TL;DR

IR35 is the informal name for the UK's off-payroll working rules, which determine whether a contractor working through an intermediary (typically a Personal Service Company, or PSC) should be taxed as an employee. Since April 2021, medium and large private-sector clients — not the contractor — have been responsible for making the employment status determination and issuing a Status Determination Statement (SDS). If the engagement is "inside IR35," the fee-payer (usually the staffing agency) must deduct income tax and National Insurance Contributions (NICs) via PAYE before paying the contractor's PSC. Non-compliance can result in HMRC assessments against the agency for the unpaid tax.

Key Takeaways

• Chapter 10 of ITEPA 2003 governs the off-payroll working rules for medium and large private-sector engagers; Chapter 8 governs where the client is a small private-sector company — in Chapter 8 cases, the responsibility for determining and paying tax stays with the contractor's PSC
• A client is "small" if it meets two of three conditions in the relevant financial year: turnover ≤ £10.2m (rising to £15m from April 2025), balance sheet ≤ £5.1m (rising to £7.5m), or fewer than 50 employees
• The Status Determination Statement (SDS) must be issued by the client to the contractor and the fee-payer (staffing agency) before the engagement begins; if it is not issued, the client itself becomes the deemed employer and bears the tax liability
• HMRC's Check Employment Status for Tax (CEST) tool is the primary method for determining IR35 status; it is not legally binding but HMRC will stand behind the result if inputs were accurate and the tool returned a determination

FAQ

Q: What is the difference between "inside IR35" and "outside IR35"? A: "Inside IR35" means HMRC would consider the contractor to be a disguised employee — if they were engaged directly rather than through their PSC, they would be an employee. In this case, the fee-payer (typically the staffing agency) must deduct income tax and National Insurance via PAYE on payments to the PSC, and the contractor loses access to the tax advantages of operating through a limited company. "Outside IR35" means the contractor is genuinely self-employed and continues to receive gross payment to their PSC, taking responsibility for their own tax affairs. The determination turns on factors including control, substitution rights, and mutuality of obligation.

Q: Does IR35 apply to a US-based contractor providing services to a UK client? A: IR35 can apply to a US-based contractor if they provide services to a UK-based client through an intermediary such as a PSC, and the engagement is with a medium or large UK client under Chapter 10 of ITEPA 2003. The key test is whether the worker would be considered an employee if engaged directly. If the engagement is inside IR35, the UK client must issue an SDS and the fee-payer (which could be a US or UK staffing intermediary) must operate PAYE on payments. US contractors in this situation should take advice from a UK tax specialist.

Q: Who is liable if an IR35 determination is wrong? A: Under the off-payroll rules, if the client fails to issue an SDS or issues a "contrived" one without taking reasonable care, the liability passes back up the chain to the client. If the client issues a valid SDS but it turns out to be wrong, and the client took reasonable care (including using CEST accurately), HMRC can only collect from the fee-payer or the contractor, not the client. Staffing agencies acting as fee-payers should build contractual protections requiring clients to indemnify the agency for incorrect SDS determinations.

What IR35 Requires of Staffing Agencies

Under the off-payroll working rules that have applied to medium and large private-sector engagers since April 2021, the staffing agency occupies the fee-payer position in most contractor supply chains. As fee-payer, the agency is legally responsible for deducting income tax and National Insurance Contributions (NICs) from payments made to a contractor's PSC where the client has determined the engagement is inside IR35. The client issues the Status Determination Statement (SDS), but the agency bears the operational and financial burden of operating PAYE correctly on the gross payment to the PSC.

This creates several practical obligations. First, the agency must have a process for receiving and verifying the SDS from the client before the engagement begins. If the client fails to issue an SDS, the client itself becomes the deemed employer and the obligation shifts up the chain — but the agency should not simply start paying a contractor without confirming status determination exists. Second, where the SDS says inside IR35, the agency must calculate the deemed payment — which takes the gross fee paid to the PSC and extracts income tax and both employee and employer NICs before payment. Third, the agency must maintain records of each SDS received, the engagement dates, and the payments made. Contractors have the right to request the SDS from the agency and to raise a disagreement through the client's formal status dispute process, which the client must respond to within 45 days.

How IR35 Works in Practice

A financial services firm (large private-sector client) engages a data engineer through a staffing agency. The engineer operates through their own PSC. Before the engagement starts, the client completes a CEST assessment and determines the role is inside IR35 — the engineer has no meaningful right of substitution, the client controls their working hours and location, and the engagement is ongoing with no fixed deliverable. The client issues an SDS to both the agency and the contractor's PSC.

The agency now must operate PAYE. When the PSC invoices the agency £10,000 for the month, the agency does not pay the PSC £10,000 gross. Instead, the agency calculates the deemed payment by subtracting the employer NICs (currently 13.8% on earnings above the secondary threshold), arriving at the deemed payment amount, then applies PAYE income tax and employee NICs to that figure. The net sum goes to the PSC; HMRC receives tax and NICs through the agency's payroll. The contractor receives the after-tax residual from the PSC. Outside IR35, the same £10,000 invoice would pass gross to the PSC, and the contractor would manage their own tax through self-assessment and corporation tax.

Small Company Exemption and Chapter 8

Not all engagements fall under Chapter 10 of ITEPA 2003. Where the end client is a "small" company under Companies Act definitions — turnover at or below £10.2 million (rising to £15 million from April 2025), balance sheet at or below £5.1m (rising to £7.5m), and/or fewer than 50 employees — Chapter 8 applies instead. Under Chapter 8, the obligation to determine IR35 status and account for any resulting tax sits with the contractor's own PSC, not the client or the fee-payer. The staffing agency in a Chapter 8 chain pays gross to the PSC and has no PAYE obligation.

Agencies must verify client size annually. A client that was small in one financial year may grow above the threshold the next, shifting the engagement from Chapter 8 to Chapter 10. Agencies should build a client size review into their annual contract renewal process and include a contractual obligation on the client to notify the agency if their size classification changes during the engagement. Failure to identify a Chapter 10 transition means the agency operates under the wrong regime — which is a fee-payer compliance failure even where the error originated with the client.

HMRC Enforcement and Penalties

HMRC has operated IR35 compliance reviews against staffing agencies and their clients using a combination of targeted investigations and data-matching exercises. Where an investigation finds that a fee-payer operated PAYE incorrectly — either by failing to deduct tax on an inside-IR35 engagement or by applying the wrong deemed-payment calculation — HMRC will issue a determination of unpaid tax plus interest. Penalties for failure to take reasonable care range from 0% to 30% of the unpaid amount; for careless errors, 0–30%; for deliberate understatement, up to 70%; and for deliberate understatement with concealment, up to 100%.

The April 2024 offset mechanism addressed a long-standing inequity: previously, where HMRC collected PAYE from the fee-payer for an incorrect inside-IR35 determination, the contractor's PSC still owed corporation tax on the same income, creating double taxation. Under the offset rules, where HMRC collects from the fee-payer, the tax already paid by the PSC or contractor is credited against the fee-payer's liability. Agencies that receive indemnities from clients for incorrect SDS determinations should ensure their agreements specify how the offset mechanism interacts with any indemnity payment — overpayment recovery processes changed with the 2024 rules.