IR35 legislation is a set of anti-avoidance tax laws that eliminate tax discrepancies between contractors and employees with the same responsibilities.
Inland Revenue 35 (IR35) is a form of U.K. legislation that specifically targets “disguised employees.” Her Majesty’s Revenue and Customs (HMRC) defines disguised employees as workers who provide services to clients through their own limited companies while functioning essentially as employees.
Also known as “off-payroll working rules,” IR35 legislation ensures that these contractors pay similar income tax and National Insurance Contributions as regular employees in comparable roles. The rule is designed to close the “deemed employment” tax loophole when firms hire contractors to fulfill employees’ roles. Preventing deemed employment also ensures that:
- Firms pay proper employment taxes for their workforce
- Firms provide employees with appropriate benefits
- Contractors pay income taxes and national insurance contributions (NICs)
Initially, it was the contractor’s responsibility to determine whether their contract fell within IR35, but this proved challenging to enforce. Now, the responsibility to correctly classify laborers falls on public and private sector employers, which increases employers’ risks of hiring independent contractors in the United Kingdom.
Because of this liability, it’s crucial for employers who hire independent contractors or sole proprietors in the U.K. to understand the legislation and its organizational impacts. This guide explains what scenarios this legislation applies to and how organizations can ensure global compliance with the newest regulations.
The off-payroll working rules (IR35)
IR35’s off-payroll working rules mandate contractors working through intermediaries to pay similar tax and insurance contributions as regular employees when essentially functioning as employees. An intermediary is usually the worker’s limited company, often called a Personal Service Company (PSC).
Since their introduction in 2000, the rules have undergone significant changes in two key phases. In April 2017, public-sector organizations became responsible for determining contractors’ employment status and managing appropriate tax deductions. This reform shifted the responsibility from contractors’ PSCs to public-sector clients, affecting organizations like local authorities, universities, and national service bodies.
In April 2021, these requirements extended to medium and large private sector organizations. This expansion applies to businesses meeting at least two of these criteria:
- Annual turnover exceeding £10.2 million
- Balance sheet total over £5.1 million
- More than 50 employees
The reforms address what HMRC identified as widespread non-compliance, with estimates showing that less than 10% of PSCs correctly applied the rules before the changes. Under the current system, the end client must:
- Determine the employment status of contractors
- Issue status determination statements
- Maintain detailed records of determinations
- Establish processes for handling status disagreements
Today, the legislation affects approximately 180,000 individuals who work through PSCs and would be considered employees if engaged directly. Due to the IR35 reform, the contractor PSC population has been dramatically reduced, with up to 200,000 contractors no longer operating through limited companies. The financial impact has been substantial, with the Treasury valuing IR35 at £1.8 billion annually in tax revenue.
Who do IR35 rules apply to?
IR35 legislation creates a framework for determining employment status when contractors provide services through intermediaries. This tax legislation affects three primary groups: individual contractors, end clients, and fee-payers.
Individual contractors
Contractors operating through PSCs or other intermediaries must understand their position relative to IR35. The legislation applies when these professionals provide services to clients through:
- Their own limited company (PSC)
- A partnership
- Another intermediary structure
End client responsibilities
Medium and large organizations must take an active role in IR35 compliance. These businesses have specific obligations:
- Determine the IR35 status of all contractor engagements
- Issue Status Determination Statements (SDS)
- Maintain precise records of all determinations
- Implement status disagreement processes
Fee payer obligations
When a contract falls inside IR35, the fee payer assumes significant responsibilities:
- Deduct income tax from contractor payments
- Process insurance contributions
- Handle employer NICs without deducting from contractor wages
- Submit all deductions to HMRC
Inside vs. outside IR35
The classification of a contract as inside or outside IR35 determines how payments and taxes are handled:
Inside IR35
- Contractor is treated as an employee for tax purposes
- Fee-payer manages tax and NIC deductions
- Employment-style tax treatment applies
Outside IR35
- Contractor maintains self-employed status
- Payment is processed through invoicing
- Contractor manages their own tax affairs
Small business exemption
Small organizations remain exempt from determining IR35 status if they meet two or more of these criteria:
- Annual turnover below £10.2 million
- Balance sheet total under £5.1 million
- 50 or fewer employees
In these cases, the contractor’s PSC retains responsibility for determining IR35 status and managing tax obligations.
