Two chapters, two very different calculations
An inside-IR35 conclusion does not mean the same tax machinery applies in every case. Part 2 of ITEPA 2003 contains two separate regimes, and the one that governs your engagement depends entirely on the size of your end client.
Chapter 8 (the original intermediaries legislation, in force from 6 April 2000) applies where the client is a small company, a non-corporate entity that meets the small-company turnover test, or an overseas client with no UK fee-payer. Here the PSC determines its own status and, if inside IR35, runs a year-end step calculation to produce a deemed employment payment.
Chapter 10 (the off-payroll working rules, extended to medium and large private-sector clients from 6 April 2021) applies where the client is medium or large. Here the client determines status, issues a Status Determination Statement, and the fee-payer (usually the agency closest to the PSC in the chain) operates PAYE and NIC before paying the net amount to the PSC.
The dividing line is client size, measured against the Companies Act 2006 s.382 thresholds as imported by ITEPA 2003 s.60A. For financial years beginning on or after 6 April 2025, a company is small if it meets two or more of: turnover not more than £15m, balance sheet not more than £7.5m, and not more than 50 employees. Because of the relevant-financial-year lag and the two-consecutive-years rule, the earliest a previously medium client can exit Chapter 10 scope on the back of those raised thresholds is 6 April 2027. For most 2026/27 engagements with medium or large clients, Chapter 10 still applies.
Where the end client is medium or large but there is no agency in the chain (the contractor contracts directly with the client), the end client itself becomes the fee-payer and must operate the deemed direct payment under Chapter 10. The mechanics are identical; only who runs the PAYE changes. Where there is a chain of agencies, the fee-payer is the party that makes the direct payment to the PSC (typically the agency at the bottom of the chain), and liability sits with that party unless the status determination chain has broken down above it.
Understanding which chapter governs matters before any deemed-payment calculation, because the mechanics and the allowances differ substantially. The full consequences for take-home pay are covered in our inside-IR35 guide; this page sets out the upstream calculation mechanics only.
Chapter 10: the deemed direct payment by the fee-payer
Under Chapter 10 the deemed payment is not a year-end calculation performed by the PSC. It happens in real time, payment by payment, and is operated by the fee-payer under ITEPA 2003 s.61N.
Step 1: strip out VAT and direct materials
The fee-payer starts with the gross amount it is due to pay the PSC. Before treating any of it as employment income, it removes two items: the VAT the PSC has charged (VAT is not the contractor's income; it flows through to HMRC via the PSC's VAT return) and the direct cost of any materials that were genuinely supplied to the client as a pass-through cost rather than as part of the labour fee. Applying PAYE to VAT or materials would create a fictitious tax base. The legislation at s.61N explicitly provides for these deductions.
After these two deductions, what remains is the deemed direct payment figure, the sum treated as gross salary for PAYE and NIC purposes.
Step 2: PAYE and employee NIC on the deemed direct payment
The fee-payer runs PAYE on the deemed direct payment at the contractor's marginal income tax rate, exactly as it would for an employee. Employee primary Class 1 NIC applies at 8% on earnings between the primary threshold (£12,570 in 2026/27) and the upper earnings limit (£50,270), and at 2% above the upper earnings limit.
The fee-payer deducts these amounts and pays the net balance to the PSC. The PSC receives the contract income minus tax and employee NIC.
Step 3: employer NIC on top
Employer secondary Class 1 NIC at 15% (above the secondary threshold of £5,000 in 2026/27) is a cost on top of the deemed direct payment, not deducted from it. The fee-payer pays this directly to HMRC. The Apprenticeship Levy (0.5% of the annual pay bill above £3m) is also payable by the fee-payer where applicable, though most mid-sized agencies operate below that threshold.
The result is that the fee-payer's total outlay exceeds the gross contract rate by the employer NIC it bears. The PSC receives the contract rate less VAT, less materials, less PAYE, less employee NIC, while the fee-payer separately absorbs employer NIC on top.
