If your business engages contractors, you may be aware of HMRC’s set-off rules, introduced to address long-standing concerns about double taxation in IR35 cases. While these changes are a positive step, there is a common misconception that they significantly reduce the financial risks of incorrectly applying IR35.
Although the revised calculation is more equitable, the core liabilities remain firmly with the engaging companies. Penalties, interest, Employer’s National Insurance Contributions, and, where applicable, the Apprenticeship Levy continue to apply and can result in substantial costs.
What Is the Set-Off Rule
Over many years, businesses expressed concerns regarding HMRC’s management of IR35 compliance. The primary issue was straightforward: if a contractor was inaccurately classified as outside IR35, the hiring company might incur the obligation to pay the full PAYE and National Insurance contributions, even if the contractor’s personal service company had already remitted these taxes. Essentially, this situation led to double taxation of the same income.
The set-off rule, effective from April 2024, was introduced to address this concern. It permits HMRC to deduct certain taxes already paid by the contractor or their company when assessing the PAYE liability resulting from an IR35 determination, thereby reducing the overall tax liability.
For instance, if HMRC establishes a PAYE liability of £50,000 and the contractor’s company has already paid £30,000, the employer’s liability amounts to only £20,000.
Although this represents an advancement over previous regulations, numerous businesses mistakenly believe their risk is entirely mitigated — a misconception that could prove costly.
Changes in IR35 Enforcement:
Prior to April 2024, HMRC maintained a stringent stance on non-compliance. When a contractor was considered to have been improperly classified as an independent contractor rather than an employee, the employing company was liable for the full amount of PAYE Income Tax and National Insurance contributions, irrespective of whether the contractor’s personal service company had already remitted tax on the same income. In effect, the company bore the total tax liability.
Currently, under the revised regulations, HMRC evaluates ‘Potential Lost Revenue.’ This methodology accounts for taxes previously paid by the contractor or their company, including Corporation Tax, Income Tax, and employee National Insurance contributions, and subsequently deducts these amounts from the company’s PAYE obligations.
Where the Risks Remain
Despite the implementation of a set-off mechanism, certain areas continue to expose businesses to substantial financial risks.
HMRC retains the authority to impose penalties for a lack of reasonable care.
This represents a common point of vulnerability for companies. HMRC expects companies to exercise due diligence when determining whether a contractor falls within or outside the scope of IR35. If HMRC establishes that reasonable care was not exercised, penalties of up to 30% of the unpaid tax may be levied.
Careless behaviours encompass failing to maintain proper records, relying solely on contractual terms without considering actual working practices, or neglecting to reassess arrangements as roles evolve. Essentially, any indication that the decision was not thoroughly contemplated could result in penalties.
The penalty amount varies depending on how the issue is identified. Should a business disclose the problem voluntarily, penalties may be reduced to a range between 0% and 15%. Conversely, if HMRC discovers the issue during a compliance review, penalties generally range from 15% to 30%.
For instance, if £20,000 remains payable after set-off, a 20% penalty would amount to an additional £4,000 to the total liability.
Interest Is Charged and Can Accumulate Quickly
In addition to taxes and penalties, HMRC imposes interest on overdue PAYE and National Insurance payments, commencing from the original due date. When HMRC reviews previous cases, interest may accrue over multiple years. Given that current interest rates are substantially higher than in recent years, this can substantially augment an IR35 settlement, potentially amounting to several thousand pounds depending on the age of the liability.
You’re Still Liable for Employer National Insurance
This is the part that often causes confusion. The set-off rule only applies to the worker’s tax and does not reduce your Employer National Insurance Contributions or the Apprenticeship Levy if applicable. These costs are separate, and you are fully responsible for paying them.
Employer NICs are currently at 15% on earnings above a certain threshold. For example, paying a contractor £60,000 in a year could result in about £8,280 in Employer National Insurance costs.