When the rules apply
IR35 rules come into effect when specific working arrangements and employment characteristics are present in a contractor-client relationship.
Triggering conditions
The legislation applies when a contractor provides services through an intermediary structure while operating in an employee-like capacity. Key triggers include:
- Services delivered through an obvious Personal Service Company
- Work performed through a partnership or managed service company
- Direct engagement with end clients through these intermediary structures
Employment status indicators
Three primary factors determine whether a contract falls inside IR35:
Control and supervision
The rules likely apply when the client dictates:
- Working hours and schedule
- Location of work
- Methods and procedures
- Direct oversight of tasks and deliverables
Right of substitution
A genuine right of substitution suggests outside IR35 status. The contractor should:
- Have the ability to send a qualified replacement
- Bear the cost of the substitute
- Maintain control over the substitute’s work
Mutuality of obligation
Inside IR35 indicators include:
- Expected regular work patterns
- Guaranteed minimum hours
- Client obligation to provide ongoing work
- Contractor obligation to accept offered work
Additional status tests
- Financial risk. A contractor typically demonstrates genuine financial risk by investing in their own equipment, carrying professional insurance, and being responsible for fixing defective work at their own expense. They may also incur losses or gain profits based on project outcomes.
- Integration. The degree of integration into a client’s organization is assessed through factors like access to staff benefits, use of company email addresses, and participation in internal meetings. A contractor who is deeply embedded in the client’s organization is more likely to be considered inside IR35.
- Business structure. A genuine business structure is evidenced through maintaining a professional marketing presence, operating from dedicated business premises, serving multiple clients, and holding relevant professional certifications that demonstrate independence from any single client.
Working through an umbrella company
An umbrella company serves as an intermediary employer for contractors, managing payroll administration and tax obligations while providing statutory employment benefits. These organizations create a formal employment relationship with contractors who work on temporary assignments for various end clients.
How umbrella companies work
The umbrella company becomes the contractor’s legal employer, creating a continuous employment structure across multiple assignments. The company processes payments through Pay As You Earn (PAYE), deducting income tax and NICs before paying the contractor. This arrangement establishes a clear chain of payment from the end client through any recruitment agencies to the umbrella company.
Benefits for contractors
Working through an umbrella company offers several advantages:
- Statutory employment rights, including sick pay and holiday pay
- Pension contributions and other employee benefits
- Simplified administration with no company accounts or tax returns
- Continuous employment record between assignments
- Professional insurance coverage
Financial considerations
The umbrella company model typically results in higher tax obligations than operating through a PSC. The contractor receives employee status and pays full PAYE tax and NICs. While this reduces take-home pay, it eliminates concerns about IR35 status and provides greater certainty around tax obligations.
Unfortunately, the government’s published guidance on umbrella companies is “largely unhelpful,” warns Julia Kermode, CEO of PayePass, a company specializing in umbrella company compliance.
“The government’s latest guidance on umbrella companies is basic at best. With tax avoidance schemes getting smarter and continuously exploring new ways to lure in recruiters and workers, this document is nowhere near comprehensive enough,” she adds, highlighting that agencies should take matters into their own hands and prioritize compliance themselves.
What happens if IR35 applies?
When IR35 applies, contractors lose significant control over their tax arrangements as employment taxes must be deducted from the source. The fee-payer must deduct income tax and contributions before paying the contractor’s limited company.
Tax deduction process
The fee-payer calculates a “deemed direct payment,” which treats the contractor’s fees as employment income. From this amount, they deduct PAYE tax and employee NICs while also paying employer NICs and any applicable Apprenticeship Levy. These employer contributions cannot be lawfully deducted from the contractor’s fees.
Responsibilities and consequences
When IR35 applies, each party in the contracting chain faces specific obligations and potential risks:
- Contractors must adapt to receiving payments after tax and NICs deductions, losing tax planning flexibility while maintaining responsibility for company administration despite reduced tax benefits.
- End clients and fee payers assume the critical responsibility of issuing Status Determination Statements, managing correct tax deductions, and bearing liability for any unpaid taxes resulting from incorrect determinations.
