Employment status tax issues need not derail a business sale

Whether it is private equity houses looking to sell off a business in their portfolio, or a group company looking to sell an underperforming subsidiary, the need to proactively identify and remedy problems reflects the growing scrutiny of employment status-related tax compliance by would-be investors. This scrutiny is partly owing to HM Revenue & Custom’s (HMRC’s) increased focus on the taxation of temporary labour and also to various legislative reforms, which serve to expose businesses – and, by extension, those that seek to acquire them – to greater liability in respect of employment-related tax of temporary workers.

If tax issues are only identified when deals are mid-transaction, the consequences can be significant – from delays whilst enhanced due diligence is undertaken, to downward price adjustments, enhanced warranty and indemnity protection for the buyer or, in some cases, deals falling through entirely. As a result, early preparation is critical to protecting deal value and achieving a smooth sale.

In the UK, there are four main tax risks a review should cover:

• The IR35 rules;
• Employment tax status of self-employed individuals;
• The agency worker tax rules;
• The umbrella company tax rules.

IR35

When a UK employer enters into a contract of employment, payments to the employee must be made via the Pay As You Earn (PAYE) system with income tax and employee National insurance contributions (NICs) deducted prior to payment. Employer NICs are also payable in respect of those employees.

However, businesses can engage individuals under non-employment arrangements, where they can be treated as self-employed for tax purposes and paid “off-payroll” without UK employment taxes being deducted through the PAYE system.  

It is common, for instance, for consultants wishing to engage with businesses on a freelance basis to set up their own 'personal services company' (PSC). Under the UK’s IR35 regime, medium and large businesses wishing to engage individuals via a PSC are required to determine whether the individual would be an employee for tax purposes if they had engaged directly with the business – known as being “inside IR35”. Where that is the case, the business must pay the individual via the PAYE system and pay employer NICs that fall due.

When businesses think about the need for IR35 compliance, it is often in the context of managing tax risks in relation to a potential enquiry from HMRC. However, the need for managing IR35 tax risks is relevant to protecting the value of a business too – particularly where the owners are considering an exit in the near future.

Employment tax status of self-employed individuals

Even if a business engages an individual on a temporary work contract directly, rather than through a PSC, the business must still undertake an assessment of their employment tax status.

There is no codified legal test to determine employment status for tax purposes. Rather, the test has been developed through court decisions and is based on several factors – including whether there is 'mutuality of obligation' between the parties, the level of control that a business has over the worker, whether the worker can provide a substitute, how integrated the worker is in the client’s business and whether the worker is in business on their own account.

HMRC has published detailed guidance and has also developed the ‘Check Employment Status for Tax’ (CEST) tool to determine employment status for tax purposes of individual workers. HMRC has said that it will stand by a CEST determination, as long as the information inputted remains true and accurate. CEST may not always provide a determination and is estimated to fail in 15% of cases.

There is a common misconception that CEST is only relevant in relation to IR35 compliance –   where individuals are engaged via PSCs; however, CEST can also be used when a business seeks to engage individuals on a self-employed basis.

Agency tax rules

With agency workers, the relationship between the engaging business and the individual being engaged is concluded via an intermediary recruitment agency. In most circumstances, the agency would be liable for paying UK employment-related taxes of those workers. However, HMRC is increasingly scrutinising tax compliance across labour supply chains and demonstrating a willingness to directly question businesses about the specific supply of labour arrangements they have in place with agencies.

For prospective investors, they want to know that selling businesses are not turning a blind eye to non-tax compliant agency arrangements – because there is a risk that HMRC would become aware they are doing so and would then question whether the business’ other tax arrangements, for which the business would be held liable, are in order.

Umbrella company tax rules

Rules affecting the use of umbrella companies came into force in April 2026, which shift responsibility for unpaid payroll taxes – and penalties and interest – from the umbrella company to the entity engaging the umbrella.

In most cases, the entity contracting with the umbrella company would be a recruitment agency. However, where there is no agency in the supply chain, the end client business would become liable for an umbrella company’s unpaid PAYE taxes. End client businesses could also be exposed to the tax liabilities of umbrellas when using non-UK recruitment agencies.

Under the new rules, end client businesses can be held joint and severally liable for the PAYE taxes and employer NICs of workers engaged through umbrella companies, meaning HMRC can recover unpaid tax from the end client even where the umbrella company is at fault.

These new rules mean there is now a greater onus on businesses planning a sale to review their engagement of temporary workers via umbrella companies. Prospective investors’ due diligence would be expected to focus on this issue, given the heightened exposure to tax risk arrangements with umbrella companies create.

The challenge for businesses

For businesses, the ability to engage temporary workers – whether to support on specific projects, access skills not present within the existing workforce, or to respond to a spike in demand for resources, for example – offers welcome flexibility and scalability. However, for large businesses, temporary labour supply chain arrangements can be complex, involving various contracting parties. The ability to manage compliance and exposure to employment tax risks can be further complicated by decentralised controls and different business functions having different arrangements in place when engaging temporary workers. This often results in tax, legal and compliance functions having limited oversight of where and how temporary workers are engaged across a business.

This complexity increases the risk that businesses may fail to apply tax rules consistently across their labour supply chains or may have supply of labour arrangements in place that increase exposure to tax risks. Compliance failings when engaging with temporary labour not only expose a business to the risk of an HMRC challenge for unpaid tax, but are also issues that investors are taking increasingly seriously in buyer-side due diligence.

Businesses preparing for a sale that fail to consider supply of labour tax risks can expect prolonged timelines for reaching a deal, deal costs to rise, and potential chipping of the sale price by prospective investors.

Identifying and addressing these risks proactively, before a sale process begins, will put a business in a materially stronger position.