The IR35 hypothetical contract, explained

In short: IR35 ignores your limited company and the agency, and imagines a contract made directly between you and the end client. If that imaginary — "hypothetical" — contract would be a contract of employment, the engagement is inside IR35.

Where the test comes from

Both sets of IR35 rules ask the same question. Chapter 8 of the Income Tax (Earnings and Pensions) Act 2003, which applies when the client is small, and Chapter 10, the off-payroll rules for medium and large clients and the public sector, both apply where — if the services had been provided under a contract directly between the client and the worker — the worker would have been an employee of the client.

How the hypothetical contract is built

1. Start with the real contracts. Usually there are at least two: between your company and the agency, and between the agency and the client. Both matter — the client's terms may say very different things about substitution or control from the ones you signed.
2. Add the real arrangements. How the work is actually done, what was said and agreed, and how both sides behave. Terms that don't reflect the true agreement can be disregarded (Autoclenz v Belcher, 2011).
3. Imagine you contracted with the client directly on those terms.
4. Apply the normal employment-status test to that imagined contract — personal service, mutuality of obligation, control, and then the overall picture (Ready Mixed Concrete, 1968).

What Atholl House added

In HMRC v Atholl House Productions Ltd [2022] EWCA Civ 501 — the case about broadcaster Kaye Adams — the Court of Appeal clarified that the hypothetical contract has to be read in the light of the circumstances known to both the worker and the client. It also confirmed that whether the worker is in business on their own account is part of the overall picture. The case was sent back to be decided again on the correct basis.

What this means for you

• Ask for the upstream terms. If the agency–client contract says the client controls your work or must approve any substitute, that can undermine better wording in your own contract.
• Make sure the end client agrees. A substitution right in your contract carries little weight if the client would never accept a substitute.
• Keep evidence of your business. Other clients, marketing, your own equipment and insurance help show the wider context.

When you use IR35 Checker you can upload the agency–client terms or your SDS alongside your contract, so the report reflects more of the hypothetical contract.

Sources: ss49 and 61M ITEPA 2003; HMRC v Atholl House Productions Ltd [2022] EWCA Civ 501; Autoclenz Ltd v Belcher [2011] UKSC 41. General information, not legal or tax advice.