IR35 and off-payroll working: taxed as an employee, with none of the rights

IR35 was meant to catch people who were employees in all but name and taxed as something cheaper. What it produced, after two decades and two reforms, was a different unfairness: large numbers of genuine contractors taxed as if employed, at the discretion of the company hiring them, with none of the rights that employment is supposed to carry.

The employed and self-employed tax divide

The UK system taxes employees and the self-employed differently. An employee's income runs through PAYE, including employee National Insurance (currently 8% on earnings between GBP 12,570 and GBP 50,270) and employer National Insurance (15% from April 2025). A self-employed sole trader pays Class 4 National Insurance at lower rates and no employer NICs at all. A contractor working through a Personal Service Company - their own limited company - can take income as a mix of salary and dividends, with dividends carrying no NICs, historically producing a materially lower combined tax and NI burden than equivalent employment income.

The difference is not an accident. It reflects genuine differences in risk and entitlement. A contractor through a PSC gets no sick pay, no paid holiday, no employer pension contribution, no employment rights, and carries the full cost of finding the next contract. But for workers who were, in economic substance, long-term quasi-employees of a single organisation - same job, same desk, same supervision as the employees beside them - the tax advantage was an asymmetry HMRC labelled "disguised employment."

The original legislation, 2000

IR35 - the Intermediaries Legislation - was introduced by the Finance Act 2000. It required a contractor working through a PSC to assess whether, if the intermediary company were ignored, they would be treated as an employee of the end client for tax purposes. If so - an "inside IR35" determination - the PSC had to pay PAYE and NICs on the relevant income. The test turned on the common-law factors of control, substitution, and mutuality of obligation, plus secondary factors. It was controversial from the start, with critics arguing it caught independent professionals who had genuinely chosen self-employment and bore genuine commercial risk.

The 2017 and 2021 reforms

The original IR35 failed on enforcement. The determination was made by the contractor, the financial incentive to land on "outside IR35" was strong, and HMRC had neither the resources nor the access to client working practices to challenge those determinations at scale. Only a fraction of contractors who arguably should have been inside were paying accordingly.

The government's answer was to move the determination to the engager:

• From April 2017, all public sector bodies became responsible for determining whether IR35 applied to the contractors they engaged. Where an engagement was inside IR35, the fee-payer (usually the agency) became liable for operating PAYE and paying employer NICs.
• From April 2021 (delayed a year from the planned April 2020 date because of COVID-19), the same obligations extended to medium and large private-sector businesses. At that reform, the small-company carve-out used the Companies Act thresholds then in force: a company was small if it met at least two of turnover not more than GBP 10.2 million, balance sheet not more than GBP 5.1 million, and not more than 50 employees. Small companies kept the original position, with the contractor determining their own status. (Those thresholds were later raised, to GBP 15 million turnover and GBP 7.5 million balance sheet, from April 2025; the 50-employee figure was unchanged.)

The result for many contractors was immediate and severe. To avoid legal liability and administrative complexity, a large number of medium and large organisations issued blanket "inside IR35" determinations across their entire contractor populations, without individual assessment - treating every limited-company contractor as inside IR35 regardless of the substance of each engagement. A 2020 survey of more than 12,000 contractors found the UK's flexible workforce was being "decimated by rife non-compliance with the Off-Payroll legislation by clients." Contractors placed inside IR35 paid tax and NICs as if employed while receiving none of the rights that employment confers - no sick pay, no paid leave, no protection against unfair dismissal - the worst of both worlds.

Separately, a significant number of organisations, including some public-sector bodies, simply terminated contracts with PSC contractors rather than handle status determinations, reducing the availability of specialist contract work and, in places, creating acute skills shortages.

The CEST tool

HMRC provides the Check Employment Status for Tax (CEST) tool to help engagers make determinations, and commits to stand by results produced by CEST where accurate information has been entered. But tax professionals have criticised CEST for omitting key common-law factors - notably mutuality of obligation - producing results that are not always a reliable guide to legal status, and that tend, where the position is marginal, to return "inside IR35." The tool that was supposed to give engagers certainty instead nudged borderline cases toward the safer answer for HMRC.

The offsets fix, 2024

A structural unfairness in the post-2017 regime was partially remedied in the Finance Act 2024. Where HMRC found on investigation that a contractor had been wrongly determined "outside IR35," the taxes the contractor had already paid through their PSC - corporation tax, income tax on dividends, NICs - could be offset against the additional liability imposed on the engager. Without this offset, the same income could be taxed twice: once through the PSC, and again through PAYE when HMRC challenged the determination. The fix applies retrospectively from April 2017. That it took until 2024 to stop the state collecting twice on the same income tells its own story about how the regime was built.

The SME and freelancer squeeze

Smaller businesses and individual freelancers sit at the sharpest edge of IR35, from more than one direction.

As contractors. Moving the determination to large engagers, combined with blanket determinations and risk-averse behaviour, has cut the practical availability of outside-IR35 work. Contractors who structure their affairs to reflect genuine self-employment can find themselves inside IR35 at the engager's discretion - paying meaningfully more tax on the same income for the same work, with no corresponding employment rights.

As small businesses engaging contractors. Small companies remain responsible for their own status assessments as engagers once they grow past the threshold, creating sudden and significant compliance obligations. With no bright-line test, reliance on a CEST tool with acknowledged limitations, and genuine legal uncertainty in borderline cases, this is a disproportionate burden on businesses without in-house employment-tax expertise.

The unresolved policy question. IR35 sits inside a broader, unsettled debate about how the self-employed should be taxed relative to employees - one the Office of Tax Simplification examined across multiple reports without a settled legislative outcome before it was abolished in 2023. The question it was wrestling with remains open.

International equivalents

Worker-classification battles of this kind are not specific to the UK.

United States. The IRS applies a multi-factor behavioural, financial, and relationship test to decide whether a worker is an employee or independent contractor, and the Department of Labor and IRS coordinate enforcement against misclassification. In California, Assembly Bill 5, signed by Governor Newsom in September 2019 and effective 1 January 2020, replaced the common-law control test with the three-part ABC test - requiring businesses to treat workers as employees unless they can show the worker is free from the company's control, the work is outside the company's usual course of business, and the worker is independently established in that trade. AB5 had immediate effects on California's freelance and gig workers, including widespread cancellation of contracts with journalists and writers, leading to a partial amendment via AB 2257 in September 2020 that added professional exemptions.

Australia. The Fair Work Act 2009 requires assessment of the "real substance, practical reality and true nature" of the relationship, not just the label on the contract. The ATO and Fair Work Ombudsman jointly target sham contracting, with maximum civil penalties of up to AUD 469,500 per contravention for larger employers (a fivefold increase in force from 27 February 2024).

Canada. The CRA can reclassify workers as employees for tax purposes, making the employer liable for income tax withholding and CPP and EI remittances. Since June 2024, federal legislation has created a presumption of employee status when a worker's classification is contested under the Canada Labour Code.