Inside IR35, the 55% Tax Rate, so much for fairness.

How can HMRC take more in tax than an inside-IR35 contractor takes home, while still claiming the system is fair, when outside-IR35 contractors and employees already pay broadly similar amounts of tax? Let me explain.....

HMRC says the off-payroll rules make sure a worker pays “broadly the same Income Tax and National Insurance as an employee would”. That is the official line.

The difficulty is that this only describes part of what happens.

A direct employee is paid through PAYE. Their wages are not subject to VAT, because services provided by an employee to their employer are outside the scope of VAT.

An outside-IR35 contractor works through a company. That company pays corporation tax on profit, and the individual then pays dividend tax when profits are taken out. So outside IR35 is not tax free. HMRC still takes a substantial amount through company tax and personal tax.

An inside-IR35 contractor is usually paid through an umbrella or other intermediary. HMRC’s umbrella guidance and its key information example show that the assignment rate is first reduced by employer costs such as employer National Insurance, Apprenticeship Levy, holiday pay arrangements, pension costs and umbrella margin before gross pay is calculated. PAYE and employee National Insurance are then deducted from what is left.

Outside IR35 already carries a real tax burden

The outside contractor does not sit outside the tax system. The company pays corporation tax, and the contractor then pays dividend tax on distributions. HMRC’s published rates also confirm the personal allowance taper above £100,000, which increases the effective marginal rate in that band.

So the case for IR35 should not be based on the idea that outside contractors pay little or nothing. They do pay tax. The difference is that they are running a business and carrying business risk. They have to cover gaps between contracts, buy equipment, pay for training, fund pensions, and manage their own contingency.

Inside IR35 creates a different problem

Inside IR35 is often described as putting the contractor on a similar footing to an employee. In tax terms, that is only partly true.

A real employee gets PAYE treatment, but they also get an actual employment relationship. That may include continuity, notice, redundancy protection, employer benefits, a pension contribution, and internal support for training and development.

The inside contractor normally does not get that package. They are still temporary, they still face the risk of contracts ending, and they still have to think about pension, training and downtime themselves. At the same time, HMRC’s umbrella model means the assignment rate is reduced by employer-side costs before the worker even gets to gross pay.

That is why many contractors see inside IR35 as worse than either of the cleaner models. It is not the same as being a normal employee, and it is not the same as running a business.

Why inside rates rise in the real world

If an outside contractor is pushed inside IR35, their take-home usually falls unless the day rate rises. That is because the inside structure is carrying more tax liabilities. Employer-side costs come out of the assignment rate first, then PAYE and employee NIC are taken from gross pay. HMRC’s umbrella example shows that clearly.

That is why inside roles often command a higher day rate in practice. The rate increase is not because the work changed. It is because the tax and payment structure changed.

Once the rate rises, the VAT on the labour supply rises as well, because supplies of staff are normally standard-rated for VAT. That is different from a direct employee, where wages are outside the scope of VAT.

The VAT issue

This is where the comparison with direct employment becomes awkward.

A direct employee has no VAT on wages. HMRC is clear on that.

A supply of staff is normally subject to VAT at the standard rate. HMRC is clear on that too.

So an inside contractor can end up in a position where HMRC says they should be taxed broadly like an employee, but the labour still sits in a VATable supply chain that a real employee would never be in. That means the worker can face employment-style tax treatment while the client is still paying VAT on the labour supply.

That is not the same as saying wages themselves are subject to VAT. They are not. The point is that the inside structure can still make the engagement more expensive than direct employment because the labour is being supplied through a VATable chain.

Worked comparison

Take a role with a market value of £600 a day over 220 days. That gives a base annual labour value of £132,000.

