IR35 is the single biggest compliance risk for agencies that use contractors. Get it wrong and you face retrospective tax bills, penalties, and interest going back up to six years. Get it right and you can engage contractors confidently, knowing your agency is protected.
This guide explains IR35 in plain English. No jargon, no legalese. We cover what it is, how to determine status, what your obligations are as an agency, the penalties for getting it wrong, and the changes coming in April 2026.
What Is IR35? A Plain-English Explanation
IR35 (Off-Payroll Working Rules) is UK tax legislation that determines whether a contractor working through a limited company should be taxed as an employee. If an engagement is "inside IR35," PAYE income tax, employee National Insurance, and employer National Insurance must be deducted — even though the contractor operates through their own company.
The rules look at the reality of the working relationship, not just what the contract says. HMRC examines three key factors: control (does the client dictate how, when, and where the work is done?), substitution (can the contractor send someone else to do the work?), and mutuality of obligation (is the client obliged to offer work and the contractor obliged to accept it?).
If the engagement looks like employment in substance, it falls inside IR35. If the contractor is genuinely running their own business and this particular engagement is just one of their clients, it is likely outside IR35.
Inside IR35 vs Outside IR35: What It Means for Your Agency
Outside IR35: the contractor is genuinely self-employed. You pay their company the agreed day rate. They handle their own tax through their limited company. Your agency pays no employer NI, no pension, no holiday pay. This is the most cost-effective way to engage contractors.
Inside IR35: the contractor is a "deemed employee" for tax purposes. The fee-payer (usually the agency) must deduct PAYE income tax, employee NI, and employer NI from the contractor's payment before paying them. This adds approximately 14% to your cost and eliminates most of the financial benefit of using a contractor.
| Factor | Outside IR35 | Inside IR35 |
|---|---|---|
| Payment | Gross day rate to contractor's company | Net after PAYE, employee NI, employer NI |
| Employer NI (agency cost) | £0 | 15% on deemed salary |
| Cost to agency (£300/day) | £300/day | ~£342/day |
| Employment Allowance | N/A | Cannot be claimed on deemed employees |
| Contractor take-home | Higher (tax-efficient extraction) | Lower (similar to employee net pay) |
For a full cost breakdown, see our contractor vs employee cost comparison.
How to Determine IR35 Status
HMRC assesses three main factors. No single factor is decisive — it is the overall picture that matters.
1. Control
Does the client control how, when, and where the work is done? If the contractor sets their own hours, works from their own location, and decides their own methods, this points to outside IR35. If the client dictates working hours, location, and approach, it looks more like employment.
2. Substitution
Can the contractor send someone else to do the work in their place? A genuine right of substitution (and evidence it has been exercised or would be accepted) is a strong indicator of outside IR35. If the client expects only this specific person, it looks like employment.
3. Mutuality of Obligation (MOO)
Is the client obliged to offer work and the contractor obliged to accept it? In employment, there is an ongoing obligation on both sides. A genuine contractor can turn down work, and the client has no obligation to keep providing it. Project-based engagements with clear end dates are stronger here.
HMRC provides the Check Employment Status for Tax (CEST) tool to help with determinations. Use it for every engagement and save the results. CEST is not perfect — it can produce "indeterminate" results in some cases — but using it demonstrates "reasonable care," which reduces penalties if HMRC later disagrees. HMRC updated CEST in April 2025 with a dedicated Mutuality of Obligation section and tightened substitution criteria. Our guide to the HMRC CEST tool 2026 changes explains what the update means for agency assessments and whether existing determinations need to be re-run.
Your Obligations as an Agency
Agencies sit in the middle of the supply chain between the end client and the contractor. Your obligations depend on whether the end client is classified as small or medium/large.
| Obligation | Small End Client | Medium/Large End Client |
|---|---|---|
| Who determines IR35 status? | The contractor's own company | The end client |
| Status Determination Statement | Contractor's responsibility | End client must issue; agency must pass to contractor |
| Operating PAYE (if inside) | Contractor's company | Fee-payer (usually the agency) |
| Employer NI liability | Contractor's company | Fee-payer (usually the agency) |
Agency as fee-payer
If there is no agency in the chain, the end client is the fee-payer. If there are multiple agencies, the one closest to the contractor is the fee-payer. The fee-payer bears the employer NI cost and PAYE operation for inside-IR35 engagements.
The Small Company Exemption
Small companies are exempt from the off-payroll working rules. This means the contractor determines their own IR35 status, and the agency has no obligation to operate PAYE or pay employer NI.
A company is "small" if it meets two of the following three criteria:
- Annual turnover not more than £15m (increasing from £10.2m in April 2026)
- Balance sheet total not more than £7.5m (increasing from £5.1m in April 2026)
- Not more than 50 employees
This matters because many of the agencies and end clients in the creative industry are small companies. If your end client qualifies as small, the compliance burden shifts entirely to the contractor. However, you should still satisfy yourself that the engagement is structured genuinely — reputational and commercial risks remain even if the tax liability sits with the contractor.
