If HMRC has opened an enquiry into your IR35 status, or you believe a challenge is coming, the outcome will depend almost entirely on evidence and legal argument, not on what your contract says alone. This guide explains the IR35 rules in full, how HMRC investigates and the realistic paths to resolution.
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What is IR35?
IR35 is the shorthand name for the intermediaries legislation, originally introduced in April 2000 to counteract arrangements where individuals who were in substance employees of a client engaged that client through their own personal service company (PSC) or other intermediary, thereby paying lower rates of income tax and National Insurance than a comparable employee. The name comes from the Inland Revenue press release number 35 of 1999 that first announced the measure.
At its core, IR35 asks a single question: if the intermediary (the PSC) did not exist and the worker contracted directly with the end-client, would that engagement be one of employment? If yes, the worker is a “deemed employee” and the payments made through the PSC must be subjected to PAYE income tax and National Insurance contributions, as though they were a salary.
What makes IR35 technically complex is that the answer to that question is not determined by the contract alone. It turns on the entire factual matrix of the working relationship, how work is supervised, who decides how and when it is done, whether the worker genuinely bears financial risk and whether a genuine right of substitution exists. HMRC’s view and the tribunal’s view can differ substantially from the contractor’s own assessment.
Chapter 8 vs Chapter 10 ITEPA 2003
The current legislative framework has two distinct chapters in the Income Tax (Earnings and Pensions) Act 2003:
Chapter 8 ITEPA 2003, the original IR35
Chapter 8 is what most people mean when they refer to “old IR35.” Under Chapter 8, the PSC itself is responsible for determining whether the engagement would be employment absent the intermediary. If it would, the PSC must operate PAYE on a deemed payment at the end of each tax year. This regime applies to all engagements where Chapter 10 does not apply, in particular, workers in the private sector engaged by small companies (see below) and all engagements before April 2017 in the public sector and April 2021 in the private sector.
The practical implication is that for Chapter 8 cases, including any investigation by HMRC of historical years, the tax, NIC and penalty liability falls on the PSC, not the engager. HMRC will open a compliance check into the PSC and seek unpaid PAYE and NICs plus interest and penalties.
Chapter 10 ITEPA 2003, the off-payroll working rules
Chapter 10 fundamentally restructures who bears responsibility. Introduced for the public sector in April 2017 and extended to medium and large private-sector engagers from April 2021, Chapter 10 requires the end-client to:
- determine the worker’s employment status for each engagement;
- issue a Status Determination Statement (SDS) setting out the determination and reasons; and
- pass the SDS down the contractual chain to any agency and to the worker.
The fee-payer (usually the agency immediately above the PSC in the chain) then operates PAYE on the payments made to the PSC. If the determination is wrong, the liability, unpaid PAYE and NICs, sits with the fee-payer. If no SDS is issued or it is issued negligently, the liability reverts to the end-client.
The employment status tests
Whether an engagement constitutes employment (or is akin to employment for IR35) is assessed against a body of case law built up since the 1960s. The foundational case is Ready Mixed Concrete (South East) Ltd v Minister of Pensions and National Insurance [1968] 2 QB 497, which identified three conditions necessary for a contract of service (employment): the worker agrees to provide work or skill in exchange for remuneration; the worker agrees to be subject to sufficient control by the other party; and all other terms are consistent with a contract of service.
IR35 case law has developed further tests from this base:
Mutuality of obligation (MOO)
Mutuality of obligation is often described as the most fundamental threshold test. For employment to exist there must be an obligation on the engager to offer work and an obligation on the worker to accept and perform it. Where a contractor works on a genuinely project-specific basis with no obligation to accept further engagements, and the client is under no obligation to offer them, the MOO argument is that employment cannot exist.
In practice this is the hardest test to satisfy because most engagements, particularly those running for months or years, involve at least implied obligations on both sides. HMRC tends to argue MOO is met whenever there is any work being performed under a contract. The tribunal’s approach in cases such as Christa Ackroyd Media Ltd v HMRC [2019] and RALC Consulting Ltd v HMRC [2023] is to look at the reality of the relationship: did the worker in practice have to continue and was the client committed to continuing to use them?
Control
The control test asks who decides how, when, where and what. A self-employed contractor working to a deliverable without day-to-day supervision is outside employment; an individual who attends the client’s premises, follows the client’s working hours and processes and is managed by the client’s own staff is likely inside. The tribunal in Kickabout Productions Ltd v HMRC [2022] EWCA Civ 29 confirmed that control must be assessed globally across the whole engagement, financial control, control over how work is done and integration into the client organisation are all relevant.
