Who Bears the IR35 Risk When a Recruitment Firm Is Involved?
You run a 15-person digital agency in Manchester. You need a senior developer for a six-month project. You call a recruitment firm, they find you a contractor who operates through their own limited company. You sign a contract with the recruitment firm, and you pay the recruitment firm. The recruitment firm pays the contractor.
Who is responsible for determining the contractor's IR35 status? And if HMRC later decides that contractor was inside IR35, who pays the tax and National Insurance?
This is one of the most misunderstood areas of the off-payroll rules. And getting it wrong can cost you tens of thousands of pounds in back taxes, interest, and penalties. Working exclusively with agency founders, we see this confusion regularly. Let's clear it up.
The Off-Payroll Rules: A Quick Refresher
The off-payroll rules (commonly known as IR35) apply when a contractor provides their services through an intermediary, typically their own limited company. If the contractor would be classed as an employee if they were engaged directly, they are considered "inside IR35." The engager (the agency or end-client) then becomes responsible for deducting PAYE and National Insurance from the fees paid to the contractor's intermediary.
Since April 2021, medium and large organisations in the private sector have been responsible for determining the contractor's status and issuing a Status Determination Statement (SDS). Small companies (meeting two of three criteria: turnover under £10.2m, balance sheet under £5.1m, fewer than 50 employees) are exempt, the contractor's own limited company bears the responsibility instead.
But here is where it gets complicated. When a recruitment firm sits between your agency and the contractor, who is the "end-client" for IR35 purposes? And who is the "fee-payer"?
The End-Client vs. The Fee-Payer: Why the Distinction Matters
Under the off-payroll rules, the end-client is the organisation that receives the benefit of the contractor's work. That is your agency. The fee-payer is the organisation that pays the contractor's intermediary. That could be your agency, or it could be the recruitment firm, depending on how the chain is structured.
This distinction matters because the off-payroll rules for recruitment agency contractors place different obligations on different parties in the chain.
If your agency is the end-client (which it almost certainly is), you are responsible for:
- Determining the contractor's IR35 status
- Issuing a Status Determination Statement (SDS) to the contractor and the next party in the chain
- Ensuring the SDS is reasonable and taking reasonable care
If your agency is also the fee-payer (because you pay the contractor's intermediary directly), you are also responsible for deducting PAYE and National Insurance if the contractor is inside IR35.
If the recruitment firm is the fee-payer (because you pay them, and they pay the contractor), the recruitment firm is responsible for the tax deductions, but only if your agency has correctly determined the contractor's status and issued a compliant SDS.
The Liability Trap: What Happens When the SDS Is Wrong
Here is where many agencies get caught out. You engage a recruitment firm. You tell them the contractor is outside IR35. You do not issue a formal SDS. The recruitment firm pays the contractor gross. Everyone is happy.
Then HMRC investigates. They decide the contractor was actually inside IR35. Who pays?
Under the rules, if the end-client (your agency) fails to take reasonable care in determining the contractor's status, or fails to issue a compliant SDS, the liability for the unpaid tax shifts to the end-client, even if the recruitment firm was the fee-payer.
That means you could be on the hook for the contractor's unpaid income tax, employee NI, employer NI, and the Apprenticeship Levy. Plus interest. Plus penalties.
For a contractor earning £600 per day over six months, that could be a liability of £35,000 to £45,000. For a single contractor. If you have several contractors working through recruitment firms, the numbers add up fast.
How to Structure Engagements to Protect Your Agency
The safest approach is to take responsibility for the status determination yourself, regardless of who pays the contractor. Do not rely on the recruitment firm's assessment. Do not rely on the contractor's own assessment. HMRC will come to you.
Here is the practical process we recommend to our agency clients:
Step 1: Determine the Contractor's IR35 Status
Use HMRC's CEST (Check Employment Status for Tax) tool as a starting point. But be aware: CEST is directional, not definitive. It often gives unreliable results for complex arrangements. For higher-risk engagements, commission a professional IR35 review from a qualified tax adviser.
Consider the actual working practices: Does the contractor have substitution rights? Do they bear financial risk? Do they provide their own equipment? Are they integrated into your team? These are the factors that matter.
