What is IR35 in the UK? Why does it exist?

In the UK, IR35 is a set of tax rules designed to identify individuals who work like employees but evade standard income tax and National Insurance contributions by funnelling their income through an intermediary, such as a personal service company (PSC). If your contract falls inside IR35, HM Revenue and Customs (HMRC) views you as an employee for tax purposes, meaning your earnings are subject to standard Pay As You Earn (PAYE) deductions. If your contract falls outside IR35, you are considered a legitimate separate business entity, allowing you to pay yourself via a combination of salary and dividends, which is generally more tax-efficient.

What is IR35 and why does it exist?

HMRC introduced the IR35 legislation—officially known as the “off-payroll working rules”—to close a loophole in the UK tax system. Before these rules, a worker could leave their full-time job on a Friday and return to the exact same desk on Monday, doing the exact same work, but as a contractor operating through their own limited company.

By doing this, the worker avoided standard employment taxes, and the hiring company avoided paying Employer’s National Insurance contributions. HMRC labels these individuals “disguised employees.” The core purpose of IR35 is to ensure that people who work in the same way as employees pay roughly the same tax and National Insurance as employees, regardless of their corporate structure.

How do you know if your contract is inside or outside IR35?

Determining your tax status relies entirely on the reality of your day-to-day working relationship and the specific wording of your contract. HMRC does not look at your job title; they look at how the work is actually done.

To establish where your contract falls, HMRC and UK courts rely heavily on three core tests of employment:

1. Control

• Inside IR35: The client dictates your working hours, instructs you exactly how to complete the tasks, and closely supervises your daily routine. You are integrated into their team hierarchy.

• Outside IR35: You are hired as an independent specialist to deliver a specific outcome. You decide when, where, and how you complete the project, as long as you meet the agreed deadlines and specifications.

2. Substitution

• Inside IR35: The contract requires your personal service. If you are sick or unavailable, you cannot send someone else to do the work in your place; the client expects you specifically.

• Outside IR35: Your limited company is contracted to do the job, not you personally. You have a genuine right to provide a qualified substitute worker to complete the services without the client unreasonably rejecting them.

3. Mutuality of Obligation (MOO)

• Inside IR35: There is an expectation of ongoing work. The client is obligated to offer you tasks, and you are obligated to accept them. When a project ends, they look for something else for you to do.

• Outside IR35: The contract is project-specific. Once the project is finished, the relationship ends. The client has no obligation to offer more work, and you have no obligation to accept further contracts if offered.

Who decides your IR35 status?

The rules regarding who is responsible for determining your IR35 status changed significantly with the introduction of the off-payroll working reforms. Who makes the decision depends entirely on the size of your end-client.

Under Companies House guidelines, a private sector client is classified as a small business if it meets at least two of the following criteria: an annual turnover of not more than £10.2 million, a balance sheet total of not more than £5.1 million, or 50 or fewer employees. If your client meets this definition, the responsibility to assess IR35 stays with you.

If the client is medium or large, they must provide you with a Status Determination Statement (SDS), which explains their decision and the reasoning behind it.

What is the financial impact of being inside vs outside IR35?

The financial difference between working inside or outside IR35 is substantial, affecting how you extract money from your business and the amount of tax you owe.

Working Inside IR35

When you are inside IR35, your income is taxed as if you were a standard employee. The organisation paying your fee (either the client or the recruitment agency) must deduct Income Tax and Employee National Insurance contributions through PAYE before paying your limited company.

You do not get the tax benefits of running a limited company, nor do you receive traditional employee benefits like paid holiday, sick leave, or workplace pensions from the end-client.

Working Outside IR35

When you work outside IR35, your limited company invoices the client for the full gross amount with no tax deducted at source. The money belongs to your company. You can then withdraw these funds in a highly tax-efficient manner—typically by paying yourself a small, tax-free or low-tax salary up to the National Insurance threshold, and taking the remainder of your income as business dividends, which carry lower tax rates than standard employment income.

You can also claim valid business expenses against your corporate profits, reducing your overall Corporation Tax bill.

How can you protect your business and stay compliant?

Navigating IR35 requires proactive management to avoid unexpected tax penalties and interest from HMRC. If you are responsible for setting your own status, or if you want to challenge an incorrect assessment from a client, you should focus on practical steps:

• Gather Evidence: Keep a record of your independent working practices. Save emails where you decline work outside your project scope, or documents showing you use your own tools and software.

• Review Written Contracts: Ensure your formal written agreement accurately reflects an independent, business-to-business relationship, explicitly highlighting clauses for substitution and lack of control.

• Avoid Employee Habits: Do not accept a staff discount card, do not request a company email signature that implies a staff role, and do not attend internal staff events like company AGMs or staff holiday parties.