If your total payroll exceeds £3 million, the Apprenticeship Levy is also due, charged at 0.5% of total payroll, which would add an extra £300 to the same £60,000 contractor payment.
None of these additional employer costs is covered by the set-off; they are neither reduced nor refunded, and must be paid by your business. Even if the tax liability appears lower on paper, these extra costs can make an IR35 assessment very costly.
How to Minimise Your Exposure
Businesses can take practical measures to lower the risk of IR35 non-compliance and its potential financial impact.
Evaluate Each Contractor Accurately
HMRC offers the Check Employment Status for Tax (CEST) tool as a helpful starting point. Nevertheless, it should not be used as the sole criterion. An accurate assessment must align with the actual working arrangements, not just the written contract.
Important factors include the level of control exercised over the contractor, the existence of a genuine right of substitution, and whether the individual is running an independent business. These elements are crucial to HMRC’s evaluation and should be considered with care.
Keep Clear and Detailed Records
If HMRC reviews your IR35 decisions, it will expect evidence showing that you exercised reasonable care. This includes keeping records such as Status Determination Statements, notes on assessments, records of working practices, and relevant correspondence.
Maintaining thorough records is crucial not only for defending a status decision but also for proving that your company has followed a proper, thoughtful process.
Review Arrangements on a Regular Basis
Employment status isn’t static. A contractor initially outside IR35 can later fall inside it as roles evolve and working practices change. Regular reviews ensure that assessments stay accurate and aligned with actual working conditions. Periodic reassessments can also detect potential problems early, helping to prevent HMRC scrutiny.
Stay on Top of Changes
IR35 is still evolving. Tribunal decisions, updates in HMRC guidance, and legislative changes can influence how the rules are understood and enforced. Businesses hiring contractors should keep themselves informed and adjust their processes as needed.
Seek Professional Support Where Appropriate
IR35 is a complex area where the line between employment and self-employment can be blurry. Due to the possible financial risks, many companies opt to consult specialists for status evaluations, documentation, and ongoing compliance.
Taking proactive measures early on is much more cost-effective than facing the repercussions of an HMRC investigation later.
Changes in 2026: The Small Company Threshold and What It Means for IR35
It is also crucial at this stage to assess whether the off-payroll working regulations influence your company.
Effective from April 2026, modifications to the thresholds within the Companies Act indicate that an increased number of companies may meet the criteria of small companies, thereby potentially exempting them from the scope of IR35.
When a company qualifies as small, the responsibility to determine employment status transfers to the contractor’s personal service company rather than to the engager. Consequently, the engager is not required to issue a Status Determination Statement or to deduct PAYE under IR35. Nevertheless, this exemption necessitates careful evaluation.
A company’s classification as small is contingent on meeting at least two statutory thresholds for turnover, total assets, and employee count, which are assessed over time and can be affected by factors such as growth, restructuring, or group affiliations.
An erroneous assessment of small company status may expose a business to challenges from HMRC, accompanied by the same liabilities, penalties, and interest applicable to non-compliance with IR35. In addition to this change, IR35 remains subject to ongoing review. The set-off rule should not be perceived as a reason for companies to become complacent, as HMRC remains committed to requiring well-reasoned judgments and supporting evidence for their determinations.
How We Can Help
At The Infinity Group, we provide assistance to businesses requiring precise management of IR35 compliance, particularly when internal resources or expertise are limited.
Outsourcing payroll functions to us guarantees a systematic approach that supports maintaining compliance with IR35 regulations when necessary. We perform employment status assessments, verify payroll configurations in accordance with HMRC standards, and oversee contractor engagements as they evolve.
When operational practices change or HMRC guidelines are revised, we advise clients of the implications and suggest appropriate courses of action. Furthermore, we review supply chains to ensure compliance with IR35. Responsibilities are met across all involved parties, understanding that non-compliance can pose risks for the engaging company. Our goal is simple: support compliance, minimise exposure, and enable you to run your business confidently.