In the first of two articles, Peter Rayney explains how to navigate the IR35 and off-payroll working rules.
The ‘original’ IR35 rules - now found in ITEPA 2003, Pt 2, Ch 8 – have been in place for some twenty-five years. Gordon Brown introduced this legislation with the aim of tackling ‘disguised employment’ arrangements. Broadly, these arose where workers or contractors personally provided their services to the client or end-user through a personal service company (PSC).
This is illustrated below:
In recent years, radical changes have been made to the original provisions. The current position is now as follows:
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If the PSC supplies the relevant services to a ‘small’ business (i.e., the client or end-user), the PSC owner is responsible for determining whether the services are supplied under an ‘employment relationship’. If they are, the PSC must calculate the deemed employment income and apply PAYE and Class 1 National Insurance contributions (NICs). For simplicity, this is referred to as the IR35 regime.
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If the PSC supplies its services to a large or medium-sized business or any public sector entity (of any size), the recipient client or end-user is responsible for determining whether the services are provided under a deemed employment relationship. Where this is the case, the client or end-user must deduct PAYE and account for Class 1 NICs. This is often described as off-payroll working.
IR35 regime
To be within IR35, the owner-worker must hold at least 5% of the ordinary share capital of the PSC, which will invariably be the case. Furthermore, the client or end-user must be a ‘small business’ (as determined largely under the Companies Act 2006 definitions).
In a supply chain, the ‘small business’ test is only applied to the end-engager or client – the size of the other firms involved in the chain is irrelevant and the size of the PSC is not a factor.
On an ongoing basis, a singleton company is treated as ‘small’ for a tax year starting after the Companies Act 2006 accounts filing deadline for an accounting period in which it qualified as small. This is normally nine months after the end of the accounting period, so there can be quite a lag between the actual ‘tested’ accounting period and the relevant tax year for IR35.
Since April 2025, the definition of a small business has changed (two of the relevant thresholds have increased). Thus, a company or business will now be ‘small’ if it satisfies at least two of the following three criteria for the relevant accounting period (group companies are dealt with on a ‘consolidated’ basis):
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annual turnover no more than £15m; |
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gross balance sheet total no more than £7.5m; or |
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average number of employees no more than 50. |
Of course, many PSC owners may be unable to determine the status of their clients, customers or end-users. Consequently, the law provides that they can ask ‘their’ client or end-user to confirm whether they are a small business. The confirmation must be given within 45 days. This is to provide certainty to the workers and others involved about the relevant tax rules that will apply (see HMRC’s Employment Status Manual at ESM10011A).
PSC responsible for status determination
The owner-worker of a PSC is effectively responsible for determining whether the PSC’s fee income should be treated as ‘employment’ or ‘self-employment’ income. The test is determined by ignoring the PSC and imputing a hypothetical contract directly between the worker and the client or end-user.
If this analysis shows that the income from the contract is within IR35 (i.e., it arises from an employment relationship), the fee must be included in the IR35 calculations (see example below). Importantly, any income arising from the PSC providing the owner’s services as a director will always be caught by IR35.
On the other hand, if the PSC owner considers there is a genuine ‘self-employment’ relationship with the client or end-user, the income would fall outside IR35 (the income from the engagement would get booked in the PSC as sales, and after deducting allowable trading expenses the taxable profit would be taxed in the normal way).
The assessment of whether a contract is from employment or self-employment can be fraught with difficulties and this topic has understandably spawned a vast body of jurisprudence over the last decade! In the last five years or so, there have been over ten decided cases alone dealing with TV and sports or radio presenters involving potentially huge IR35 ‘back-tax’ bills for Lorraine Kelly, Christa Ackroyd, Kaye Adams, Adrian Chiles and so on. This followed a spate of targeted HMRC IR35 enquiries into the media sector. A review of these cases shows the often finemargins involved in the ‘employment versus self-employment’ analysis.
Bearing in mind that IR35 is self-assessment, it is perhaps not surprising that many PSC owners have taken a generous interpretation of the law or given themselves the benefit of the doubt. HMRC has tried to assist by introducing its own CEST (check employment status tool) that can be accessed online - but it is by no means perfect!
A simple worked example of the calculation of the deemed IR35 income is shown below.
Example: Calculating deemed employment income under IR35
Lauren is an IT contractor and works through her (100%-owned) PSC company – Lauren IT Services Ltd. The company is based near Sundon Park, Luton.
All of the income received by her company for the year ended 31 March 2025 is from ‘small business’ clients in the private sector. It is accepted that all the income is from ‘employment’ engagements.
The company’s results for year to 31 March 2025 are:
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£ |
£ |
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Income received (net of VAT) |
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180,000 |
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Less: Expenses |
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‘Non-allowable’ travelling and subsistence costs |
6,700 |
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Accountancy and company secretarial costs |
6,500 |
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Telephone, internet and stationery |
5,500 |
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Basic salary paid to Henry and Employer’s NIC cost |
12,570 |
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Employer’s NICs on salary (£12,570 – £9,100) × 13.8% |
479 |
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Employer pension contributions |
6,000 |
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Total expenses |
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(37,749) |
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Net profit before tax |
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142,251 |
The calculation of the deemed employment income under IR35 is as follows:
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£ |
£ |
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Deemed employment income |
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180,000 |
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Less: Allowable expenses under IR35 |
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Salary + NICs paid in year (£12,570 + 479) |
13,049 |
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Employer’s pension contribution |
6,000 |
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General expense deduction – 5% × £180,000 (gross fee income) |
9,000 |
(28,049) |
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Deemed IR35 net employment income |
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151,951 |
The company will have to account for PAYE and Class 1 employers’ and employees' NICs on the deemed employment income.
Off-payroll working
According to HMRC research, before the off-payroll rules were introduced in 2017 and 2021, some 90% of PSCs had failed to properly comply with the IR35 regime. Furthermore, it appears that HMRC had not been able to police IR35 compliance effectively. According to Treasury estimates, the continuing lack of compliance in this area would have led to many billions of lost tax revenue. The introduction of the off-payroll working rules (found in ITEPA 2003, Pt 2, Ch 10) was the Government’s response to this worsening problem.
The off-payroll working provisions shift the main tax compliance burden and tax collection responsibility to the engager or fee payer instead of the PSC. This brings its own set of problems and challenges, which I will be exploring in next month’s article
Practical tip
The IR35 or off-payroll working rules only apply where individuals provide their services through a PSC. Where services are provided as a ‘sole trader’, it remains the case that the engager must always consider whether the services are provided via a genuine self-employment.
