Understanding IR35 and Off-Payroll Working Rules

Few areas of UK tax law generate as much confusion — and as much anxiety — as IR35. Since the off-payroll working rules were extended to the private sector in April 2021, every medium and large business that engages contractors through personal service companies has had to grapple with employment status determinations, fee-payer obligations, and the risk of getting it wrong.

This guide explains what IR35 is, how the off-payroll rules work in practice, and what steps you should take to stay on the right side of HMRC.

What is IR35?

IR35 is the name given to the intermediaries legislation, originally introduced in 2000. Its purpose is to tackle what HMRC calls "disguised employment" — situations where a worker provides their services through an intermediary (usually a personal service company or PSC) but would be considered an employee if they were engaged directly.

The core question IR35 asks is: if you stripped away the intermediary, would the working arrangement look like employment? If the answer is yes, the worker is "inside IR35" and should be taxed as an employee — paying income tax and National Insurance through PAYE rather than taking dividends from their company.

Who is responsible for making the determination?

Before April 2021, the contractor's own company was responsible for deciding whether IR35 applied to an engagement. The off-payroll working rules shifted that responsibility to the end client — but only for medium and large businesses.

A business is considered medium or large if it meets two or more of the following thresholds:

• Annual turnover above £10.2 million
• Balance sheet total above £5.1 million
• More than 50 employees

If your business falls below all three thresholds, you are a small company and the responsibility remains with the contractor's PSC. However, you should still understand the rules, because they affect who you can engage and on what terms.

The three tests of employment status

HMRC and the courts use three primary tests to determine whether an engagement is one of employment or self-employment. No single test is decisive — it is the overall picture that matters.

Personal service

Does the contractor have a genuine right to send a substitute to do the work in their place? If they must perform the work personally, this points towards employment. If they can (and in practice would) send a suitably qualified replacement without the client's approval, this points towards self-employment.

The substitution clause in the contract must be real and exercisable, not just theoretical. HMRC will look at what actually happens in practice, not just what the paperwork says.

Mutuality of obligation

Is there a mutual obligation for the client to provide work and for the contractor to accept it? In an employment relationship, the employer must offer work and the employee must do it. In a genuine contracting arrangement, there is no obligation on either side beyond the specific project or deliverable.

If a contractor has been working for you continuously for two years with no gaps, receiving regular assignments without any formal engagement process, the mutuality of obligation test is likely to point towards employment.

Control

Does the client control how, when, and where the work is done? Employees are typically told how to do their job, when to work, and where to work. Contractors, by contrast, should have significant autonomy over their methods, schedule, and working location.

If your contractor must attend your office from 9 to 5, follow your processes, report to a line manager, and cannot work for other clients during the engagement, those are strong indicators of employment — regardless of what the contract says.

How to make a status determination

For medium and large businesses, the process works as follows:

1. Assess the engagement using the three tests above. HMRC provides a free online tool called CEST (Check Employment Status for Tax) to help, though it has been criticised for producing incorrect results in borderline cases.

2. Issue a Status Determination Statement (SDS) to the contractor and the fee-payer (which may be an agency sitting between you and the contractor). The SDS must state your conclusion — inside or outside IR35 — and the reasons for reaching it.

3. Take reasonable care in making the determination. This means considering the actual working practices, not just the contract terms. If you fail to take reasonable care, HMRC can transfer the tax liability to you as the end client.

4. Maintain records of your assessments, the evidence you considered, and any disagreements raised by contractors. You may need to defend your determinations years later if HMRC opens an enquiry.

What happens if an engagement is inside IR35?

If you determine that IR35 applies, the fee-payer (the entity that pays the contractor's PSC) must deduct income tax and employee National Insurance from the payment before passing it on. The fee-payer must also pay employer National Insurance on top.

In practice, this means the contractor receives significantly less money than they would under an outside-IR35 arrangement. Many contractors will negotiate higher day rates to compensate, or they may choose not to work with you at all.

The fee-payer is responsible for operating PAYE and reporting the deductions through Real Time Information (RTI), just as they would for an employee. If the fee-payer is an agency, the obligation falls on them. If you engage the contractor directly, the obligation is yours.

The disagreement process

Contractors have the right to challenge your status determination. If a contractor disagrees with your SDS, they must provide their reasons in writing. You then have 45 days to respond with either a revised determination or a confirmation of the original one, together with your reasons.

Ignoring a disagreement or failing to respond within the deadline does not just create bad feeling — it can shift the tax liability to you as the end client. Take every disagreement seriously and respond promptly.

Common mistakes businesses make

Blanket determinations. Some businesses have taken an "inside IR35 for everyone" approach to avoid the complexity of individual assessments. This is not taking reasonable care — it is avoiding the obligation entirely. It also drives away skilled contractors who genuinely operate outside IR35.

Relying solely on CEST. While CEST is a useful starting point, it does not cover all the relevant factors and has been shown to produce inaccurate results in some cases. Supplement it with professional advice for borderline engagements.

Ignoring working practices. The contract might say the contractor can send a substitute, but if they have never done so and you would not accept one, HMRC will look at the reality. Ensure your working practices match the contractual terms.

Failing to reassess. Engagements can change over time. A contractor who started on a defined project with clear deliverables might gradually shift into a role that looks more like a permanent position. Reassess your determinations regularly, especially when the scope of work changes.

Record keeping and payroll integration

Managing IR35 compliance becomes significantly easier when your contractor engagements are tracked alongside your regular payroll. You need to know which contractors are inside IR35, when their determinations were made, and when they are due for reassessment.

Good payroll and HR software can help you manage this alongside your standard PAYE obligations, ensuring that deductions are calculated correctly and reported to HMRC on time.

The penalties for getting it wrong

If HMRC determines that you have failed to take reasonable care, or that your status determinations are incorrect, the tax liability can be transferred from the contractor's PSC to you as the end client. This includes income tax, employee and employer National Insurance, and potentially interest and penalties.

In serious cases, HMRC can also pursue penalties for careless or deliberate inaccuracies in tax returns, which can add up to 100% of the tax underpaid.

Looking ahead

IR35 remains one of the most contentious areas of UK tax policy. The rules have been subject to multiple reviews, consultations, and revisions since their introduction, and further changes are possible. Staying informed, maintaining good records, and taking genuine care with each determination is the best way to protect your business — whatever changes come next.

The bottom line: engage contractors on their merits, assess each engagement honestly, and document everything. IR35 compliance is not about finding loopholes — it is about getting the working relationship right from the start.