Will IR35 Shrink Demand for Contractors?

Acuity Knowledge Partners
5 min readOct 12, 2023

IR35 is a piece of legislation designed to stop workers from fraudulently claiming to be contractors (i.e., off payroll), for personal benefit. It was introduced in 1999 and became law at the start of the year 2000. HM Revenue and Customs (HMRC) found in 1999 that many contractors were gaining income tax benefits and avoiding National Insurance (NI) contributions by creating intermediaries in the form of limited companies between them and the employing companies. Despite the law governing income tax being in force for many years, most limited-company contractors continued to enjoy these benefits, as they were responsible for determining employment status and, therefore, penalties for tax evasion (if found out by HMRC) were limited to them. Over 90% of contractors were non-compliant with IR35 rules, according to HMRC estimates. As a result, HMRC implemented public-sector reforms in April 2017, shifting the responsibility for determining employment status from limited-company contractors to the company employing them. These reforms will be extended to medium-size and large organisations in the private sector from April 2020.

What determines employment status?

Determining employment status for tax purposes is not easy. The three key factors, known as the principal tests to identify employment are listed below:

  • Control: What degree of control does the client have over what, how, when and where the worker completes the work, i.e., is the contractor supervised or advised on how the work should be carried out?
  • Substitution: Is personal service by the worker required, or can the worker send a substitute in their place, i.e., can the contractor send a substitute in their place?
  • Mutuality of obligation: This is a concept where the employer is obliged to offer work, and the worker is obligated to accept it, i.e., does the contractor have the right to define the scope or work and deny the task requested by the employer?

HMRC also offers an online tool that can be used to Check for Employment Status for Tax (CEST). This tool determines employment status based on the answers input for a series of questions related to, for example, the nature of work and terms of contract. Like with any other tool, accuracy of the output depends on the accuracy of the data input by the employer.

Impact of IR35 on the private sector

Changing the rules would mean higher costs for employers and lower net take-home income for contractors. Employers may consider increasing pay for contractors critical to the project to factor in the additional tax and NI contribution that the contractor has to bear. Apart from the cost of engaging contractors, employers would now have to factor in the cost involved in ensuring that their existing contractors comply with the new rules and in periodically reviewing the status of all their contractors. For contractors, the new rules would mean a higher tax on their income that could reduce their net take-home pay by as much as 20%, making it less lucrative to be a contractor.

Research by Be Digital UK found that four of 10 companies are reviewing their strategies for procuring contractors under IR35 and exploring the option of phasing out these contractors when the new rules are in force.

A survey conducted by contractor insurance provider Qdos Contractor revealed that 89% of the 1,339 contractors surveyed wanted to be offered employment rights when working under IR35, raising costs for employers.

More than 50% of UK contractors and consultants will leave their current contracts before 6 April 2020, according to research published by accounting firm inniAccounts. This would mean that their respective projects would be at risk, with less than 10% of contractors and consultants looking to take up permanent roles. The research also suggests that about 47% of the firms are considering offshoring work to mitigate the risk to current and future projects.

According to an article in the Financial Times, 50 of 53 contractors in Deutsche Bank’s (DB’s) team supporting Financial Crimes Compliance have decided to walk out of their contracts, as the terms of employment offered by DB are unfavourable, with the contractors standing to suffer a pay cut of 25% under IR35.

Potential options for employers

  • Move all contractors under IR35 — This is a safe option for employers to avoid tax liabilities, HMRC fines and reputational damage. Many large organisations are already taking this approach, although it is unlikely to be favourable to their contractors and could lead to high churn rates.
  • Move contractors to permanent roles — The employer will lose the flexibility to scale up or down as per business need, and this approach would pile on the long-term costs associated with full-time employees such as training costs and retirement benefits. However, it would retain knowledge and, therefore, is considered to be a good option.
  • Invest time and money to assess the status of each contract — Review each contract and project requirement in light of the new regulations and engage only those contractors who fall outside of IR35. As per HMRC estimates, only 10% of the existing contracts may be IR35-compliant; this may, therefore, not be a scalable option.
  • Use managed service providers — This is a strategy worth considering, as the firm can lock in its costs based on agreed service levels and outcomes. This would not only solve the immediate issue on hand but would also save significant costs for the firm in the long run. This option also provides the firm the flexibility of terminating contracts at short notice. According to research published by inniAccounts, 47% of respondents to its survey see this as a viable solution.
  • Place/hire contractors through recruitment outsourcing agencies that function as umbrella firms — The new IR35 rules are likely to lead to recruitment agencies setting up umbrella companies to hire contractors on a permanent-pay basis while they renegotiate the contractors’ terms of contract with the end employer. The recruitment agency will treat the contractors as payroll employees, but will not grant them the employee benefits typically offered by companies. However, this option would still be more expensive than the contractor model, as the recruiting firm will incur all statutory costs, eroding its profit margins. The Inland Revenue Department’s (IRD’s) treatment of such an arrangement would also need to be assessed, as the IRD may consider it to be a method of tax avoidance.

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