Liz Truss's top aide in Downing Street will no longer be paid through his lobbying firm - after the arrangement prompted outrage.
No 10 confirmed on Tuesday chief of staff Mark Fullbrook will now be put on a special adviser contract and paid directly by the government.
The Liberal Democrats said the "U-turn raises more questions than it does answers, including about Liz Truss's judgement".
"Why did No 10 spend days trying to defend this appointment only to backtrack when it came under scrutiny?" they added.
It comes after The Sunday Times reported the senior aide to the Prime Minister would receive his wages via Fullbrook Solutions, a lobbying firm he set up in April but which has since suspended commercial activity.
The Cabinet Office insisted over the weekend it was not "unusual" for a special adviser to join the government on "secondment".
A spokesperson for Mr Fullbrook had also insisted: "This is not an unusual arrangement. It was not put in place for tax purposes and Mr Fullbrook derives no tax benefit from it."
But on Tuesday a No 10 spokesperson said: "While there are established arrangements for employees to join government on secondment, to avoid speculation Mark Fullbrook will be employed directly by the government on a special adviser contract.
"All government employees, including those joining on secondment, are subject to the necessary checks and vetting, and all special advisers declare their interests in line with Cabinet Office guidance."
The arrangement had already prompted outrage from the opposition and Labour's deputy leader Angela Rayner said it was an "inappropriate appointment at the heart of Downing Street".
She added it raised "serious questions about what sensitive and privileged information this on-loan lobbyist will have access to at the heart of government".
"The Tories under Liz Truss are devoid of ethics. A Labour government will clean up politics with an Independent Ethics and Integrity Commission to restore standards in public life".
On Sunday The Guardian also reported that Ms Truss had promised Mr Fullbrook his company would run the Tories' next election campaign if he joined her No 10 team.
A No 10 source declined to comment on the claim and the Prime Minister's official spokesperson said: "Decisions on running electoral campaigns of any party would not be one for me".
Mr Fullbrook's representatives have been contacted for comment regarding the claim.
