Inside IR35 explained: tax and payroll
A contract found inside IR35 makes the fee-payer deduct Income Tax and employee National Insurance from the worker's fee, then pay employer National Insurance at 15% on top [1]. The employee rate sits at 8% on earnings between the primary threshold and the upper earnings limit, and 2% above it, the same rates a direct employee pays [2].
Inside IR35 means the engagement is treated as employment for tax. The worker supplies services through a company, but the off-payroll working rules require that the income is taxed broadly as though the worker were a direct employee of the client [3]. Understanding what that involves matters for the party running the payroll, because the mechanics are more than a simple deduction.
This article explains what inside IR35 means, how the deemed employer operates PAYE, how the deemed direct payment is calculated, and how rights, statutory pay, and double-tax relief work. It reflects the position for the 2026-27 tax year.
Key takeaways
- Inside IR35 means the engagement is taxed as employment, with deductions made before the fee reaches the worker's company.
- The fee-payer becomes the deemed employer and runs PAYE on a figure called the deemed direct payment.
- Employer National Insurance at 15% and the Apprenticeship Levy are paid on top of the fee and cannot be recovered from the worker.
- Being a deemed employee for tax does not grant employment rights such as holiday pay from the deemed employer.
- Set-off rules stop the same income from being taxed twice where tax has already been paid.
What inside IR35 means
The off-payroll working rules apply when a worker who supplies services through an intermediary would have been an employee if engaged directly [4]. When a client determines that this is the case, the contract is inside the rules, often described as inside IR35. For public-sector clients and medium or large private-sector clients, the client makes that determination and issues a status determination statement [5].
The consequence is that the fee stops being a simple business-to-business payment. The party that pays the worker's intermediary, the fee-payer, has to treat the payment as employment income and deduct tax before it passes on the net amount [6]. The full framework, including the size tests that decide who is responsible, sits in the guide to the IR35 off-payroll working rules.
How the deemed employer runs the payroll
The fee-payer immediately above the worker's intermediary becomes the deemed employer. It has to operate PAYE on the deemed direct payment, report it through Real Time Information, and account to HMRC [7]. A deemed employer therefore needs a real, working payroll process, which is where HMRC-recognised payroll software that submits the Full Payment Submission correctly becomes essential.
The deductions the fee-payer makes
The deemed employer deducts Income Tax and the employee's National Insurance from the deemed direct payment, then pays employer National Insurance and, where it applies, the Apprenticeship Levy on top [8]. Crucially, employer National Insurance cannot be taken out of the worker's fee; it is an additional cost the deemed employer bears [9].
The table below sets out who pays what on an inside-IR35 engagement for the 2026-27 tax year.
| Charge | Rate | Borne by |
|---|---|---|
| Income Tax | 20%, 40% or 45% by band | Deducted from the worker's payment |
| Employee National Insurance | 8% to the upper earnings limit, 2% above | Deducted from the worker's payment |
| Employer National Insurance | 15% above the secondary threshold | Paid by the deemed employer, on top |
| Apprenticeship Levy | 0.5% of the pay bill, where it applies | Paid by the deemed employer, on top |
Accountants managing several deemed-employment payrolls at once typically rely on a payroll bureau platform that keeps each client scheme distinct and correctly reported.
Calculating the deemed direct payment
The deemed direct payment is the taxable figure, and it is reached by a short sequence of steps. The starting point is the amount paid to the intermediary, less any VAT [10]. From that, the deemed employer deducts the direct cost of materials and any expenses that would have been deductible from an employee's earnings [11].
If the result is nil or negative, there is no deemed direct payment. Otherwise, the remaining figure is treated as employment income and taxed through PAYE [12]. Under the reformed rules that apply when a client makes the determination, there is no flat-rate allowance to reduce that figure [13].
When the contractor's own company applies the rules
Where the end client is a small business or is wholly overseas, the reformed rules do not shift responsibility to the client. Instead, the worker's own company applies the original form of the legislation and works out a deemed employment payment itself [14]. This is a different calculation from the client-led one.
Under that original computation, the intermediary can reduce the relevant income by a flat 5% allowance before applying the other deductions, a relief that does not exist under the client-led rules [15]. The company then deducts pension contributions and any National Insurance it has already paid on the worker's salary and benefits before arriving at the deemed payment [16]. Contractors running this calculation through their own small-company payroll should keep clear records of every deduction.
Rights, statutory pay, and pensions
Inside IR35 decides status for tax, not for employment law. A worker taxed as a deemed employee does not gain employment rights, such as holiday pay, from the deemed employer [17]. The deemed employer is also not required to operate auto-enrolment or provide a workplace pension for the worker [18].
Statutory payment entitlement instead flows through the worker's own company. Because the deemed payment is subject to Class 1 National Insurance, it can build entitlement to statutory payments, and the worker is protected from paying National Insurance a second time when the money is drawn from the intermediary [19]. The interaction between these deductions and the wider cost of employment is explored in the guide to employer National Insurance.
Avoiding double taxation
A recurring worry with inside-IR35 engagements is that the same income could be taxed twice, once through the deemed employer and again in the company's hands. The legislation prevents this. Where the intermediary has borne deductions already made by the deemed employer, the worker does not pay tax or National Insurance again on that income when it is taken out of the company [20].
From 6 April 2024, a further set-off applies. Regulations allow HMRC to offset tax and National Insurance already paid by a worker and their intermediary against a deemed employer's later PAYE liability on the same income, which reduces the risk of over-collection where a determination is corrected after the fact [21].
Conclusion
Inside IR35 turns a business-to-business fee into an employment-taxed payment, and it hands the compliance work to whoever pays the worker's intermediary. The headline is the deduction of Income Tax and employee National Insurance, but the detail that catches people out is the employer National Insurance at 15% that lands on top of the fee, together with the calculation of the deemed direct payment and the separation between tax status and employment rights.
For the deemed employer, the practical challenge is running an accurate PAYE process for workers who are not conventional employees. As status enquiries stay active and employer National Insurance sits at a higher rate, the engagers who cope best are those that treat inside-IR35 payrolls with the same rigour as any other, supported by software built to keep the deductions, submissions, and set-off relief correct.
Frequently asked questions
Who pays the tax on an inside IR35 contract?
The fee-payer, the party that pays the worker's intermediary, becomes the deemed employer and accounts for the tax. It deducts Income Tax and employee National Insurance from the deemed direct payment through PAYE, then pays employer National Insurance at 15% and any Apprenticeship Levy on top. The worker's company receives the net amount and does not tax the same income again.
Does inside IR35 give a contractor employment rights?
No. The off-payroll working rules decide employment status for tax only, not for employment law. A deemed employee does not gain rights such as holiday pay or a workplace pension from the deemed employer. Any employment rights and pension arrangements run through the worker's own company, not through the client or fee-payer.
How is the deemed direct payment calculated?
The deemed employer starts with the amount paid to the intermediary and removes any VAT. It then deducts the direct cost of materials and any expenses that would have been deductible from an employee's earnings. If the result is positive, that figure is the deemed direct payment and is taxed through PAYE. Under the client-led rules there is no flat-rate allowance, though the original computation used by small-client engagements does allow a 5% reduction.
Can the same income be taxed twice under IR35?
The rules are designed to stop that. Where the deemed employer has already made deductions, the worker does not pay tax or National Insurance again when the income is drawn from their company. From 6 April 2024, HMRC can also set off tax and National Insurance already paid against a deemed employer's later liability on the same income, further reducing the risk of double taxation.
