risks and uses their own tools.
- Contractors operating outside IR35 often use their own equipment, pay for their own insurance, and may not get paid if the work isn’t satisfactory.
- In contrast, employees typically use the employer’s resources and face little to no financial risk.
Note
You can’t just rely on one or two points to determine status. HMRC looks at the entire working relationship, how the contract is written and how the work is actually carried out in real life. Even if a contract says one thing, the actual working practices could show something different.
How IR35 Works in the Public and Private Sectors?
Public Sector
Since April 2017, public sector clients have been responsible for determining the employment status of contractors. If they conclude that the worker falls inside IR35, the fee-payer—who could be the agency or the client—must deduct Income Tax and NICs before making payments.
Private Sector
Since April 2021, these same rules also apply to medium and large private sector clients. That means these clients must:
- Determine the employment status of workers.
- Provide a Status Determination Statement (SDS) with reasons.
- Communicate the SDS to the worker and any agency involved.
Small private sector businesses (as defined below) are exempt, and the responsibility for determining IR35 status remains with the worker’s intermediary (PSC).
Definition of a Small Business
A business is considered small if it meets two or more of the following criteria:
- An annual turnover of not more than £10.2 million,
- Balance sheet total of not more than £5.1 million,
- 50 employees or fewer.
Working Through an Umbrella Company
When a worker is employed through an umbrella company, the off-payroll working rules (IR35) generally do not apply.
This is because the umbrella company acts as the contractor’s direct employer and operates PAYE—deducting Income Tax and National Insurance Contributions before paying the worker.
Key Points to Keep in Mind
- Check Compliance: Make sure the umbrella company is legitimate and fully compliant with tax laws.
- Avoid Tax Avoidance Schemes: Be cautious of any umbrella offering unusually high take-home pay through loans or other non-taxable arrangements—these are often non-compliant and can leave you with unexpected tax bills.
- Pay slip Clarity: Your pay slip should clearly show your pay, deductions (employee NIC, tax), and should not include any employer deductions from your gross pay.
Record Keeping and Compliance
Maintaining accurate records is essential for both clients and intermediaries to demonstrate compliance with the off-payroll working rules (IR35). HMRC may request evidence of decisions made and processes followed, especially in the case of an investigation or dispute.
What Should Be Recorded?
Clients and intermediaries should:
- Keep all Status Determination Statements (SDS): Each SDS issued must be saved, along with the reasoning and evidence behind the determination.
- Record communication: Maintain a record of all communications with the worker and agency (if applicable) regarding the SDS, including when it was issued and any disputes raised.
- Document the use of CEST or other assessment methods: If HMRC’s CEST (Check Employment Status for Tax) tool is used, download and retain the result along with the answers provided.
- Maintain audit trails: Ensure a clear trail showing how decisions were made and who was involved in making them.
Failing to keep adequate records could increase the risk of non-compliance and potential tax liability.
Penalties for Non-Compliance
Failing to comply with IR35 can result in:
- Liability for unpaid tax and NICs – including both employer and employee National Insurance Contributions, plus any income tax that should have been deducted.
- Interest on late payments – HMRC charges interest from the date the tax should have been paid until the date it is settled.
- Financial penalties – especially where reasonable care has not been taken in determining employment status or issuing the correct SDS.
However, if a client can demonstrate that they took reasonable care—such as using HMRC’s CEST tool properly, keeping records, and assessing each engagement individually—HMRC may reduce or waive the penalties.
Conclusion
Navigating the off-payroll working rules (IR35) can be complex, but understanding your responsibilities whether you're a contractor, client, or agency is essential to staying on the right side of HMRC. With the right processes in place, including accurate status determinations, record-keeping, and awareness of the roles within the supply chain, you can minimise the risk of unexpected tax liabilities and penalties.
By taking reasonable care, using tools like HMRC’s CEST, and seeking professional advice where needed, organisations and contractors can meet their obligations with confidence. IR35 is not just about compliance, it’s about fairness and clarity in working arrangements, helping ensure that everyone pays the correct tax in line with how they actually work.
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