IR35

Before IR35 came into effect in 2000, some workers would set up PSCs to avoid paying employee-level taxes. These workers, while working like employees, paid less tax and NICs compared to someone in the same role as a direct employee. IR35 was then introduced to curb this “disguised employment.” For example, a project manager working for a company might leave their position as an employee, set up a limited company, and return to the same role as a contractor through their PSC. Despite performing the same duties, they would pay lower taxes. To address this loophole, IR35 was introduced to ensure fairness and to maintain the integrity of the UK tax system.

Over the years, HMRC (His Majesty’s Revenue & Customs) has tightened IR35 regulations, recognising that disguised employment affects not only tax revenue but also the broader labour market, leading to an uneven playing field between employees and contractors.

IR35 has a direct impact on how businesses and contractors structure their working relationships. For contractors, their classification as “inside IR35” or “outside IR35” determines how they are taxed:

• Inside IR35: A contractor is classified as “inside IR35” when their working arrangement is determined to be similar to that of an employee. In this case, they are deemed to be “employed for tax purposes,” even if they are technically engaged as a contractor. They are subject to deductions for income tax and NICs at source through PAYE (Pay As You Earn). This means the hiring business or agency deducts taxes before the contractor receives their pay, leaving them with a reduced take-home amount.
• Outside IR35: A contractor is classified as “outside IR35” when their working arrangement is determined as genuinely independent. In this case, they are viewed as running their own business, providing services to the client. They can pay themselves through a combination of salary and dividends from their personal service companies (PSCs), which often results in lower overall tax liabilities. Contractors outside IR35 typically have greater control over their earnings and financial arrangements. They are also not subject to NICs in the same way as those inside IR35.

Understanding whether a contractor is inside or outside IR35 is essential for both contractors and businesses. For employers, complying with IR35 means taking responsibility for assessing a contractor’s status and ensuring accurate deductions for those deemed inside IR35. This requires a careful evaluation of the contractor’s working arrangements and relationship with the business.

Note that since April 2026, the small company exemption applies to a wider group of businesses following an increase in the qualifying thresholds – companies with a turnover below £15m and a balance sheet below £7.5m may now be exempt from the off-payroll working rules entirely, with IR35 status determination reverting to the contractor’s PSC.

Here is the summary of the most recent IR35 reforms and what to expect moving forward:

• Public sector (2017): Since April 2017, public sector organisations have been responsible for determining the IR35 status of their contractors. This reform was introduced to address the issue of “disguised employees”—individuals who operate as contractors but work under conditions similar to employees, thereby avoiding full income tax and NICs. Under the Intermediaries Legislation, the responsibility for ensuring correct tax deductions shifted from the contractor to the public sector client or the fee-paying intermediary in the supply chain.
• Private sector (2021): In April 2021, similar rules were extended to medium and large businesses in the private sector. Before this date, contractors were responsible for determining their own IR35 status. Now, the hiring organisation must decide whether a contractor falls inside or outside IR35. This shift was intended to bring greater accountability and consistency to off-payroll arrangements across the UK.
• Addressing double taxation (2024): Starting April 6, 2024, the UK government addressed the issue of double taxation under IR35 by introducing a legislative fix. This change ensures that both the contractor and the fee-paying party (e.g., the client or agency) are not taxed twice on the same income. If a contractor has already paid taxes on disputed income, the fee-paying party can offset those amounts against their own tax liability. This amendment promotes fairness, reduces financial risks for businesses engaging contractors, and eliminates unnecessary tax burdens on contractors, fostering a more balanced and compliant workforce.
• April 2025: Employer NI increased from 13.8% to 15%, with the secondary threshold dropping from £9,100 to £5,000. This raised the cost of inside IR35 engagements by roughly £1,500-£3,500 per year for a typical contractor. HMRC also tightened liability transfer rules in supply chains involving umbrella companies.
• April 2026: Small company thresholds increased (turnover to £15m, balance sheet to £7.5m), reclassifying approximately 14,000 companies as small and therefore exempt from the off-payroll working rules. However, because IR35 size tests are determined by reference to the prior financial year, most affected companies will not feel the practical impact until April 2027 at the earliest – organisations should verify their prior year figures before assuming exemption applies. Separately, new umbrella company PAYE rules came into force requiring agencies to deduct PAYE directly rather than paying umbrella companies gross, with agencies and end users now jointly and severally liable if an umbrella provider fails to account for PAYE and NICs correctly.