Using current HMRC rates and umbrella mechanics, the broad picture looks like this:

Model	Basis	Client cash cost incl. VAT	VAT in client cost	Approx. HMRC take, excl. VAT	Approx. HMRC take, incl. VAT in chain	Approx. net to worker
Direct employee	Employer cost equivalent to £600/day	£132,000	£0	~£57,600	~£57,600	~£74,400
Outside IR35	£600/day via PSC	£158,400	£26,400	~£50,500	~£76,900	~£81,500
Inside IR35, no uplift	£600/day via umbrella	£158,400	£26,400	~£56,900	~£83,300	~£73,800
Inside IR35, 20% uplift	£720/day via umbrella	£190,080	£31,680	~£72,900	~£104,600	~£84,200

These figures are illustrative, not personal tax advice, but they reflect the structure shown in HMRC’s PAYE, NIC, VAT and umbrella guidance.

The table shows four things.

First, outside IR35 already produces a meaningful tax take. It is not a low-tax model in any ordinary sense.

Second, inside IR35 at the same headline day rate can leave the worker with less than outside IR35, because the assignment rate is reduced before PAYE even starts.

Third, if the inside contractor pushes for a higher rate to restore take-home, the client cost rises and the VAT rises with it.

Fourth, inside IR35 can leave HMRC taking more than the worker takes home, once the full tax take in the chain is counted.

Using the figures in the table:

For inside IR35 at £600 a day with no uplift, the worker takes home about £73,800, while HMRC takes about £83,300. That means HMRC takes roughly £9,500 more than the contractor keeps. Put another way, HMRC takes about 53% of the combined tax-plus-take-home total, leaving the worker with only 47%.

For inside IR35 at £720 a day with a 20% uplift, the worker takes home about £84,200, while HMRC takes about £104,600. That means HMRC takes roughly £20,400 more than the contractor keeps. In percentage terms, HMRC takes about 55% of the combined total, leaving the worker with only 45%.

Let that sink in 55% tax rate for inside IR35 Contractor, with no rights, no expenses, no job security, or pension.

Mobility and expenses

This also affects where people are willing to work.

Since April 2016, tax relief for home-to-work travel and subsistence has been restricted for workers providing personal services through an employment intermediary, such as an umbrella company, where they are subject to supervision, direction or control, or the right of it.

HMRC’s Employment Status Manual sets this out, and the policy paper behind the change explains that the aim was to stop workers engaged through intermediaries claiming relief that direct employees could not usually claim.

In practice, that means an inside contractor working away from home is often in a much weaker position on travel and subsistence than an outside contractor running a genuine business. Train fares, fuel, hotels and meals can stop being tax-efficient business expenses in the way many contractors expect. At the same time, the income funding those costs has already been pushed through PAYE and employee NIC, with employer-side costs already taken out of the assignment rate upstream.

That changes behaviour. If a role is two hundred miles away and the worker cannot sensibly offset travel and accommodation costs, the role becomes much less attractive unless the rate goes up. So inside IR35 does not just affect take-home pay, it also makes it harder to take on work that involves travel or working away from home.

Training, skills and self-funding

A contractor normally funds a lot of their own development. That includes exams, courses, lab equipment, cloud spend, software, books and time between contracts. Outside IR35, the contractor is at least operating through a business structure that allows them to plan around that.

Inside IR35 leaves less room. If more of the contract value is lost to employer-side costs, PAYE and NIC before the worker sees the money, there is less available for training, pension saving and contingency. That does not show up neatly on a tax table, but it does affect how easy it is for someone to keep their skills current.

The main point

If you only compare PAYE and NIC, you can say inside IR35 looks closer to employment.

If you look at the whole position, including VAT on staff supply, the loss of deductible travel in many intermediary arrangements, the reduction in take-home at the same headline rate, and the lack of direct employee protections, the position is much less tidy.

Outside IR35 already pays tax.

Direct employment has no VAT on wages and comes with an actual employment relationship.

Inside IR35 can combine lower take-home, higher client cost, VAT in the supply chain, limited expenses for mobility, and less room for pension, training and contingency.

That is why many people do not accept the simple line that it creates parity. It may move tax treatment in that direction, but the wider commercial and practical position is still not the same.