IR35 is one of the most important tax legislations affecting contractors and freelancers in the UK. Officially known as the Intermediaries Legislation, IR35 was introduced to tackle tax avoidance by individuals working through personal service companies (PSCs) while functioning like regular employees. If you are a contractor, freelancer, or business engaging such individuals, understanding IR35 is essential to ensure compliance and avoid costly penalties.
This article breaks down IR35 in simple terms, explaining its purpose, impact, how to determine IR35 status, and what happens if you are caught inside IR35.
Learn more about IR35 rules and their impact on contractors.The official term for IR35 is the Intermediaries Legislation. And in fact, IR35 was just the title of the press release issued by HMRC in 1999 ahead of its introduction in 2000. It read, ‘Inland Revenue 35’, hence the term IR35.
IR35 is a tax legislation that aims to prevent disguised employment. By this we mean that it’s in force to identify if a contractor is genuinely self-employed or is working as a disguised employee and therefore avoiding tax.
In theory, its existence makes sense. But in practice, the arrival of IR35 over two decades ago brought with it a number of issues - the biggest of which is how you tell the difference between a genuine contractor and a disguised employee.
A contractor working for a company as an IT consultant but performing the same duties as a full-time employee may fall under IR35.
IR35 applies to both private and public sector organisations, with recent changes placing the responsibility for determining IR35 status on the hiring company in many cases.
Before IR35, many workers operated through limited companies or umbrella companies to benefit from tax advantages. This meant they could:
Pay themselves a small salary and take most income as dividends, reducing tax liability.
Avoid employer National Insurance contributions (NICs) as they were technically not employees.
To close this loophole, IR35 was introduced in April 2000, forcing contractors to assess their employment status and ensuring they pay taxes fairly if they work under employment-like conditions.
If you work outside IR35 your contract and working practices are structured in a way that reflects a genuine business to business relationship. In other words, you are truly self-employed and therefore can continue to pay yourself via your limited company - sometimes referred to as a personal service company (PSC) - with a certain level of tax efficiency.
In contrast, if you deliver your services to a client in a manner that resembles employment, you should be operating inside IR35. Due to this, HMRC is of the view that you should be taxed like an employee. You’ll therefore pay Income Tax and National Insurance Contributions (NICs), as an employee.
Both of the above terms are known as ‘IR35 status’. We’ll now explain some of the factors that are taken into account when determining IR35 status.
| Feature | Inside IR35 | Outside IR35 |
|---|---|---|
| Tax treatment | PAYE (Income Tax & NICs) | Corporation Tax, Dividend Tax |
| Employment rights | No employment rights | Full control over contracts |
| Financial control | Limited control | Greater financial benefits |
HMRC assesses whether a contractor is inside or outside IR35 using several key criteria:
Control
This relates to the level of control that exists in the working relationship. If, for example, you find that your client has a high level of control over how you deliver your services (such as your working hours, where you’re expected to work from and the autonomy you have over your work), you may find that your assignment points towards an employment relationship and therefore belongs inside IR35.
Look at it like this - while employees must abide by the processes of their employer, often report to managers, work from an office and typically have set working hours, in theory, a genuine contractor should have some freedom over how they carry out their work.
Mutuality of Obligation (MOO)
MOO focuses on the obligation a client has to provide paid work to you and the obligation you have to accept this work. In an ideal world, in an outside IR35 contract MOO shouldn’t exist. Contractors, as business owners, should be able to turn down work from clients as and when they want. Employees, on the other hand, have an obligation to work for their employer, which is why MOO is present in employment contracts.
Personal Service
This is centred on whether you provide your services as a business or as you, Joe Bloggs. Again, to strengthen your case for operating outside IR35, it’s important not to deliver a personal service. This is something that employees do and it puts you at risk of your contract being classed as inside IR35.
Many contractors opt to include the right of substitution in their contract (and exercise this right), given it begins to paint a picture of a business to business relationship. For example, an employee couldn’t send in someone else - even if they were qualified - to do their work. But a true contractor should be able to.
Part and parcel - is the contractor part and parcel of their client’s organisation, like an employee? Or is there a clear and distinct difference between how they are treated?
