What is IR35 and Why Does It Cause So Much Stress?
IR35, also known as the ‘off-payroll working rules‘, is a piece of UK tax legislation that has been a source of confusion and anxiety for contractors and freelancers for over two decades. Its purpose is to tackle ‘disguised employment’—a situation where a worker provides services to a client through their own limited company (often called a Personal Service Company or PSC), but their working relationship is, in reality, that of an employee.
The core principle of IR35 is to ensure that if a contractor works like an employee, they should pay broadly the same Income Tax and National Insurance as an employee would. This strikes at the heart of the tax efficiency that makes contracting an attractive career path, creating high stakes for getting the determination right.
Recent reforms have shifted the responsibility for determining IR35 status from the contractor to the end client for most engagements. This change has fundamentally altered the landscape, making it more critical than ever for contractors to understand the rules, their rights, and how to demonstrate their genuine self-employed status.
The Core Question: Are You ‘Inside’ or ‘Outside’ IR35?
Every contract you undertake will be assessed as either ‘inside’ or ‘outside’ the IR35 rules. This determination dictates how you will be taxed for that specific engagement.
‘Inside IR35’
If your contract is determined to be ‘inside IR35’, HMRC considers you an employee for tax purposes. You are a ‘disguised employee’. For that contract, your fees will be subject to PAYE, meaning Income Tax and both employee’s and employer’s National Insurance Contributions will be deducted at source by the fee-payer (usually the client or recruitment agency) before you receive payment.
‘Outside IR35’
If your contract is determined to be ‘outside IR35’, you are considered a genuine business-to-business service provider. You can continue to operate through your limited company, receiving the gross fee for your services. You remain responsible for your own taxes, typically paying yourself a combination of a small salary and dividends, which is more tax-efficient.
The Three Key Tests of Employment Status
HMRC and tax tribunals look beyond the written contract to the reality of the day-to-day working relationship to determine IR35 status. They use several key tests derived from decades of employment law.
1. Control: Who is in charge?
This is a fundamental test that assesses the client’s degree of control over how, when, and where you perform your work.
- Indicators of being ‘Outside IR35’ (Self-Employed): You have a high degree of autonomy. You decide the methods used to complete the project and have control over your working hours and location.
- Indicators of being ‘Inside IR35’ (Employee-like): The client exercises significant control, dictating specific working hours, requiring you to work from their office, and supervising your work closely, much like a line manager would an employee.
2. Right of Substitution: Can you send someone else?
This test examines whether ‘personal service’ is required. A genuine, unfettered right to send a suitably qualified substitute to perform the work in your place is one of the strongest indicators of being outside IR35.
- Indicators of being ‘Outside IR35’: Your contract contains a clause allowing for substitution, and this right is genuine. The client is paying for a service to be completed, not for you personally to do the work.
- Indicators of being ‘Inside IR35’: The client requires you personally to carry out the work and has the right to reject any substitute you might offer.
3. Mutuality of Obligation (MOO): Is there an ongoing relationship?
MOO refers to the obligation of an employer to provide work and the obligation of an employee to accept it. In a genuine contracting arrangement, this mutuality should not exist beyond the scope of the current project.
- Indicators of being ‘Outside IR35’: The contract is for a specific, defined project. Once it is complete, the client has no obligation to offer you more work, and you have no obligation to accept it.
- Indicators of being ‘Inside IR35’: There is an expectation of continuous work. The contract may have a long notice period, or it may be repeatedly renewed, creating a relationship that resembles permanent employment.
Other Important Factors in Determining IR35 Status
While the three tests above are primary, other factors help to build an overall picture of whether you are ‘in business on your own account’.
- Financial Risk: Do you bear genuine financial risk? This could include correcting errors at your own expense, having to purchase your own professional indemnity insurance, or investing in your own equipment.
- Provision of Equipment: Do you use your own laptop, software, and tools to complete the work, or does the client provide everything? Using your own equipment is a strong pointer towards self-employment.
- ‘Part and Parcel’: How integrated are you into the client’s organisation? Having a client email address, a role on the company organisation chart, or managing permanent staff can suggest you are ‘part and parcel’ of the business, which is an indicator of employment.
The Financial Impact: The Real Cost of Being Inside IR35
The financial difference between an ‘inside’ and ‘outside’ determination is significant. When inside IR35, your income is treated as a ‘deemed payment’. This means it is subject to PAYE deductions for Income Tax and National Insurance.
