What is IR35, Rules Explained: A Complete Guide for UK Contractors and Businesses

IR35 is UK tax legislation designed to determine whether a contractor working through their own limited company should be treated as an employee for tax purposes. Also known as “off-payroll working rules,” IR35 affects how contractors pay Income Tax and National Insurance contributions.

IR35 legislation applies when HMRC considers a contractor to be a “disguised employee” – someone who works like an employee but operates through their own company to potentially reduce tax obligations. The rules ensure that individuals who work in an employment-like manner pay similar tax and National Insurance contributions to employees.

Key Purpose: IR35 prevents tax avoidance where contractors might otherwise pay corporation tax (19-25%) plus dividend tax instead of higher Income Tax rates and National Insurance contributions that employees pay.

Who It Affects: Contractors working through personal service companies (PSCs), typically limited companies, who provide services to clients either directly or through recruitment agencies.

How IR35 Works: Inside vs Outside

IR35 status determines how contractors pay tax on their earnings, creating two distinct scenarios:

Outside IR35 (Not Caught)

When a contract is deemed outside IR35, contractors can:

• Pay themselves a small salary (typically around £12,570 to utilise the Personal Allowance)
• Extract remaining profits as dividends, paying dividend tax rates
• Claim legitimate business expenses
• Benefit from entrepreneurs’ relief on eventual company sale

Inside IR35 (Caught)

When caught by IR35, contractors must:

• Pay Income Tax and National Insurance as if they were employees
• Lose access to most business expense deductions
• Have taxes deducted at source by the client or agency
• Miss out on dividend tax advantages

IR35 Determination Rules: Private vs Public Sector

The assessment process differs significantly depending on whether you’re working with private or public sector clients.

Public Sector (Since 2017)

Client Responsibility: Public sector clients must assess each contractor’s IR35 status and issue a Status Determination Statement (SDS).

Payment Process: If inside IR35, the public sector client deducts tax and NICs directly from payments, treating the contractor like an employee for tax purposes.

Private Sector (Since April 2021)

Size Threshold: Only medium and large private companies (meeting two of: £10.2m turnover, £5.1m balance sheet, 50+ employees) must make IR35 determinations.

Client Determination: Qualifying clients assess IR35 status and issue Status Determination Statements, with the fee-payer (often recruitment agencies) responsible for tax deductions when inside IR35.

Small Company Exception: Small private sector clients are exempt – contractors continue to self-assess their IR35 status.

The Three Key Tests for IR35 Status

HMRC and tribunals evaluate IR35 status using three primary tests, each carrying different weight in the overall assessment:

1. Control (Most Important)

Definition: Whether the client controls what work is done, how it’s performed, when it’s completed, and where it takes place.

Employee Indicators:

• Client dictates working hours and location
• Client provides detailed instructions on task completion
• Limited autonomy over work methods
• Required attendance at meetings and company events

Contractor Indicators:

• Freedom to decide how to complete deliverables
• Flexible working arrangements
• Autonomy over work methods and timing
• Focus on results rather than prescribed processes

2. Substitution (Highly Significant)

Personal Service Requirement: Whether the contractor must personally perform the work or can send someone else in their place.

Strong Contractor Indicators:

• Unrestricted right to send substitutes
• No client approval required for replacement workers
• Contractor bears cost of substitution
• Previous use of substitutes accepted by client

Employee Indicators:

• Contract requires personal service
• Client approval needed for any substitutes
• Limited or no substitution rights
• Client relationship depends on specific individual

3. Mutuality of Obligation (Supporting Factor)

Definition: Whether there’s an ongoing obligation for the client to provide work and the contractor to accept it.

Employee Indicators:

• Expectation of ongoing work availability
• Contractor obliged to accept offered work
• Regular, predictable work patterns
• Integration into client’s organisational structure

Contractor Indicators:

• Project-based engagements with defined end dates
• No guarantee of future work
• Freedom to decline additional projects
• Arms-length commercial relationship

Additional Factors Affecting IR35 Status

Beyond the three main tests, several other factors influence IR35 determinations:

Financial Risk

Contractor Indicators:

• Responsibility for correcting defective work at own cost
• Investment in equipment, tools, or premises
• Potential for profit or loss based on performance
• Commercial invoicing arrangements

Integration and Part of Organisation

Employee-Like Indicators:

• Integration into client’s organisational structure
• Use of client email addresses and business cards
• Inclusion in internal communications and directories
• Participation in employee benefits or social activities

Equipment and Premises

While less significant than historical cases suggested, equipment provision still matters:

• Contractor Indicators: Providing own laptop, software, tools
• Employee Indicators: Client provides all necessary equipment

IR35 Assessment Tools and Resources

HMRC’s Check Employment Status for Tax (CEST) Tool

HMRC’s official online tool helps assess IR35 status, though it has limitations:

Advantages:

• Free and officially recognised
• HMRC generally accepts determinations showing contracts outside IR35
• Regularly updated to reflect current guidance

Limitations:

• Doesn’t cover all scenarios comprehensively
• Some questions lack nuance for complex arrangements
• May not reflect tribunal decisions on borderline cases

Professional IR35 Reviews

Many contractors opt for professional reviews providing:

• Detailed contract analysis
• Comprehensive status reports
• Insurance backing for determinations
• Ongoing support for contract negotiations

Consequences of Getting IR35 Wrong

For Contractors

Inside IR35 (Incorrectly Assessed as Outside):

• HMRC can demand back taxes covering up to 6 years
• Interest and penalties on unpaid amounts
• Potential National Insurance contributions owed
• Personal liability even when working through limited companies

For Clients and Agencies

Medium/Large Private Sector Clients:

• Liability for unpaid Income Tax and NICs when making incorrect outside IR35 determinations
• Transfer of liability to fee-payer (usually agencies)
• Penalties for unreasonable care in making determinations

IR35 Planning and Mitigation Strategies

Contract Structure

Key Elements for Outside IR35:

• Clear substitution clauses with practical ability to use
• Results-focused deliverables rather than time-based work
• Flexible working arrangements
• Commercial termination clauses
• Equipment and expense provisions

Working Practices

Behavioral Factors:

• Maintain arm’s length commercial relationships
• Avoid integration into client’s organisational structure
• Use own equipment where practical
• Invoice professionally with clear payment terms
• Demonstrate financial risk through project-based pricing

Multiple Client Strategy

Working with several clients simultaneously strengthens outside IR35 position by demonstrating:

• Genuine business operation
• Commercial independence
• Diversified income streams
• Reduced dependency on single clients

Recent IR35 Developments and Future Changes

2021 Private Sector Reforms

The extension of off-payroll working rules to large private sector clients significantly changed the contractor landscape:

• Shift from contractor self-assessment to client determination
• Increased compliance burden on clients
• Greater certainty but reduced flexibility for contractors

Ongoing HMRC Focus

HMRC continues prioritising IR35 compliance through:

• Increased investigations and enquiries
• Improved guidance and tooling
• Closer scrutiny of high-risk sectors
• Enhanced data collection and analysis capabilities

External Links to HMRC/GOV