Risks of IR35 non-compliance for employers

• Higher tax liabilities: If HMRC determines that a contractor has been misclassified as outside IR35 when they should have been inside, the hiring business could be required to pay all the unpaid taxes, employer NICs, and penalties, including interest on overdue payments. In some cases, if the employer fails to comply with IR35, employees in the company may face indirect consequences in terms of resource reallocation or future tax increases.
• Hefty fines and penalties: On top of paying backdated taxes, businesses may face significant fines if HMRC determines they failed to exercise reasonable care in assessing IR35 status. Other factors, such as poor documentation, blanket classifications, failure to reassess roles, or deliberate misclassification, can also increase the risk of penalties.
• Legal risks: If contractors are misclassified, it can trigger HMRC investigations, which may lead to fines, back taxes, and penalties. Such issues can disrupt a contractor’s business, strain client relationships, and potentially impact job security, as clients may become hesitant to continue working with contractors who pose a compliance risk. 
• Reputational damage: Non-compliance with IR35 can harm your company’s reputation, making it harder to attract contractors or employees in the future. Contractors may view the company as disorganised or unfair, while clients or partners may lose trust in the business.
• Competitive disadvantage: An organisation that is known for a poor approach to legislation would suffer a disadvantage to its competitors and may be excluded from applying for government contracts and be removed from preferred supplier lists.
• Contractual breaches: The organisation may even be in breach of contracts or terms and conditions they have agreed to and could be liable for indemnities and warranties under these if they have not complied with the legislation.

Risk of IR35 non-compliance for contractors

• Financial penalties: Contractors misclassified as outside IR35 may result in the client company being liable for back taxes and NICs, as the client is responsible for IR35 status in medium and large enterprises. HMRC can charge penalties, and interest may be added to any unpaid taxes. If non-compliance is deliberate, penalties could be as high as 100% of the unpaid tax.
• Loss of tax benefits: Contractors who are incorrectly classified as outside IR35 may lose the ability to benefit from legitimate tax advantages, such as drawing income through dividends or offsetting expenses. This can lead to unexpected reductions in take-home pay.
• Legal consequences: Non-compliance can trigger an investigation by HMRC, which can be time-consuming and costly. Contractors may need to hire legal or tax experts to defend their status. In extreme cases, deliberate tax evasion could lead to legal action or criminal charges.

Small companies are exempt from the off-payroll working rules, meaning they do not need to issue Status Determination Statements (SDS) and the responsibility for IR35 status determination sits with the contractor’s PSC rather than the hiring organisation. From April 2026, a company qualifies as small if it meets at least two of the following three criteria: annual turnover below £15m, balance sheet total below £7.5m, and fewer than 50 employees.

Your company’s size for IR35 purposes is assessed by reference to your prior financial year – not the current one. This means that even though the new thresholds took effect from 6 April 2026, most companies will not see the practical impact until April 2027 at the earliest, once their 2025-26 accounts have been filed. If you are unsure whether your company qualifies, you should review your most recent filed accounts against the three criteria above, or speak to a compliance specialist.

Two significant changes took effect from 6 April 2026. First, the small company thresholds increased, meaning approximately 14,000 additional companies are now exempt from the off-payroll working rules. Second, new umbrella company PAYE rules came into force, requiring agencies to deduct PAYE directly from umbrella workers’ pay rather than paying the umbrella company gross. Agencies and end users are now jointly and severally liable if an umbrella provider fails to account for PAYE and NICs correctly.

A Status Determination Statement is a written document that a medium or large end-user client must provide to both the contractor and any agency in the supply chain before the first payment is made. It sets out whether the engagement is inside or outside IR35 and the reasons for that determination. Clients must also provide a process for contractors or agencies to challenge the determination. Failure to issue a valid SDS transfers liability for any unpaid tax to the end-user client.

If HMRC determines that a contractor has been incorrectly classified as outside IR35, the fee payer – typically the end-user client or agency – becomes liable for all unpaid income tax, employee NICs, employer NICs, and interest on late payments. Penalties of up to 100% of the unpaid tax can apply where HMRC determines that reasonable care was not taken. Since April 2024, HMRC must take into account any tax already paid by the contractor when calculating the liability, which reduces the risk of double taxation.

CEST (Check Employment Status for Tax) is HMRC’s free online tool for assessing IR35 status. While it provides a useful starting point, it has been criticised for not covering all relevant case law factors – notably mutuality of obligation. HMRC has stated it will stand behind CEST results provided the information entered is accurate, but the tool returns an “undetermined” result in a significant proportion of cases. Most compliance specialists recommend using CEST alongside a thorough review of actual working practices, rather than relying on it as the sole basis for a determination.

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