Penalties for Getting IR35 Wrong
HMRC can investigate up to 6 years of payments and charge:
- Unpaid PAYE income tax
- Employer NI at 15% on all deemed payments
- Employee NI (which you bear if you cannot recover it from the contractor)
- Interest from the date the tax should have been paid
Penalties on top of the unpaid tax:
| Behaviour | Penalty Range |
|---|---|
| Reasonable care taken (used CEST, documented reasoning) | 0% |
| Careless (did not take reasonable care) | 0–30% |
| Deliberate (knew it was wrong) | 20–70% |
| Deliberate and concealed | 30–100% |
The key defence is demonstrating reasonable care. Use CEST for every engagement, document your reasoning, issue Status Determination Statements, and keep records. If you can show you took the determination seriously and followed a proper process, penalties are significantly reduced — often to zero.
April 2026 Changes: What You Need to Know
Small company thresholds increase
Turnover threshold rises from £10.2m to £15m and balance sheet from £5.1m to £7.5m. More end clients will now qualify as "small," shifting IR35 determination responsibility back to the contractor. This is positive for agencies: fewer engagements where you bear the compliance burden.
New umbrella company obligations
End clients must ensure umbrella companies correctly operate PAYE and NICs. If you use umbrellas for inside-IR35 contractors, verify they are compliant. Non-compliant umbrellas could leave your agency exposed to tax liabilities.
HMRC enforcement focus
HMRC continues to prioritise IR35 compliance checks in the professional services and creative sectors. Agencies with multiple contractor engagements are higher priority for investigation than those with one or two.
Joint and Several Liability: New Umbrella Company Rules (April 2026)
From 6 April 2026, new Joint and Several Liability (JSL) rules mean that agencies and end clients can be held liable for unpaid PAYE and National Insurance if an umbrella company in the labour supply chain fails to account for these deductions correctly. This is a significant change that directly affects any business using umbrella companies to engage workers.
Previously, if an umbrella company collected PAYE and NIC from a worker's pay but failed to pass it on to HMRC, the liability sat with the umbrella alone. HMRC's only recourse was to pursue the umbrella company — which, in cases of non-compliance, had often become insolvent or disappeared entirely. The new JSL rules close this gap by allowing HMRC to pursue other parties in the supply chain.
Who is affected?
Any business in the labour supply chain that uses umbrella companies to engage workers. This includes recruitment agencies, staffing firms, and end clients. The rules apply to all payments made on or after 6 April 2026, regardless of when the contract was signed.
The liability cascade
Under the JSL rules, HMRC follows a specific order when pursuing unpaid tax. First, they pursue the umbrella company itself. If the umbrella cannot or does not pay, HMRC can then transfer the liability up the chain to the agency that engaged the umbrella. If the agency also cannot satisfy the debt, HMRC can pursue the end client.
This creates a powerful incentive for agencies and end clients to ensure the umbrella companies they work with are genuinely compliant. It is no longer enough to assume the umbrella is handling things correctly — you need evidence.
Practical implications for agencies
For agencies that place contractors through umbrella companies, the JSL rules demand a proactive approach to due diligence. You should vet umbrella providers before adding them to your supply chain, monitor their ongoing compliance, and maintain a preferred supplier list of umbrellas that meet your standards.
Pay particular attention to deduction statements. Compare what the umbrella says it is deducting with what the worker actually receives. Discrepancies between the gross pay, deductions, and net pay on payslips are a red flag. If the numbers do not add up, you could be dealing with a non-compliant umbrella — and under the new rules, that tax liability could land on your agency.
Umbrella company due diligence checklist
- Verify the umbrella company is registered as an employer with HMRC and holds a valid PAYE scheme
- Check that payslip deductions (PAYE, employee NIC, employer NIC) match expected amounts for the gross pay
- Review the umbrella company's financial standing — check Companies House for filed accounts, outstanding charges, and any insolvency warnings
- Require regular compliance certificates or audit reports from the umbrella, confirming tax has been paid to HMRC
- Maintain records of all due diligence carried out, including dates, documents reviewed, and conclusions reached
- Establish a preferred supplier list and remove any umbrella that fails to meet your compliance standards
The JSL rules apply to all payments made on or after 6 April 2026. If your agency uses umbrella companies in any part of its supply chain, review your arrangements now. Waiting until HMRC comes knocking is not a strategy — the whole point of these rules is that the liability has already shifted to you.
Group Structures and the Small Company Exemption
The small company exemption is one of the most important thresholds in IR35 compliance. A company that qualifies as "small" shifts the IR35 determination responsibility to the contractor, removing the compliance burden from the end client and the agency. The thresholds are: annual turnover under £15m, balance sheet total under £7.5m, and fewer than 50 employees. A company must meet two of these three criteria to qualify. Note that size is assessed against the prior financial year's accounts, which means most reclassifications from the April 2026 threshold change take practical effect in April 2027 for clients with standard year ends. Our IR35 small company threshold 2026 guide explains the timing rules and how to check whether your client has actually reclassified.
