IR35 (the off-payroll working rules) requires UK businesses to assess whether contractors who provide services via personal service companies (PSCs) are, in substance, working like employees. If they are — and the assessment is wrong — the business faces back-dated tax, NI, and penalties. This guide explains how IR35 applies to UK SMEs and what you can do to reduce your risk.
What Is IR35 and Why Does It Exist?
IR35 was introduced to close a tax gap: some contractors were operating through limited companies, paying themselves dividends rather than salary, and thereby paying significantly less tax and NI than an equivalent employee. HMRC's position is that if a contractor works like an employee — same hours, same control, same integration — they should be taxed like one.
The rules were extended to medium and large private sector businesses in April 2021. From that point, the responsibility for making the IR35 determination shifted from the contractor to the business engaging them.
Does IR35 Apply to My Business?
The off-payroll rules apply to you if you are a medium or large business. Under the Companies Act definition, you are medium or large if you meet two or more of:
- Annual turnover above £10.2 million
- Balance sheet total above £5.1 million
- More than 50 employees
If you are a small business (below those thresholds), the responsibility for the IR35 determination remains with the contractor — not with you. However, you should still be aware of the rules, as your business may cross the threshold as it grows.
How Do You Determine IR35 Status?
HMRC assesses IR35 status based on the practical reality of the working relationship, not what the contract says. The key tests are:
1. Control
Does the business control what work the contractor does, when they do it, and how? A genuine contractor exercises their own professional judgement and method. An employee follows instructions.
2. Substitution
Can the contractor send a substitute to do the work? A genuine contractor can. An employee cannot — the business is engaging the individual personally.
3. Mutuality of Obligation
Is the business obliged to offer work and the contractor obliged to accept it? Mutuality of obligation is a hallmark of employment — a genuine contractor has no guaranteed workflow.
Other factors
Integration into the business, financial risk, provision of equipment, exclusivity, and the length and terms of the engagement are all relevant.
What Happens if You Get It Wrong?
If HMRC determines that a contractor was wrongly classified as outside IR35, the business is liable for:
- Unpaid PAYE income tax (at the contractor's marginal rate)
- Employer and employee National Insurance contributions
- Interest on unpaid amounts
- Penalties (typically 30–100% of unpaid tax, depending on whether HMRC views the error as careless or deliberate)
These amounts can be backdated to when the engagement started — often several years. HMRC has increased its focus on IR35 compliance since 2021 and the number of investigations is rising.
How Does Offshore Staffing Remove IR35 Risk?
When you engage VLS Sourcing, you are paying a service fee to a legal entity in India — VLS Sourcing Pvt. Ltd. The individual providing the service is employed by us in India. They do not operate a UK personal service company. They are not a UK contractor.
IR35 applies to arrangements where a UK individual provides services via a UK PSC to a UK business. That chain does not exist in a VLS Sourcing engagement. You are outside the IR35 framework entirely for those roles.
This is not tax avoidance — it is a straightforward B2B service arrangement with an Indian company. You pay us a fee; we employ the individual and manage all Indian payroll compliance.
Should You Use HMRC's CEST Tool?
HMRC provides the Check Employment Status for Tax (CEST) tool to help businesses assess IR35 status. It is a useful starting point, but it has limitations — it does not cover every scenario, and HMRC does not commit to accepting CEST results in all cases. For any significant contractor engagement, we recommend taking advice from a qualified tax adviser.
Disclaimer
This article is general guidance only and does not constitute tax or legal advice. IR35 is a complex and fact-specific area of law. Always take independent professional advice before making decisions about contractor engagements.
Want to remove IR35 risk for new hires?
Our EOR model places remote professionals on our Indian payroll — keeping your business entirely outside the IR35 chain for those roles. Book a free call to find out if it works for your situation.
Learn About Our EOR Model →Published by VLS Sourcing UK. This article is general guidance only and does not constitute legal, tax, or financial advice. Always seek independent professional advice for your specific situation.