Step 2: Issue a Status Determination Statement
This is not optional. You must issue an SDS to the contractor and to the recruitment firm (or whoever is the next party in the chain). The SDS must state the determination, the reasons for it, and the date it was made.
Keep a copy on file. You will need it if HMRC ever asks.
Step 3: Agree Who Handles the Tax Deductions
If the contractor is inside IR35, someone needs to deduct PAYE and National Insurance. If your agency pays the recruitment firm and the recruitment firm pays the contractor, the recruitment firm should handle the deductions, but only if you have issued a compliant SDS.
If the recruitment firm refuses to handle the deductions (some do, because they do not want the administrative burden), you may need to restructure the engagement so your agency pays the contractor's intermediary directly. Or find a different recruitment firm.
Step 4: Get It in Writing
Your contract with the recruitment firm should clearly state who is responsible for the status determination, who is responsible for the tax deductions, and what happens if HMRC challenges the arrangement. Do not rely on verbal agreements.
What About Small Agencies? Are You Exempt?
If your agency qualifies as a small company under the Companies Act definitions (turnover under £10.2m, balance sheet under £5.1m, fewer than 50 employees), the off-payroll rules do not apply to you in the same way. The contractor's own limited company bears the responsibility for determining IR35 status.
But be careful. The exemption only applies to engagements that start while you are still small. If you grow past the threshold during the engagement, the rules shift. And HMRC may look at the size of the end-client, not the recruitment firm, when determining who is responsible.
Also, just because you are exempt does not mean you should ignore IR35. If HMRC challenges the contractor and wins, the contractor's limited company pays the tax. But the contractor may come after your agency for the shortfall, claiming you misrepresented the engagement. It happens.
Practical Examples: Three Common Scenarios
Scenario 1: Your agency is the end-client and the fee-payer. You find a contractor directly through a recruitment firm, but you pay the contractor's limited company directly. The recruitment firm takes a finder's fee. You are responsible for the status determination and the tax deductions. Issue an SDS. Handle PAYE if inside IR35. Simple.
Scenario 2: Your agency is the end-client, the recruitment firm is the fee-payer. You pay the recruitment firm. They pay the contractor. You are responsible for the status determination and issuing the SDS. The recruitment firm is responsible for the tax deductions. But if you fail to issue a compliant SDS, the liability shifts back to you.
Scenario 3: The recruitment firm claims they are the end-client. Some recruitment firms will try to argue they are the end-client to avoid liability. This is almost never correct. The end-client is the organisation that receives the benefit of the contractor's work. That is your agency. Do not accept a contract that shifts the IR35 determination responsibility to the recruitment firm without professional advice.
What to Do If HMRC Comes Knocking
If HMRC opens an IR35 enquiry into a contractor your agency engaged through a recruitment firm, do not panic. But do act quickly.
First, gather all documentation: the SDS you issued, the contract with the recruitment firm, the contract between the recruitment firm and the contractor, and any evidence of the actual working practices (emails, timesheets, project plans, etc.).
Second, check whether you took reasonable care in making the status determination. If you used CEST and it gave a reasonable result, that helps. If you commissioned a professional review, even better. If you just guessed, you have a problem.
Third, contact your accountant. Working exclusively with agency founders, we have handled many IR35 enquiries for agency clients. The key is to respond promptly, provide complete information, and negotiate from a position of strength.
If HMRC decides the liability rests with your agency, you may be able to recover some of the tax from the contractor or the recruitment firm, depending on the terms of your contracts. But that is a civil matter, not a tax matter. Do not rely on it.
Final Advice: Do Not Leave This to Chance
The off-payroll rules for recruitment agency contractors are not optional. They are not something you can ignore and hope HMRC does not notice. HMRC is actively targeting the agency sector, and IR35 enquiries are on the rise.
If you engage contractors through recruitment firms, make sure you have a clear process for determining status, issuing SDS, and allocating tax responsibilities. Get professional advice. Document everything. And never assume the recruitment firm has it covered.
Your agency's financial health depends on getting this right. One bad IR35 enquiry can wipe out a year's profit. Do not let that be you.
If you want to discuss your agency's contractor arrangements, get in touch with our team. We work exclusively with agency founders and understand the specific challenges you face.
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