IR35 Explained: A Guide for UK Contractors and Hirers

IR35 — formally known as the off-payroll working rules — is one of the most complex areas of UK tax law for contractors and the businesses that hire them. This guide explains what IR35 is, how status is determined, and how both contractors and clients can stay compliant.

1. What is IR35?

IR35 was introduced in 2000 (named after the Inland Revenue press release “IR 35”) to tackle what HMRC calls “disguised employment” — where an individual performs work that is effectively employment but routes their income through a limited company (Personal Service Company, or PSC) to pay less tax and National Insurance.

If your contract falls inside IR35, HMRC treats you as an employee for tax purposes, even if you are working through your own company. You must pay income tax and National Insurance on your income as if you were on the client's payroll.

2. Who IR35 applies to

IR35 applies to contractors operating through a Personal Service Company (PSC) — typically a one-person limited company. It does not apply to:

• Sole traders (different rules apply)
• Employees directly on a payroll
• Partnerships providing genuinely independent services

If you work through an umbrella company, IR35 does not apply because you are already treated as an employee of the umbrella company.

3. Determining status — the 3 key tests

Status is determined by looking at the actual working relationship, not just the words in the contract. The three primary tests come from employment law case precedent:

Substitution

Can you send a substitute to do the work instead of you? A genuine right of substitution — where the client accepts work from someone else without having to agree to each specific person — is a strong indicator of contractor status. A nominal or theoretical substitution clause that is never actually used carries less weight.

Control

Does the client control where, when, and howyou work? High levels of control over your working methods, hours, and location suggest employment. Genuine contractors set their own methods and hours, even if the output must meet the client's specifications.

Mutuality of obligation

Is the client obliged to offer you future work, and are you obliged to accept it? Employment relationships typically involve an ongoing expectation of work. Contractors should have no automatic right to future contracts and no obligation to accept further work.

Supporting factors

• Financial risk — do you risk your own money, e.g. if the project fails?
• Equipment — do you use your own tools and equipment?
• Multiple clients — working for several clients simultaneously supports contractor status
• Business-like behaviour — your own website, business insurance, marketing

4. Status Determination Statement (SDS)

Since the April 2021 private sector reforms, medium and large companies that engage contractors through PSCs must issue a Status Determination Statement before the engagement begins. The SDS must:

• State the IR35 determination (inside or outside)
• Give reasons for the determination
• Be passed down the supply chain to all parties (agency, PSC)

Contractors have the right to challenge an SDS through the client's disagreement process. The client must respond within 45 days. If a client fails to issue a valid SDS, the tax liability stays with the client.

5. Who pays — private sector rules since April 2021

The fee-payer(usually the agency, or the end client if direct) is responsible for deducting income tax and National Insurance and paying employer's NI, where the contract is found to be inside IR35.

Small company exemption— If the end-client is a small company (meeting 2 of 3 criteria: turnover under £10.2M, balance sheet under £5.1M, fewer than 50 employees), the contractor's PSC remains responsible for determining its own status under the old pre-2021 rules.

For public sector engagements, the client has been responsible since April 2017.

6. Inside IR35 — tax implications

When a contract is inside IR35:

• Income is subject to PAYE income tax and employee NI deducted at source by the fee-payer
• The fee-payer also pays employer's NI (13.8%)
• You cannot pay yourself via dividends and take advantage of the lower dividend tax rate
• Most business expenses are no longer deductible (travel to a regular workplace, equipment the client provides)
• Your effective tax rate increases significantly compared to an outside-IR35 arrangement
• You can still take a small salary from your PSC and claim a 5% allowance (removed for public sector from 2017, removed for private sector from April 2023)

7. Outside IR35 — protecting your position

To maintain a genuine outside-IR35 position:

• Ensure your contract reflects the actual working reality— a contract saying “substitution permitted” while you always attend the same office every day will not protect you
• Include a genuine substitution clause and, if possible, have exercised it at least once
• Avoid a permanent or fixed workspaceat the client's site
• Ensure there is no automatic right of continued work between engagements
• Use your own equipment where possible
• Work for multiple clients to demonstrate a genuine business
• Have your own professional indemnity and public liability insurance

8. CEST tool

HMRC's Check Employment Status for Tax (CEST) tool is available free at GOV.UK. HMRC will stand by the result if the information given is accurate and in good faith.

Limitations to be aware of:

• CEST does not directly address mutuality of obligation
• It can return “unable to determine” for complex cases
• Employment tribunals are not bound by CEST results

For high-value or long-term contracts, specialist IR35 legal advice alongside CEST is strongly recommended.

9. Penalty risks for clients

If a client issues an incorrect SDS and the contract should have been inside IR35:

• The client (or fee-payer) becomes liable for the unpaid PAYE income tax and National Insurance
• HMRC can charge interest on unpaid amounts from the date they were due
• Penalties for inaccurate SDS range from 0% (prompted, reasonable care) to 100% of the tax unpaid in cases of deliberate concealment
• HMRC has increased its focus on IR35 compliance checks since 2023

10. Blanket bans on PSC contractors

Following the 2021 reforms, many large businesses — including banks, financial services firms, and major corporates — issued blanket bans on engaging contractors via PSCs to avoid compliance risk entirely. Contractors affected by blanket bans have limited legal recourse unless the ban can be shown to be indirectly discriminatory. If you face a blanket ban:

• Consider working through an umbrella company (you become an employee of the umbrella)
• Negotiate a direct employment contract
• Seek alternative clients who accept PSC contractors

Key dates