TL;DR

Off-payroll working - commonly known as IR35 - refers to the tax legislation in Chapter 10 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003) that determines whether a contractor working through a personal service company (PSC) or other intermediary should be taxed as an employee. Since April 2021, medium and large private sector organisations bear responsibility for determining IR35 status, issuing a Status Determination Statement (SDS), and operating PAYE where the engagement is inside IR35. Errors carry PAYE and NIC liability at the fee payer level, with penalties up to 100% of unpaid tax for careless or deliberate misclassification.

What This Means in Practice

IR35 does not prevent contractors from operating through limited companies - it determines whether those companies are a genuine business intermediary or a vehicle for disguised employment. The test asks a single question: if the personal service company did not exist and the contractor worked directly for the client, would that person be an employee? If the answer is yes, the engagement is inside IR35 and the contractor must be taxed as an employee, regardless of what the contract between the PSC and the client says.

The legal tests applied to determine IR35 status are the same common law employment status tests used across all UK employment contexts: control (does the client direct how, when, and where the work is done?), substitution (does the contractor have an unfettered right to send a suitable substitute without client approval?), and mutuality of obligation (is there an obligation on the client to offer work and the contractor to accept it?). Additional factors considered include whether the contractor works exclusively for one client, uses the client's equipment, works set hours at the client's premises, and is integrated into the client's management structure.

Prior to April 2021, the contractor's own PSC was responsible for applying the IR35 test and paying the appropriate tax if the engagement was inside IR35. This self-assessment model generated substantial non-compliance because contractors had a direct financial incentive to find their engagements outside IR35. The April 2021 reform (which applied to the public sector from April 2017) shifted this responsibility to the end client for medium and large businesses. Small companies are still subject to the old rules, meaning the PSC remains responsible for IR35 determination for engagements with clients that qualify as small companies under the Companies Act 2006 (turnover below £10.2 million, balance sheet below £5.1 million, fewer than 50 employees - two of three must be met).

The practical consequence of an inside-IR35 determination is that the fee payer - the party that pays the PSC's invoice, which in most supply chains is the staffing agency rather than the end client - must operate PAYE on the relevant portion of the invoice. The agency deducts income tax and employee NICs and pays employer NICs on top, in the same way as for a directly employed worker. The contractor's PSC receives a reduced payment (the net amount after deductions), and the contractor draws from the PSC with no further PAYE obligation on the same income.

Why Recruitment Agencies Need to Know This

Agencies sitting in the payment chain between the end client and the contractor's PSC are the fee payer under the off-payroll rules, which means they bear PAYE and NIC liability for incorrect inside-IR35 determinations. If the client issues an SDS indicating inside IR35, the agency must operate PAYE. If the agency fails to do so - whether because it was given incorrect information by the client or because it failed to obtain the SDS - the agency is liable for the unpaid tax.

This creates two distinct liability risks. The first is where the client provides a faulty SDS that says outside IR35 when the engagement is actually inside - the agency's liability in this scenario transfers back to the client under Chapter 10 ITEPA 2003 if the client provided fraudulent or inaccurate information. The second is where the agency fails to request an SDS at all or does not cascade the determination correctly through the supply chain. In this case, liability stays with the agency regardless of what the client intended.

For agencies running large books of PSC contractors, the administrative burden is significant. Each engagement requires a documented SDS, a process for receiving challenges from contractors, and a dispute resolution timeline (clients must respond to SDS challenges within 45 days or be treated as agreeing the determination was incorrect). Agencies acting as the fee payer must also ensure they obtain the SDS before making the first payment on an inside-IR35 engagement.

HMRC's compliance approach has focused on large-scale investigations of contractors in financial services, technology, and media sectors. Agencies that supply contractors into investment banks, broadcasters, or government departments have faced the heaviest scrutiny. HMRC's Connect analytics system cross-references PSC accounts, personal tax returns, and payroll data to identify discrepancies that indicate outside-IR35 treatment of what HMRC believes are inside-IR35 engagements.

In Practice

A specialist IT staffing agency places a data architect through the architect's PSC with a financial services client. The client, which qualifies as a large company under the Companies Act 2006, issues an SDS in February stating the engagement is inside IR35. The architect's PSC invoices the agency at £850 per day for a 20-day month.

The agency processes the invoice under the off-payroll rules. The deemed employment payment is £17,000. The agency deducts income tax at 40% on the amount above the basic rate band (adjusting for the month's allocation of the personal allowance), deducts employee NICs at 8%, and pays employer NICs at 13.8% over the secondary threshold. The contractor's PSC receives a net payment of approximately £10,840. The agency pays the employer NICs in addition to the invoice amount.

The architect challenges the SDS, arguing the right of substitution in the contract is genuine. The client conducts the 45-day review, concludes the substitution clause is not exercised in practice and the engagement remains inside IR35, and issues a revised SDS with the same determination and a documented rationale. The agency continues operating PAYE. The architect's PSC remains dormant for tax purposes on this income stream.

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