No 5% allowance under Chapter 10
There is no 5% administrative expenses allowance under Chapter 10. Chapter 10 has never included the 5% allowance: it was not part of the regime when it was introduced for the public sector in April 2017, nor when it was extended to the private sector in April 2021. The full amount of the fee, after stripping VAT and materials, is subject to PAYE and NIC with no flat deduction for the PSC's running costs. This is one of the reasons the Chapter 10 tax cost is higher, in percentage terms, than the Chapter 8 calculation for an equivalent engagement.
Chapter 8: the year-end step calculation by the PSC
Where Chapter 8 applies, the PSC is responsible for its own inside-IR35 calculation. The legislation (ITEPA 2003 ss.54 to 58) sets out a step-by-step method for arriving at the deemed employment payment at the end of each tax year. Unlike Chapter 10's real-time per-payment approach, this is a single year-end exercise.
Step 1: aggregate the relevant engagement income
The starting point is the total income received from the relevant engagement (or engagements) during the tax year, including any benefits in kind received from the intermediary in connection with the services. This is the gross income before any deductions.
Step 2: deduct the 5% allowance
From the aggregate income, the PSC deducts 5% as a flat administrative expenses allowance. This covers the cost of running the company in an inside-IR35 world: accountancy fees, insurance, company administration and similar overheads. It is a blanket deduction, not an itemised one; the PSC does not need to account for each pound of overhead up to the 5% ceiling.
Crucially, this allowance is retained under Chapter 8 and has never been part of Chapter 10. On a contract rate of £100,000 a year, the 5% deduction reduces the calculation base by £5,000 before any other adjustment is made. That difference accumulates materially over a full year.
Step 3: deduct actual allowable employment-type expenses
After the 5% allowance, the PSC deducts expenses that would have been deductible had the contractor been employed directly: genuine business travel to temporary workplaces (subject to the 24-month rule), professional subscriptions, equipment used wholly for the engagement and similar items. Note that home-to-client travel is generally not deductible for an inside-IR35 engagement, because each separate engagement is treated as a separate employment with a permanent workplace. The deductible expenses at this step are narrower than many contractors assume.
Step 4: deduct employer pension contributions
Employer pension contributions paid by the PSC in connection with the relevant engagement are deducted from the calculation base. This is a genuine planning lever: an employer pension contribution reduces the deemed payment, saves corporation tax (on a paid basis), and carries no employer or employee NIC. The annual allowance for 2026/27 is £60,000 across all contributions, with the taper applying where threshold income exceeds £200,000 and adjusted income exceeds £260,000, reducing to a floor of £10,000.
Step 5: deduct salary already paid under PAYE
Any salary the PSC has already paid to the contractor and put through PAYE during the year is deducted. The deemed employment payment is designed to represent only the additional inside-IR35 income that has not yet been taxed as employment income; double-counting already-taxed salary would inflate the liability unfairly.
Step 6: gross down for employer NIC
Employer secondary Class 1 NIC at 15% (above the secondary threshold of £5,000 in 2026/27) sits outside the deemed payment rather than inside it. To work backwards from the total adjusted pool of money to the correct gross deemed salary, the step calculation accounts for the employer NIC so that the employer NIC and the gross deemed salary together equal the available pool. The resulting adjustment reduces the headline deemed payment figure, and the employer NIC is then payable on top.
The resulting figure, after all six steps, is the deemed employment payment on which PAYE income tax and employee Class 1 NIC are due. The PSC must operate this through its payroll by 19 April (or 22 April for electronic payment) following the end of the tax year.
One practical consequence of the year-end timing is that the PSC will have held the engagement income for up to twelve months before the deemed employment PAYE is paid over. The company needs to ensure it retains sufficient cash to meet the liability. Cash-flow planning is therefore a genuine concern for a PSC operating under Chapter 8 in an inside-IR35 engagement, particularly where the director has drawn down funds throughout the year in anticipation of the usual salary-and-dividend model only to find a larger-than-expected deemed payment at year-end. An accountant familiar with IR35 will model this position at the start of the tax year rather than at the end.