Personal service and substitution
A genuine right to send a substitute, i.e. to have someone else perform the engagement without requiring the client’s approval based on the identity of the substitute, points strongly against employment. The practical problem is that many “substitution clauses” in contracts are not genuinely unfettered: the client’s consent is required, or the substitute must be approved or substitution has never been exercised. Tribunals probe whether the right is real or purely notional.
Other factors
Beyond the core three tests, tribunals also consider: whether the worker provides their own equipment; financial risk (fixed-price contracts, liability for defects); whether the worker has multiple concurrent clients; and integration into the engager’s organisation (business cards, email address, internal directory listings, attendance at company social events). No single factor is determinative, the tribunal evaluates the picture as a whole.
How HMRC opens an IR35 enquiry
HMRC uses several routes to identify IR35 risk:
- Compliance check letters: HMRC issues a formal compliance check notice to the PSC (under Chapter 8) or to the engager or fee-payer (under Chapter 10), requesting information about specific engagements.
- CEST output challenges: Where an engager has issued SDS determinations using the CEST tool, HMRC may challenge the accuracy of the inputs and, consequently, the validity of the determination.
- HMRC Connect data-matching: HMRC’s Connect system cross-references RTI payroll data, company accounts, VAT returns and contractor invoicing patterns. Long-term engagements with a single client showing a single-source income stream draw automated risk flags.
- Sector-specific campaigns: HMRC has run targeted IR35 compliance campaigns in sectors including IT, financial services, locum medicine and media, often triggered by sector-wide patterns of non-compliance HMRC has identified.
- Third-party referrals: Agencies, accountants and engagers may refer compliance concerns, voluntarily or under legal obligation.
The CEST tool
HMRC’s Check Employment Status for Tax (CEST) tool is an online questionnaire that produces an employment status determination for a described engagement. HMRC has stated it will stand behind CEST results, but only where the answers given are accurate and the tool is used correctly.
The CEST tool has two well-documented structural weaknesses. First, it does not adequately test mutuality of obligation, HMRC has acknowledged this. Second, its substitution questions can produce “outside IR35” results in circumstances where a tribunal would regard the factual matrix differently. The First-Tier Tribunal has made clear in multiple decisions that it does not treat a CEST output as definitive. For a fuller analysis, see our CEST tool guide.
Status Determination Statements (SDS)
From April 2021, medium and large private-sector engagers must issue an SDS for each engagement within scope of Chapter 10. The SDS must state whether the worker would be an employee or office-holder absent the intermediary and give reasons for that conclusion. An SDS without reasons is invalid in law.
Workers and agencies have a statutory right to challenge the SDS within 45 days of receiving it. The engager must respond within 45 days of receiving the challenge: if it does not, the SDS is deemed to have been issued without reasonable care and liability for PAYE and NICs may revert to the end-client. For full detail on the SDS process, see our SDS guide.
The fee-payer liability chain
Under Chapter 10, the liability chain runs: end-client → agency → fee-payer (the entity immediately above the PSC in the contractual chain) → PSC. The fee-payer (often an agency) operates PAYE on payments it makes to the PSC where the SDS records an inside-IR35 determination.
If the end-client fails to issue an SDS or issues a negligent one, it retains the liability. If a fee-payer passes fraudulent information up the chain (e.g. fraudulently misrepresenting that an engagement is outside IR35), the liability jumps back to the fee-payer. Understanding where liability sits is critical before responding to any HMRC compliance action, as the exposure may be at a different level of the chain than initially assumed.
Penalties and interest
Where HMRC successfully establishes that a deemed employment payment should have been taxed under IR35 and was not, the tax consequences are:
- PAYE income tax and employee’s NICs: treated as an underpayment by the party in the chain that should have deducted them, typically with interest from the due date.
- Employer’s NICs: due from the fee-payer (under Chapter 10) or the PSC (under Chapter 8).
- Penalties under s98A Taxes Management Act 1970: for failure to operate PAYE correctly, with penalty ranges depending on behaviour (careless, deliberate or deliberate and concealed).
- Failure-to-notify penalties: where the PSC failed to notify HMRC of its Chapter 8 liability.
Penalty abatement is available for disclosure, cooperation and the quality of information provided. The earlier a voluntary disclosure is made, the greater the reduction available. Where HMRC opens a compliance check without any prior disclosure, the “prompted” disclosure penalty range applies, generally producing a higher floor.
