Key Points
Draft legislation released in July introduces a new Chapter 11 in Part 2 of ITEPA 2003, effective from 6 April 2026. Equivalent NIC legislation will follow.
● Relevant parties in the labour supply chain (primarily agencies) will be jointly and severally liable for the PAYE obligations of umbrella companies to which they outsource labour.
● End clients will also face risks, particularly where they engage directly with umbrella companies.
● There are unanswered questions around how HMRC will use its new powers, and HMRC guidance and future case law will be required to navigate this with confidence.
“ HMRC’s recent victory in its appeal at the Upper Tribunal in the Elphysic case will strengthen
its approach to compliance and enforcement activity.”
In recent years, there has been considerable growth in employment agencies using complex labour supply chains to meet the temporary labour needs of their clients. This situation has evolved in response to various factors –sustained increases in the national minimum wage and the recent increase in employer NICs being difficult to pass on to end clients, coupled with a general pressure on margins, have all been primary factors, along with the introduction of various anti-avoidance principles in legislation that have caused agencies and their suppliers to seek alternative structures.
Most notably, mini-umbrella company (MUC) arrangements, in which workforces were split across multiple small entities in an attempt to benefit from VAT and NIC reliefs, saw significant take-up and have resulted in a significant increase in the tax gap. Although MUC arrangements have continued to be promoted by some parties, HMRC’s recent victory in its appeal at the Upper Tribunal in the Elphysic [2025] UKUT 00236 (TCC) case will strengthen its approach to compliance and enforcement activity within the sector and may, practically, mean the end of attempts to market these types of arrangements. However, other structures continue to be brought to market and attract attention from HMRC.
HMRC’s response has included targeted enforcement action along with education of businesses on the importance of undertaking due diligence across their labour supply chains. This guidance was consolidated earlier this year in guidelines for compliance (GfC) 12: Help with labour supply chain assurance, which remains a useful statement of HMRC’s expectations.
Draft finance bill
At the autumn 2024 Budget, the government announced that agencies, and in their absence end clients, would become directly responsible for ensuring PAYE and NIC compliance. Draft legislation has now been published, which will introduce joint and several liability for PAYE under a new Chapter 11 in Part 2 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003) with effect from 6 April 2026.
The stated aim of the legislation is to strengthen integrity in the temporary labour market by closing the tax gap and shielding both taxpayers and HMRC from significant financial losses tied to fraudulent umbrella company activity – including the diversion of funds to organised criminal networks. It also seeks to protect workers from unexpected income tax and National Insurance contributions caused by non-compliance, and to ensure fair competition by eliminating operators who flout the rules and undercut legitimate businesses.
Legislative overview
The draft legislation introduces new sections 61Y to 61Z1 into ITEPA 2003. These provisions apply where an individual provides services to a client but is employed by a third party – defined as an ‘umbrella company’ which supplies labour. Section 61Y is the core provision that introduces joint and several liability for PAYE. It applies where:
● a worker personally provides services to a client or enters into arrangements with a view to personally providing services to a client;
● the worker is employed by a third party (the umbrella company); and
● certain contractual conditions are met (ie the umbrella company is paid or provides services under a contract linked to the client or another person).
If these conditions are satisfied, the umbrella company and the ‘relevant party’ in the contractual chain are jointly and severally liable for PAYE due on payments made to the worker. ‘Arrangements’ are defined very widely, including ‘any agreement, understanding, scheme transaction or series of transactions (whether or not legally enforceable)’. Similarly, ‘umbrella company’ appears to capture a broad range of scenarios including, for instance, agencies and other employment businesses that may not consider themselves umbrella companies, such as ‘employers of record’ that provide basic employment services for clients with no local UK presence.
There are exclusions for arrangements already within the scope of the agency workers, off-payroll workers and managed service company legislation and relating to limited liability partnership members. However, this is subject to restrictions – s 61Y(5)(b) brings personal service companies back into charge where their use is deemed to be without commercial justification and intended to avoid the impact of Chapter 11.
Section 61Z defines the term ‘relevant party’. In a ‘standard’ scenario where there is a full labour supply chain involving a recruitment agency, the person who has the contract with the client is the relevant party. This will also be the party that is producing intermediaries’ returns showing workers not on their payroll.
Where there is no intermediary between the umbrella and the client, the client is the relevant party. The client will also be the relevant party if the business it engages with (the agency) is connected with the umbrella company or if the client contracts with a non-UK resident business.
If the client and their immediate supplier are non-resident but there is/are UK resident businesses in the supply chain, the one closest to the client will be the relevant party.
Section 61Z1 introduces the concept of ‘purported umbrella companies’. Joint and several liability will apply in relation to a ‘purported’ umbrella company in two scenarios:
● Section 61Z1(1): It is reasonable to suppose that one or more participants in the arrangement would assume that the purported umbrella company employed the worker but did not in fact do so. This appears to address circumstances where a client (or another party) assumes that the worker was employed but in fact they are engaged under a different model, such as under a contract for services. Currently, workers interacting and controlled by the client would be subject to PAYE by the agency under the agency legislation (ITEPA 2003, Chapter 7) where contracts for services apply. Under the purported umbrella company principle, it would be possible for HMRC to impose joint and several liability on the client where PAYE has not been paid in full by the employment business.
● Section 61Z1(2): A worker is engaged via an entity in which they have a material interest, and it is reasonable to suppose that one or more participants in the arrangement would assume that a substantial proportion of the amounts provided to the purported umbrella company will be paid to the individual as earnings. This may be aimed at scenarios in which one or more participators in the arrangement have assumed that a worker is engaged on an inside-IR35 basis and PAYE has been operated.