Financial risk - will the contractor rectify mistakes made when delivering their services in their own time, like a business carrying out work would? Or does the financial risk lie with the employer, as it does when an employee makes an error?
Business in your own account - is the contractor in business on their own account? Do they hold insurance? Have a website? Work with multiple clients simultaneously? Or is the limited company they work through simply a vehicle for avoiding tax?
When it comes to determining IR35 status, the words ‘picture painting’ are often used. In other words, all factors should be considered, which will then begin to paint a picture of either self-employment or employment.
HMRC's CEST Tool
HMRC provides an online tool called Check Employment Status for Tax (CEST) to help businesses and contractors determine IR35 status.
Many contractors inside IR35 opt to work through an umbrella company to simplify tax and payroll management. An umbrella company acts as an intermediary between the contractor and the client, handling tax deductions and employment benefits.
Benefits of an Umbrella Company
PAYE Tax Compliance: The umbrella company deducts Income Tax and National Insurance at source.
Employment Rights: Contractors under umbrella companies receive benefits such as holiday pay, sick pay, and maternity/paternity leave.
Simplified Administration: No need to worry about filing corporate tax returns or managing company accounts.
Avoid IR35 Hassles: Since the umbrella company directly employs you, IR35 does not apply.
Drawbacks of an Umbrella Company
Higher Tax Burden: No tax advantages like dividends; contractors pay full PAYE tax.
Umbrella Company Fees: Most umbrella companies charge a weekly or monthly fee for their services.
Less Control: Contractors working under an umbrella company have less financial flexibility than those operating through a limited company.
A limited company (personal service company or PSC) allows contractors to operate as a separate legal entity, offering tax efficiency and financial flexibility. However, IR35 directly impacts limited company contractors, requiring careful tax planning.
Advantages of a Limited Company (Outside IR35)
Tax Efficiency: Contractors can split income between salary and dividends, reducing overall tax liability.
Financial Control: You can decide how and when to pay yourself.
Business Growth: You can work with multiple clients and expand your business.
Limited Liability: Your personal assets are separate from company liabilities.
Disadvantages of a Limited Company (Inside IR35)
Higher Tax Payments: If inside IR35, you must pay PAYE tax, reducing take-home pay.
Administrative Burden: Running a limited company involves accounting, bookkeeping, and compliance costs.
IR35 Risk: Frequent HMRC investigations can lead to financial penalties if wrongly classified.
To remain outside IR35, contractors must structure their contracts and working practices correctly. This includes ensuring autonomy, taking on financial risks, and avoiding employer-like dependencies.
When IR35 was enforced in 2000, contractors were responsible for determining their own status. However, the government has long held the opinion that contractors have been abusing the rules (although there’s no real proof of this) and so introduced IR35 reform, first in the public sector in April 2017 before rolling out similar changes in the private sector in April 2021.
The responsibility for determining IR35 status depends on the type of organisation:
Public Sector & Medium/Large Private Sector Clients: The hiring organisation is responsible for deciding IR35 status.
Small Private Sector Clients: The contractor remains responsible for determining their own IR35 status.
If the client is responsible, they must provide a Status Determination Statement (SDS) explaining their decision. Contractors can challenge an SDS if they disagree with the assessment.
Following IR35 reform, it’s now nearly always up to the end client to assess the IR35 status of the contractors they engage.
In the public sector, all organisations are tasked with this, while in the private sector, medium and large businesses must administer the rules. Businesses that qualify as small are exempt from IR35 reform, which means that contractors engaged by them are still responsible for determining their own status.
It’s not just the responsibility of assessment that has shifted from the contractor, but also the risk, also known as the liability. This has transferred from the contractor to the end client, but HMRC will look to recoup the tax liability from the fee payer when the end client can demonstrate they took reasonable care in making the decision. For this reason, compliance throughout the supply chain, including any recruitment agencies, is required.
Needless to say, given the financial difference between working inside or outside IR35, contractors are advised to make sure they are operating under the correct status - even if in the majority of cases it will be their client who determines this position.
Contractors can take several proactive steps to protect themselves:
IR35 is a complex but crucial legislation for UK contractors and businesses. Understanding your IR35 status, structuring contracts correctly, and seeking expert guidance can help ensure compliance while maximising tax efficiency.