- Non-compliance carries severe penalties, ranging from 30% for careless mistakes to 100% for deliberate concealment of tax obligations. Additionally, HMRC holds investigation powers extending back four years for income tax and six years for NICs.
The issue with IR35 legislation is that rules are branded as “too complex,” according to a survey in which half of contractors believe they’ve been subjected to blanket classification.
“IR35 misclassifications are a risk to both the business making them and the workers impacted. They are non-compliant, carry the risks of claims for employment rights, inflate contract rates, reduce take-home pay, and limit access to the best talent,” Matt Fryer, Managing Director of Brookson Group, told People Management.
Tax avoidance schemes
Tax avoidance schemes promise unrealistic take-home pay through complex payment structures that attempt to exploit tax legislation loopholes. Here’s what contractors need to know:
Common schemes
- Disguised remuneration through non-repayable loans
- Offshore trust arrangements
- Split contracts dividing income
- Employee Benefit Trusts (EBTs)
Warning signs
- Promises of take-home pay above 80% of gross income
- Payment splitting between taxed and untaxed amounts
- Offshore payment routing
- False claims of “HMRC approval”
Consequences
- Mandatory repayment of unpaid taxes plus interest
- Penalties up to 100% of unpaid taxes
- Potential criminal prosecution
- Retrospective investigation powers
- Professional reputation damage
Protection
Contractors can protect themselves by accurately determining their status using HMRC’s Check Employment Status for Tax (CEST) tool and maintaining detailed records of all tax arrangements. It’s crucial to seek advice from qualified tax professionals who thoroughly understand IR35 legislation and approach any scheme promising unusually high returns with extreme caution.
HMRC actively pursues and penalizes both scheme users and promoters. Its enforcement powers include daily penalties and public naming of non-compliant schemes.
Employee vs. contractor classification: 7 factors for businesses to consider
IR35 case law established a set of employment tests that employers can use to classify all workers under their purview. The assessment criteria include:
- Control
- Substitution
- Mutuality of obligation
- Miscellaneous factors
These tests should be evaluated together to accurately assess one’s employment. Be wary of making a decision based on a single factor.
Employers should also remember that HMRC assesses these factors based on the written contract and actual working practices. If the two are not consistent, “implied” terms can supersede the written terms of a contract.
1. Control
- Inside IR35. An individual is an employee if the client controls how and when they execute their responsibilities, as well as which duties they perform.
- Potentially outside IR35. If the individual can control the constraints around their work, they might not be bound by IR35.
2. Substitution
- Inside IR35. An individual is an employee if the client does not allow them to pass off or substitute responsibilities to another individual.
- Potentially outside IR35. If the individual can send someone to complete the work in their place, then they might be a contractor outside IR35.
3. Mutuality of obligation
- Inside IR35. An individual is an employee if they are obliged to offer their services, and the client is equally obliged to accept those services.
- Potentially outside IR35. If the individual has the right to refuse work, they might be outside IR35.
Four other factors
Control, substitution, and mutuality of obligation are the primary considerations in determining employment classification. However, they don’t always paint a complete picture of the situation.
Other factors to consider include:
- The type of contract
- How the individual is paid
- Their level of financial risk
- If they supply the equipment necessary to complete their responsibilities
Each factor is enough to distinguish an inside IR35 contract from an outside one and avoid misclassification risks.
Hire global talent and maintain compliance with an HR partner
Independent contractors invite risks. With the IR35 legislation, businesses must expose any intentional or unintentional worker-employer relationships, and employers face penalties for misclassifying workers.
Navigating the hiring process in the U.K. is difficult, but businesses can save time and effort by partnering with Velocity Global’s Employer of Record (EOR). With the assistance of an EOR, employers can compliantly hire talented employees, ensure independent contractor compliance, and build a robust and scalable team.
Learn more about how Velocity Global’s team of international employment experts guides firms in understanding IR35 changes, complexities, and other U.K. employment law considerations. Reach out to us today.
Disclaimer: The intent of this document is solely to provide general and preliminary information for private use. Do not rely on it as an alternative to legal, financial, taxation, or accountancy advice from an appropriately qualified professional. © 2025 Velocity Global, LLC. All rights reserved.