The 5% allowance: the key distinction illustrated
The single biggest mechanical difference between Chapter 8 and Chapter 10 is the 5% allowance. The table below illustrates the structural difference for a single-director PSC with no other employees (so no Employment Allowance available) and a £120,000 engagement in 2026/27, using illustrative expense and pension figures to show the structure only.
| Step | Chapter 8 (small client) | Chapter 10 (medium/large client) |
|---|---|---|
| Gross contract income | £120,000 | £120,000 |
| Less VAT / materials | Not applicable (separate VAT return) | Stripped first (illustrative: £0 here) |
| Less 5% allowance | £6,000 | Nil (abolished under Chapter 10) |
| Less actual allowable expenses | £3,000 (illustrative) | No step calculation applies |
| Less employer pension contributions | £10,000 (illustrative) | No step calculation applies |
| Less salary already on PAYE | £6,708 (LEL salary, illustrative) | No step calculation applies |
| Sub-total before employer NIC adjustment | £94,292 | £120,000 (the deemed direct payment) |
| Employer NIC at 15% | Borne by PSC on top of the deemed payment | Borne by fee-payer on top of the payment to PSC |
The figures above are illustrative only and use simplified inputs to show the structural difference between the two chapters. A real Chapter 8 calculation requires the exact salary, confirmed pension contributions, the full expense ledger and the applicable PAYE codes for the tax year in question. The take-home consequences of the inside-IR35 position are set out in detail in our inside-IR35 guide.
What the PSC receives and what it can do with the income
Under Chapter 10, the PSC receives the net amount after the fee-payer has deducted PAYE and employee NIC. That net flows into the company's bank account as usual. Because the income has already been subject to PAYE, the director can generally draw it without a second income tax charge (to avoid double taxation). However, the tax-efficient salary-and-dividend extraction strategy that makes a PSC attractive for outside-IR35 income is lost on that income: there is no surplus pre-tax profit to pay as a lower-taxed dividend, because the tax has already been collected upstream.
Under Chapter 8, the PSC holds the gross income until year-end, then calculates and pays the deemed employment PAYE and NIC from those funds. Any residual after the deemed payment and employer NIC, together with genuinely deductible company expenses, becomes the company's taxable profit subject to corporation tax. The inside-IR35 year-end calculation compresses the profit available for extraction.
In both cases the contractor's ability to use the PSC as a tax-planning vehicle on inside-IR35 income is severely restricted. Employer pension contributions are often the only remaining lever of material size, and they operate the same way under both chapters. Our guide to employer pension contributions for contractors sets out how they interact with the deemed payment.
The off-payroll set-off from April 2024
Before April 2024, an incorrect outside-IR35 determination could expose a fee-payer or end client to the full PAYE and NIC liability on the deemed payment, with no credit for corporation tax, income tax or dividends the worker and PSC had already paid on the same income. This produced double taxation and inflated the cost of a wrong determination significantly.
From 6 April 2024 a statutory set-off operates under amendments to the Income Tax (PAYE) Regulations 2003. Where HMRC raises a Reg 80 determination on or after that date, it can reduce the deemed employer's PAYE liability by an estimate of the taxes already paid by the worker and PSC on the relevant income: corporation tax on company profits, income tax and employee NIC on salary drawn, and income tax on dividends. The offset applies to errors going back to April 2017 (public sector) or April 2021 (private sector), with the mechanism itself available from April 2024.
The set-off does not eliminate the liability. Employer NIC was never paid on the inside-IR35 income and cannot be credited. The offset is an HMRC-operated estimate on a trigger event, not an automatic netting the contractor or fee-payer can rely on. The post-April-2024 exposure is lower than the pre-2024 double-tax position but remains a serious risk. How status is determined in the first place, and how to challenge a determination, is covered in our guide to the off-payroll working rules for the private sector.