The introduction of the concept of ‘purported umbrella companies’ is accompanied by very little explanatory guidance. In particular, the concept of ‘reasonable to assume’ poses significant challenges, to say the least. It is to be hoped that future HMRC guidance will follow to enable us to understand the circumstances that these provisions are designed to address.
Further provisions of note include the following:
● ITEPA 2003, s 44 (treatment of workers supplied by agencies) will be amended to remove the ability of the agency to avoid liability when provided with a fraudulent document by an umbrella company, but protections will still exist where a client provides a fraudulent document.
● The PAYE Regulations will be amended to include the mechanics necessary for recovery of amounts arising under Chapter 11 and will provide freedom to require the provision of information by employment intermediaries to HMRC in relation to Chapter 11.
● Regulation 80 of the PAYE Regulations (determination of unpaid tax and appeal against determination) will be expanded to allow assessment of amounts due from an employer to any party who is joint and severally liable by virtue of Chapter 11.
The above is intended to provide only a summary of the relevant draft legislation and more details may be provided in due course. Mirroring NIC legislation is expected to follow.
Practical implications for advisers
For advisers supporting clients in the recruitment and outsourcing sectors, the new rules raise several important
considerations:
● Due diligence by agencies of their labour supply chains is already essential under current rules given the risk that VAT liabilities can be transferred up the chain if the Kittel (C-439/04) [2006] STC 1537 principle applies. However, agencies are likely to need to invest further in their capabilities once they are jointly liable for any PAYE and NIC debts.
● The removal of most protections where fraudulent documentation has been provided, and no mitigating ‘reasonable excuse’ defence, potentially poses severe challenges. Any guidance provided to an agency as a result of due diligence will need to highlight the fact that if an umbrella company has in effect lied as part of a due diligence process, this may not protect their client from transfer of liability.
● Due diligence should always be refreshed on a regular basis, but if an outsourcing arrangement is likely to continue post-6 April 2026, careful consideration should be given to whether the level of due diligence will need to be enhanced to properly manage risk under the new rules.
● End users are moving from a position in which their primary concerns are reputational and compliance with published tax strategies, into a new position where they could themselves be liable to unpaid PAYE and NIC. Some end clients who have directly engaged with umbrella companies as a way of managing risk under the off-payroll working rules will need to consider their approach to due diligence or move to a new structure. This may provide a further stimulus for large end clients with internal recruitment functions to use fixed-term contracts as an alternative to engagement via employment businesses.
Future implications and sector outlook
The wide drafting of Chapter 11 gives HMRC considerable latitude in its application. The drafting appears designed to accommodate evolving labour market structures. This flexibility, while pragmatic, places heavy reliance on future HMRC guidance to clarify operational boundaries and enforcement priorities.
The absence of any reference to a ‘reasonable excuse’ defence or a formal process to take account of any ‘reasonable steps’ that were taken marks a notable shift in HMRC’s approach. Agencies will no longer be able to lay blame solely at the door of umbrella companies, reinforcing that there is no alternative to an effective programme of due diligence.
One of the key questions around HMRC’s approach is whether their powers will be focused only on deliberate compliance failures or also on poorly managed but non-malicious umbrella businesses. Some operators of umbrella companies have long operated in a ‘he who dares wins’ environment, and the new rules may finally bring this era to a close.
There is also concern about the financial exposure of agencies. If HMRC uses regulation 80 to estimate unpaid PAYE, the methodology and fairness of those assessments will be critical. Umbrella companies will typically include workers engaged via multiple agencies on the same PAYE reference. How will fairness be ensured between the relevant agencies where PAYE has been partly paid?
There will also be questions about the future of industry accreditation schemes. While some end clients insist on using umbrella companies that are members of such schemes, and HMRC has acknowledged their efforts to try to ensure compliance, in a world where provision of fraudulent documentation by an umbrella no longer protects the victim it remains to be seen whether this will continue to have practical weight. In future, reliance on a supplier being registered with such a scheme seems unlikely to provide customers with sufficient comfort on its own.
While there are still valid reasons why an agency would want to outsource payroll, ultimately the introduction of this legislation in conjunction with pre-existing legislation relating to the facilitation of tax evasion, and the new offence of failure to prevent fraud, may give a powerful stimulus to agencies to bring their payrolls in-house.
Finally, the broad definition of umbrella companies may capture almost any labour supply chain where PAYE is missing. This raises concerns about second-tiering, neutral vendor risk, and the viability of smaller agencies operating on tight margins. In the umbrella world, consolidation into larger umbrella providers may be inevitable, with smaller firms struggling to survive.
Conclusion
The introduction of the new Chapter 11 represents a major shift in the compliance landscape for temporary labour. By moving away from a compliance environment where HMRC faces the burden of demonstrating that an agency knew or should have known about the fraudulent evasion of VAT in its supply chain, towards one where a deficiency of PAYE will allow for other parties to be pursued, the government aims to ensure that tax obligations are met regardless of the complexity or opacity of the supply chain.
For agencies, the message is clear: understand your labour supply chain, verify PAYE compliance, frequently and in sufficient depth, and do not assume that outsourcing payroll absolves you of responsibility. Failure to do this in a robust way has the potential to be fatal to their business. Advisers have a critical role to play in helping their clients navigate these changes and prepare for the April 2026 implementation date.