The new umbrella companies tax regime – an 'expansion' of IR35?

Posted: 14/11/2025

Changes are on the horizon for businesses that rely on flexible labour arrangements, so employment businesses and companies engaging with casual or self-employed workers will need to take note.

HMRC has long been concerned with the widespread use of umbrella companies given their reputation as tax avoidance schemes. Draft legislation seeking to address this may, however, have significant hidden consequences for all companies - including small companies who engage self-employed individuals through their own personal service limited companies (PSCs) by potentially extending tax liability beyond the scope of the current IR35 tax regime. 

'Umbrella company' is the term used to refer to a business that acts as the employer of workers supplied to end user clients. They take care of the payroll and employment administration allowing a flexible and 'risk free' supply of casual labour. They are frequently used by employment businesses to outsource payroll services and/or for the supply of 'self-employed' consultants or contractors to reduce the risk of the end user being caught by IR35. However, a number of umbrella companies have been found by the courts to operate unlawful tax avoidance schemes, often to the detriment of the workers they employ. 

This is why it is no surprise that HMRC has recently announced a change to the tax regime targeted at the use of umbrella companies and due to come into force in April 2026 under the Finance Bill 2026. The draft legislation introduces a new Chapter 11 into the Income Tax (Earnings and Pensions) Act 2003 (ITEPA) ('the umbrella rules').

What will change?

The new legislation will make liability for PAYE deductions 'joint and several' between the umbrella company and either the employment agency who has hired them or the end client if there is no employment agency or if the party the client contracts with is outside the UK. This means that if an employment agency or client hires an umbrella company which does not properly account for PAYE, HMRC can seek to recover any shortfall from either the agency or the client as well as from the umbrella company.

While this may be a welcome step to address misuse of umbrella companies, a closer eye on the detail reveals significant hidden risks, particularly for businesses sourcing workers either through another company such as an employment agency or directly through a PSC. This is owing to the new concept of a 'purported umbrella company' which is widely defined and covers a situation where a company supplies the services of an individual who has a material interest in that company which would include a PSC. 

If a company is classed as a purported umbrella company, a tax liability will arise on either the agency contracting with them or the end client if there is no agency. The liability would arise if it could be reasonably presumed that one or more parties in the chain believe that the majority of the payments made to the company in respect of the individual's services would be taxed as the individual's employment income but that is not in fact the case.  

Of particular note is that the IR35 rules and the off-payroll rules under chapter 10 ITEPA (the 'off-payroll rules') are disapplied so the umbrella rules will take precedence and apply automatically. This means the question of whether the individual is genuinely self-employed or operating 'outside' of IR35 becomes irrelevant and will not be a defence. 

What does this mean in practice? 

Currently, when a small company - as defined by the IR35 legislation - hires a consultant via the consultant's PSC either directly or through an agency, the off-payroll rules do not apply. As a result, the company is not required to carry out an employment status test nor is it or the agency required to make any tax deductions.  Instead, chapter 8 ITEPA (the 'old IR35 rules') applies which means that any tax liability - and therefore risk - under IR35 sits with the consultant's PSC and not the end client or the agency.

Under the government's current proposals, from April 2026, this will change. If the consultant receives the majority of their pay through dividend payments (which is common) or does not otherwise take the contract 'profits' out of the PSC as a salary, HMRC could determine that there has been a shortfall of income tax and national insurance contributions and, under the new umbrella rules, the company (as the 'client' of the PSC) or the agency that hires them could be liable for that shortfall. 

It is not just small companies at risk. Medium to large companies and employment agencies engaging contractors through PSCs will also face the same issue if it is 'reasonable to suppose that they would assume a substantial amount of the payments made to the PSC will be treated as earnings', and will be taxed accordingly.

What can companies and agencies do to protect themselves?

It is not clear what is meant by 'reasonable to suppose that [one of the other companies] would assume a substantial amount of the payments made to the [PSC] will be treated as earnings' and it is hoped that further guidance on this point will be published before the change comes into effect. 

However, it may be considered a reasonable supposition if one of the other companies believed that the consultant (engaged via a PSC) was operating inside IR35, as if they were 'employed' by the end client or, alternatively, where the client or agency just simply had not turned their mind to the issue.

This should be less of a problem for medium or large companies as they are already required to issue a Status Determination Statement (SDS) when engaging a contractor via a PSC under the off-payroll rules. If an individual is found to be inside IR35, their earnings will be taxed at source and there should be no shortfall provided, of course, this has been done correctly. If an individual is found to be outside IR35, the SDS serves as evidence that there was no assumption that the majority of the payments would be treated as income. 

What about small companies engaging with PSCs? 

As small companies are not required to comply with IR35, most do not apply their minds to the tax or employment position of contractors they engage via a PSC. However, this will need to change and they (or the agencies they engage) will need to carry out due diligence to satisfy themselves that either the contractor is genuinely self-employed or that the majority of the payments made to them are taxed as income. Companies should also ensure that appropriately-worded warranties and indemnities are included in commercial terms with any agencies or contractors they engage.

The legislation is currently in draft format and is subject to change. Further, HMRC's likely intention is to tackle rogue umbrella companies and not small companies engaging with contractors via limited companies. However, this consequence - even if unintended - will be a welcome one for HMRC. Whether this legislation stays as drafted remains to be seen but prudent businesses should start taking action now by looking closely at their policies and procedures for off-payroll and labour supply chain compliance to ensure these are robust and well documented.

If you would like further information on your IR35, labour supply chain or employment status compliance issues, please contact Kathy Potter, Katie Harris or your usual Penningtons Manches Cooper contact. 

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