Compliance defence strategy
An effective IR35 defence rests on two pillars: the contract and the working practices.
Contractual review
The written contract must genuinely reflect an outside-IR35 engagement. Key terms to review: the scope of services (deliverables-based, not time-based); an unfettered substitution right; no obligation on the engager to offer work and on the contractor to accept it; clear intellectual property ownership by the contractor; a right to work for other clients simultaneously; and no restriction on working hours or location beyond what the deliverable requires.
A contract that describes an employment relationship, however labelled, will not assist a defence. Equally, a strong contract is necessary but not sufficient if the working practices diverge from it.
Working practices evidence
The factual reality of how the engagement operates is given greater weight than the contractual terms where the two diverge. Contemporaneous evidence is the most persuasive: emails and messages demonstrating project-based working, invoices to multiple clients during the same period, records of the substitution right being offered or used, evidence of the contractor supplying their own equipment and documentation of financial risk (e.g. fixed-price quotes, liability clauses). The absence of integration evidence, no company email address, not on internal directories, not attending company away-days, also assists. For a detailed walkthrough, see our IR35 defence strategy guide.
The route to resolution
When facing an IR35 enquiry, the realistic options are:
- Voluntary disclosure and settlement: Where the evidence of inside-IR35 working is strong, an early negotiated settlement minimises interest accrual and maximises penalty abatement. This is not “giving up”, it is a cost-benefit decision made on the evidence available.
- Formal defence and HMRC dialogue: Where the factual case is strong, HMRC’s enquiry can be contested at the compliance check stage through substantive written representations supported by evidence. Many IR35 cases settle without tribunal proceedings.
- Appeal to the First-Tier Tribunal (Tax): Where HMRC issues a formal determination and the taxpayer disagrees, the appeal route is to the FTT. IR35 appeals are fact-intensive and can turn on nuanced credibility assessments, preparation of evidence bundles and witness statements is critical.
Our team has experience representing contractors, PSCs and engagers in IR35 enquiries at all stages from initial compliance check to FTT appeal. We also assist engagers in reviewing their off-payroll compliance programmes and ensuring their SDS processes meet HMRC’s expectations. For PAYE and employment compliance investigations more broadly, see our PAYE audits service and income tax investigation service.
Frequently asked questions
Can HMRC open IR35 enquiries for closed years?
Yes. HMRC can open enquiries into closed years where it suspects a loss of tax. Under Chapter 8 ITEPA 2003 (old IR35), HMRC typically has four years from the end of the relevant tax year for careless behaviour and six years for deliberate behaviour. Where HMRC discovers what it regards as deliberate non-compliance, a 20-year window may apply. Chapter 10 off-payroll liabilities (post-April 2021 private sector) sit with the fee-payer in the liability chain, but HMRC still investigates engagers’ SDS obligations and PSC compliance for pre-2021 years under Chapter 8.
Does a substitution clause in a contract guarantee outside IR35 status?
No. A substitution clause is a significant factor but not determinative on its own. Tribunals look at whether the right of substitution is genuine and unfettered and whether it has ever been exercised. A clause that exists only on paper, where in practice the client would never accept a substitute, carries limited weight. The leading authorities, including Kickabout Productions Ltd v HMRC [2022] CA, confirm that tribunals consider the totality of the working relationship, not a single contractual term in isolation.
What evidence does HMRC look for in an IR35 investigation?
HMRC seeks evidence that exposes the reality of the working relationship rather than what the contract says. Key material includes emails and messages showing supervision and control; absence of evidence of substitution actually being offered or used; evidence of a single engager over extended periods; holiday and sickness policies mirroring employee treatment; and standard-rate pay regardless of output. HMRC will also use CEST outputs, statutory returns and data from payroll intermediaries.
What is the difference between Chapter 8 and Chapter 10 IR35?
Chapter 8 ITEPA 2003 is the original IR35 legislation (“old IR35”) where the PSC bears responsibility for determining its own status and paying any deemed PAYE and NICs. Chapter 10 ITEPA 2003 is the off-payroll working regime introduced for the public sector in April 2017 and extended to medium and large private-sector engagers in April 2021. Under Chapter 10, the responsibility for making the status determination shifts to the end-client and the fee-payer bears the PAYE and NIC liability. Small private-sector companies remain exempt from Chapter 10.