People & Leadership

Guide to off payroll working rules and IR35

Discover what off payroll working rules (IR35) mean, the penalties for getting them wrong, and how to stay compliant.

The mere mention of IR35, or off-payroll working, can make some HR managers break out into a cold sweat – and for good reason. The off payroll working rules can be complex and unclear.

This article is your guide to understanding what off payroll rules (IR35) mean, the penalties for getting them wrong, and how to stay compliant.

Here’s what we cover:

What is IR35?

IR35 is made up of laws that determine whether off-payroll working applies to different workers. It was introduced to ensure businesses make the necessary PAYE payments and that contractors or sole traders also pay the correct amount of tax.

In short, IR35, or off-payroll working, aims to clamp down on tax avoidance.

The key to identifying whether IR35 or off-payroll rules apply is whether a worker can be classified as an employee but refers to themselves as another type of worker – for example, a contractor.

This is sometimes referred to as “disguised employment”, where a middleman, such as a personal service company (PSC), is used to reduce a worker’s tax burden.

Companies need to check whether a contractor who provides services to them should pay tax and National Insurance contributions (NIC) like a regular employee.

If the contractor is considered an employee under IR35, the company must make the necessary tax and NIC payments.

What are off payroll working rules?

As mentioned, off-payroll rules, also known as IR35, are tax directives designed to weed out disguised employment, where a worker is an employee in practice but classifies themselves differently, such as a contractor, to avoid paying employee taxes.

Off-payroll rules ensure that contractors operating as employees pay the correct amount of tax and National Insurance contributions (NIC).

Determining whether off-payroll working rules apply depends on whether a company is:

• A small business
• Operating in the public sector
• A private business or part of the voluntary sector.

Off-payroll working rules for small companies are different to those for other companies. Small businesses in the private sector are exempt from deciding whether a contractor falls under the off-payroll rules; instead, the contractor’s intermediary must determine whether the rules apply.

Your business will be classified as small if two of the following apply:

• It has £7.5 million or less on the balance sheet
• It has a turnover of no more than £15 million
• It employs 50 or fewer people.

Only medium and large businesses in the private and public sectors are responsible for ensuring workers are classified correctly under the off-payroll working rules.

Working out whether off payroll working rules apply can be complicated, as a few criteria must be assessed.

Businesses must think about different factors to decide whether the off payroll rules apply, such as:

• Substitution: if a business relationship doesn’t allow someone else to do the same work, and the company insists on only a specific individual for the job, this person may be classed as an employee, meaning the off-payroll rules will apply.
• Control: if a company dictates how, where, and when the work is done, this points to an employment relationship. The company will likely need to classify the contractor as an employee and pay the relevant tax and NIC.
• Mutuality of obligation: if the company is expected to continuously provide work and the contractor is expected to accept it, this looks like an employer-employee relationship, meaning the off payroll rules will apply.

Here’s an example:

Jane is a business analyst who works through her limited company for a software company, and the following applies:

• She works from 8am to 5pm, Monday to Friday, at the client’s office. The client assigns her specific tasks rather than one-off projects.
• Jane must complete the work herself; she can’t send someone to substitute for her.
• The client continues to provide Jane with work, and she is expected to accept it.
• She uses the client’s equipment, has their official email, and attends internal meetings.

It’s very likely that Jane will be inside IR35, as she meets the criteria of control, no substitution, and mutuality of obligation.

Inside vs Outside IR35: What’s the difference?

The difference between inside vs outside IR35 is whether a contractor is subject to IR35 rules.

A contractor is inside IR35 if they work directly for a client full time, without an intermediary.

If HMRC decides that a contractor provides a service that should be classified as employment rather than self-employment, they fall inside IR35.

This means the contractor must pay the same tax and NIC as a regular employee.

The company must process the contractor’s pay through payroll to deduct the necessary tax and NIC. If the worker is working through an agency, the agency is responsible for deducting the correct tax.

A worker is considered outside IR35 if they are a genuine contractor – for example, working with multiple clients through an intermediary.

If the contractor legitimately runs a business or is classified as self-employed, they are responsible for paying their own tax.

The main difference between inside vs outside IR35 is who pays taxes to HMRC. A contractor outside IR35 must handle their own tax, whereas a company or agency must deduct taxes for anyone inside IR35.

Off-payroll working penalties to be aware of

Since off payroll working (IR35) was introduced to tackle tax avoidance, failing to comply comes with serious consequences.

Here are some off-payroll working penalties to be mindful of:

• If a company misclassifies a worker’s status, it must pay income tax and NIC because of the misclassification
• If a company delays payments, HMRC has the right to charge interest from the due date until full payment is made
• HMRC can charge up to 100% on any outstanding tax
• Contractors may need to pay 30% of the tax owed, even if they were unaware of their incorrect employment status
• If a contractor knowingly operates outside IR35 despite falling within it, HMRC may require them to pay up to 70% of their tax bill.

If you can show that you made every reasonable effort to find out a worker’s status – for example, by checking the Check Employment Status for Tax (CEST) issued by HMRC and maintaining accurate records, there’s a possibility that your tax bill could be reduced or even cancelled altogether.

How using payroll software can help you stay compliant

IR35 non-compliance carries a lot of risks for businesses, but using the right payroll software can help reduce them.

HMRC has strict reporting requirements for IR35. A reliable payroll system generates accurate reports, making compliance less burdensome.

If a worker is classified as inside IR35, payroll software ensures tax calculations are correct by automatically deducting the right amount of tax and NIC.

Payroll software can help with assessing whether a worker is inside or outside IR35 by analysing different criteria, such as substitution and control, to help you figure out the correct classification.

Final thoughts

Off-payroll rules (IR35) can be a minefield. It’s in your company’s best interest to understand and correctly apply the rules. Misclassifying a worker under IR35 can be costly.

IR35 compliance isn’t something businesses can afford to ignore or handle haphazardly. Identifying whether a contractor is inside or outside IR35 is only half the challenge – you also need to manage tax deductions correctly.

The simplest way to do this is by using payroll software equipped with the right features to keep your business compliant. It’s also working with your accountant or a payroll expert if you need additional support.