Critically, you are taxed like an employee but do not receive any of the statutory benefits, such as holiday pay, sick pay, or employer pension contributions. Furthermore, the fee-payer must also account for employer’s NI, a cost that is often passed on to the contractor through a lower day rate. This can result in a substantial reduction in take-home pay.
| Metric | Outside IR35 (via PSC) | Inside IR35 (Deemed Employment) |
| Gross Invoice Value (e.g.) | £80,000 | £80,000 |
| Corporation Tax | Yes | No |
| Income Tax | On small salary & dividends | On full amount (PAYE) |
| National Insurance | Employee’s NI on salary | Employee’s & Employer’s NI (often deducted from rate) |
| Allowable Expenses | Full range of business expenses | Very limited (employment expenses only) |
| Illustrative Take-Home Pay | ~£60,000 | ~£51,000 |
Note: Figures are illustrative and depend on individual circumstances. Based on examples from tax specialists.
Navigating the Rules: The Role of the Client and the CEST Tool
Since April 2021, for engagements with medium and large private sector clients, the responsibility for determining your IR35 status rests with the client. They must assess the contract and provide you with a Status Determination Statement (SDS), which outlines their decision and the reasons behind it.
HMRC’s CEST Tool: A Flawed Friend?
Many clients use HMRC’s own online tool, Check Employment Status for Tax (CEST), to make this determination. However, this tool is widely criticised within the tax industry for its limitations:
- It often fails to provide a clear determination, returning an ‘indeterminate’ result in approximately one in five cases.
- It largely ignores the crucial test of Mutuality of Obligation (MOO), a factor that has been decisive in many tax tribunal cases.
- Its questions can be ambiguous and fail to capture the nuances of complex contracting arrangements.
Even government departments have been handed multi-million-pound tax bills after misclassifying contractors while relying on CEST, proving that its use is not a guaranteed defence against an HMRC challenge.
Conclusion: How to Protect Yourself and Stay Outside IR35
In this client-led determination landscape, contractors must be proactive in demonstrating their genuine self-employed status.
- Review Your Contract: Ensure your contract contains clauses that strongly point to an outside-IR35 status, such as a clear right of substitution and a lack of control from the client.
- Align Your Working Practices: Your day-to-day actions must mirror your contract. Exercise your autonomy, operate as a separate business, and avoid becoming ‘part and parcel’ of the client’s organisation.
- Gather Evidence: Maintain a file of evidence that proves you are in business on your own account. This could include having your own business website, holding business insurance, working for multiple clients, and investing in your own training and equipment.
- Seek Professional Advice: If you are unsure about your status, consider getting an independent IR35 contract review from a specialist.
By understanding the key status tests and actively managing how your services are contracted and delivered, you can navigate the complexities of IR35 with greater confidence.
FAQ’S-IR35 Explained: A Contractor’s Guide to ‘Inside’ vs ‘Outside’ Rules
1. What is IR35?
IR35 is UK tax legislation designed to identify individuals who are working as contractors but would be considered employees if not for their limited company (often called a personal service company or PSC). It ensures such individuals pay broadly the same tax and National Insurance as regular employees.
2. What does ‘Inside IR35’ mean?
If a contract is Inside IR35, it means HMRC considers the contractor to be effectively an employee for tax purposes. As a result:
Income tax and National Insurance are deducted at source.
You cannot claim tax relief on many business expenses.
3. What does ‘Outside IR35’ mean?
A contract Outside IR35 means HMRC sees the contractor as genuinely self-employed. Therefore:
You are responsible for paying your own taxes.
You can take advantage of tax efficiencies through your limited company.
4. How is IR35 status determined?
IR35 status is based on several factors, including:
Control – How much control the client has over your work.
Substitution – Whether you can send someone else to do your work.
Mutuality of Obligation (MOO) – Whether the client is obligated to offer work and you’re obligated to accept it.
5. Who decides IR35 status?
For public sector and medium/large private sector contracts: the client determines IR35 status.
For small private sector companies: the contractor is responsible for determining their own IR35 status.
6. What are the tax implications of being inside IR35?
If inside IR35:
You pay income tax and employee National Insurance Contributions (NICs).
Your take-home pay is significantly reduced compared to outside IR35.
Employer NICs must also be paid—usually by the fee-payer (client or agency).
7. Can I dispute an IR35 determination?
Yes. Contractors can challenge an IR35 determination if they believe it’s incorrect. If working through an agency or public-sector client, you must receive a Status Determination Statement (SDS) explaining the decision, and you can appeal.
8. Does IR35 affect all contractors?
Not necessarily. IR35 only applies if:
You work through a limited company or PSC.
The nature of your engagement is more like employment than business-to-business services.
9. What is a ‘Status Determination Statement’ (SDS)?
An SDS is a document provided by the end-client (in the public sector and medium/large private companies) that explains their IR35 status decision and the reasons behind it. It must be passed down the supply chain.
10. How can I ensure I’m outside IR35?
Work with a qualified accountant or IR35 specialist.
Ensure contracts reflect a true business-to-business relationship.
Avoid working like a permanent employee (e.g., using client equipment, fixed hours, or being part of team meetings).
Keep evidence of independence, such as marketing your services and having multiple clients.