Practical implications for contractors
Understanding the deemed payment mechanics matters for three practical reasons.
Budgeting accurately. A contractor moving from an outside-IR35 PSC arrangement to an inside-IR35 engagement will see a material reduction in net income. The Chapter 8 calculation offers some mitigation through the 5% allowance and the ability to deduct genuine expenses and pension contributions. Chapter 10 offers none of those deduction steps, though the fee-payer bears employer NIC directly. Neither route leaves as much in the contractor's hands as an outside-IR35 engagement at the same contract rate.
Record-keeping under Chapter 8. Because the PSC must work through the step calculation itself, it needs accurate records of all relevant engagement income, all employment-type expenses (with receipts or mileage logs to support the claim), any employer pension contributions and the salary put through PAYE during the year. The 5% allowance is claimed without itemisation, but the employment-type expenses at step 3 must be substantiated in the usual way. Poor records increase the risk of both underpayment and, on enquiry, penalties for inaccurate returns.
Checking the fee-payer's calculation under Chapter 10. The PSC cannot amend the fee-payer's Chapter 10 calculation, but it can and should verify that the deemed direct payment figure shown on any remittance advice correctly strips VAT and materials before PAYE is applied. Errors at this stage are not always caught automatically.
Contractors who are genuinely inside IR35 on a medium or large engagement may also find that operating through a compliant umbrella simplifies the mechanics, since the umbrella absorbs the Chapter 10 calculation and the employer NIC cost within its assignment-rate margin. Whether a retained PSC or an umbrella makes more economic sense depends on whether the contractor also holds outside-IR35 work, their profit-retention plans and the umbrella's margin relative to PSC running costs. The full comparison is set out in our inside-IR35 guide.
When Chapter 8 and Chapter 10 apply in the same year
A contractor may hold more than one engagement in a tax year, some with small clients (Chapter 8) and others with medium or large clients (Chapter 10). The two calculations run independently. The Chapter 10 fee-payers deal with their respective portions in real time on each payment. The PSC's year-end Chapter 8 calculation covers only the small-client engagements; the income from Chapter 10 engagements is excluded because it has already been taxed at source by the fee-payer.
The interaction matters for PAYE coding. The Chapter 10 deemed direct payments are reported via the fee-payer's Real Time Information (RTI) submissions as if the contractor were the fee-payer's employee. This can affect the personal tax code HMRC issues to the contractor for any Chapter 8 employment income or other earned income. A contractor with both types of engagement in the same year should ensure their accountant reconciles the position at self-assessment to avoid underpayment through coding errors.
Statutory anchors
The primary legislation is in Part 2 of ITEPA 2003. Chapter 8 (ss.48 to 61) contains the original IR35 deemed employment payment rules, with the 5% allowance and step calculation at ss.54 and 58. Chapter 10 (ss.61K to 61X) contains the off-payroll working rules, with the deemed direct payment mechanism at s.61N. The small-company exemption that determines which chapter applies is at ITEPA s.60A, read with Companies Act 2006 s.382. The April 2024 set-off operates under the Income Tax (PAYE) Regulations 2003 as amended. HMRC's manual chapters are ESM3500 onwards for the Chapter 8 step calculation and ESM10020 onwards for the Chapter 10 deemed direct payment mechanics.
Next steps
The deemed employment payment calculation determines how the tax is collected, but it does not tell the full story of what an inside-IR35 engagement costs in take-home terms. That picture, including how umbrella pay compares, what expenses you can still claim and how to manage the impact, is set out in our complete inside-IR35 guide. If you are unsure whether your engagement falls under Chapter 8 or Chapter 10, or if a client has issued a determination you want to review, our IR35 review service provides a full assessment of the position.