However, there is a critical detail that many agencies overlook: if the end client is part of a group, the parent undertaking's figures are used to assess size, not the subsidiary's. This is defined in the Companies Act 2006 and applies directly to the off-payroll working rules.
In practice, this means a small subsidiary of a large corporate group cannot claim the small company exemption. Even if the subsidiary itself has turnover of £5m, 20 employees, and a £2m balance sheet, the parent company's consolidated figures determine whether the exemption applies. If the parent exceeds two of the three thresholds, the subsidiary is treated as medium or large for IR35 purposes.
Practical impact for agencies
When placing contractors with an end client that appears small, always check whether it is part of a larger group. If it is, the end client is responsible for the IR35 status determination, must issue a Status Determination Statement, and your agency (as fee-payer) must operate PAYE for inside-IR35 engagements. Do not assume a small subsidiary means small company treatment.
Practical Risk Management for Agencies
IR35 compliance does not need to be complicated. Here is a practical framework that protects your agency without paralysing your contractor engagement process.
Assess every engagement before it starts
Run CEST before the contractor begins work, not after. Build it into your onboarding process so no engagement slips through without a determination.
Document everything
Save CEST results, keep copies of contracts showing substitution clauses, and record the working arrangements that support your determination. This is your defence if HMRC investigates.
Match contracts to reality
A contract saying "the contractor has a right of substitution" means nothing if the client would never accept a substitute in practice. HMRC looks at the reality, not the paperwork.
Review annually
Working arrangements change over time. A contractor who started on a defined project may gradually become integrated into the team. Review every ongoing engagement at least once a year.
Consider IR35 insurance
For borderline engagements, IR35 insurance (sometimes called tax liability insurance) can cover the cost of an HMRC investigation and any resulting tax liability. Premiums are typically £300–£800 per engagement per year.
IR35 Compliance Checklist for Agencies
- Maintain a register of all contractor engagements with IR35 status
- Run CEST for every new engagement before work begins
- Save and file all CEST results with date stamps
- Ensure contracts include genuine substitution, control, and MOO clauses
- Verify that contractual terms match the actual working arrangement
- Issue Status Determination Statements for medium/large client engagements
- Set up PAYE correctly for all inside-IR35 engagements
- Check end client size status against the small company thresholds
- Review all ongoing engagements annually
- Brief your team on what constitutes control, substitution, and MOO in practice
Frequently Asked Questions
What is IR35 in plain English?
IR35 is a tax rule that determines whether a contractor is genuinely self-employed or is effectively an employee. If the working relationship looks like employment, the contractor must pay similar taxes to an employee, and the agency as fee-payer must operate PAYE.
Who determines IR35 status: the agency or the end client?
For medium and large end clients, the end client determines IR35 status and issues a Status Determination Statement. The agency must pass this to the contractor and operate PAYE if the engagement is inside IR35. For small end clients, the contractor determines their own status.
What are the penalties for getting IR35 wrong?
HMRC can charge unpaid PAYE, employer NI (15%), employee NI, and interest going back up to 6 years. Penalties range from 0% (if you took reasonable care) to 100% (for deliberate concealment) of the unpaid tax. Using CEST and documenting your reasoning is your best defence.
What is the small company exemption?
Small companies (meeting two of: turnover under £15m, balance sheet under £7.5m, under 50 employees, from April 2026) are exempt from the off-payroll rules. The contractor determines their own IR35 status, and the agency has no PAYE obligation.
Does IR35 apply to sole traders?
No. IR35 only applies to contractors working through an intermediary, typically their own limited company. Sole traders are taxed on their income directly. However, HMRC can still challenge whether a sole trader is genuinely self-employed under general employment status rules.
Can I claim Employment Allowance on inside-IR35 contractors?
No. The Employment Allowance (£10,500) cannot offset employer NI on deemed employees under IR35. It only applies to genuine employees on your payroll.
How do I check IR35 status?
Use HMRC's CEST tool as a starting point. It asks questions about control, substitution, and mutuality of obligation. For borderline cases, consider specialist IR35 insurance or a professional assessment from an accountant experienced in contractor compliance.
What is Joint and Several Liability for umbrella companies?
From 6 April 2026, new JSL rules allow HMRC to pursue agencies and end clients for unpaid PAYE and National Insurance if an umbrella company fails to account for these deductions. Agencies should vet umbrella providers, check payslip deductions, and maintain records of due diligence.
Does the small company exemption apply if the end client is part of a group?
No. If the end client is a subsidiary of a larger group, the parent undertaking's consolidated figures are used to assess size. A small subsidiary of a large parent cannot claim the small company exemption, so the end client (not the contractor) determines IR35 status.
What changes in April 2026?
The small company thresholds increase (turnover to £15m, balance sheet to £7.5m), meaning more end clients qualify as small. New Joint and Several Liability rules for umbrella companies are introduced, allowing HMRC to pursue agencies and end clients for unpaid tax.