Counting the business costs of incorrect contractor classifications

Clients who run businesses should be extremely careful in classifying those they engage as contractors, as the wrong decision can result in many unfavourable outcomes, writes Mark Gleeson.

Do you provide recommendations to clients who are contractors or use contractors in their business? 

The term ‘contractor’ can be misleading and clients who do not understand the rules can be liable to significant penalties under state and federal laws.

Employer clients may incur non-tax deductible charges, including administration and interest penalties, if less than the required super guarantee amount is not paid for contractors who qualify as employees.

Good advice ensures clients satisfy their legal obligations, avoid unnecessary expenses and focus on running their business.

Similarly, clients who are contractors may actually be considered employees and an opportunity may arise to establish super guarantee entitlements for them.

Why does it matter if a person is an employee?

If a person is an employee, by using the process below, in most situations they are entitled to have super guarantee paid for them and their salary is subject to Pay As You Go (PAYG) withholding.

If a person is a contractor, super guarantee and PAYG withholding obligations do not apply.

You should also consider the relevant state or territory laws to identify any payroll tax and workers’ compensation cover obligations. These laws may have different tests to determine when contractors are considered employees. 

When is a contractor an employee?

Although clients may call themselves or others contractors, it’s important to consider how it is defined in the legislation.

For superannuation and tax law purposes, a contractor could be considered an employee in either of the following two circumstances:

1. A person works under a contract that is wholly or principally for their labour. If the terms of the contract pay the person for the performance of their labour and skills and they are not paid to achieve a specific result then it will most likely be a contract wholly and principally for the person’s labour.
2. A person whose contractual relationship is defined by an employee/employer relationship, rather than as a contractor. Key indicators consider the relationship based on common law and the Australian Taxation Office (ATO) guidance. These indicators are outlined in the table below.

Other factors may be relevant to establish whether the relationship is an employer/employee or contractor relationship.

For example, a person could be considered an employee if the principal has the right to dismiss the person, or the principal provides benefits (e.g. annual leave) or the person is required to wear a uniform.

The balance of all indicators must be considered to determine the relationship, rather than any one indicator alone.

If an individual performs work for another party through a company or trust, there is no employer/employee relationship between the individual and the other party.

This is because the company or trust (and not the individual) has entered into an agreement with the other party.

However, the individual may be the employee of the company or trust.

If there is any uncertainty to a client’s employee/contractor status, the client should refer to a tax adviser. Alternatively, the ATO decision tool on its website can assist.

What does the case law tell us?

If you consider the employee/contractor issue for your clients, you can prevent possible court cases from arising, such as those outlined below.

In Hollis versus Vabu Pty Limited, bicycle couriers were engaged in the running of its business and were treated as if they were contractors.

The High Court decided that because Vabu had considerable scope to exercise control over the performance of the couriers’ activities, such as the allocation and direction of the various deliveries, that they were employees.

In addition, the couriers were also required to wear uniforms in carrying out their duties.

The High Court noted the distinction between an employee and contractor is rooted in the difference between a person who serves their employer and a person who carries on a trade or business of their own.

Accordingly, the couriers were not running their own business, nor did they have independence in how they conducted those activities.

Even though the couriers were paid per delivery, rather than per time period engaged, it was considered to be consistent with an employment arrangement.

The couriers owned their own bicycles, bore the expenses of running them and supplied many of their own accessories.

Although it may be argued they provided the necessary tools and equipment, the High Court considered that the tools/equipment should be significant and required great skill or training for the individual to be considered an independent contractor.

A more recent case, On Call Interpreters and Translators Agency (On Call) versus Commissioner of Taxation, highlights how businesses should carefully apply the employer/contractor determination for each individual. In this case, On Call engaged interpreters and translators and treated many as contractors.

The Federal Court found that while some were running their own business, others were not.

The test applied by the Federal Court was whether an individual had a business and whether the work was being performed in and for the business of that person.

Those considered employees did not have clients in sufficient numbers or operations to suggest they were operating a business.

Conclusion

Clients who run businesses should be extremely careful in classifying those they engage as contractors.

The wrong decision can result in non-tax deductible expenses, such as the superannuation guarantee charge, and may end in costly, protracted court cases.

Alternatively, if your client is currently treated as a contractor you may be able to establish that an employer/employee relationship exists and allow the client to receive additional benefits such as superannuation guarantee and workers compensation cover.

Mark Gleeson is the technical services manager at OnePath.