The tests for determining whether an individual service provider is an employee or an independent contractor are similar — but subtly and significantly different — in a number of jurisdictions.
By way of example, Latham & Watkins attorneys in Germany, Japan and the UK have described below: (i) the legal tests for establishing an employment relationship in each jurisdiction, (ii) the consequences of incorrectly classifying an employee as an independent contractor and (iii) ways in which the risks associated with misclassification can be mitigated.
(i) The Legal Tests
In all three jurisdictions, whether an individual is an employee or an independent contractor is a question of fact.
Germany: The key question when assessing whether an individual working in Germany is an employee is: Does the company give instructions regarding the (a) content, (b) time and (c) place of work?
Japan: There are two questions relevant to whether an individual working in Japan is employed by the service recipient (company): (a) Does the individual work “in a business or office”, i.e., under the direction and supervision of the company?, and (b) Is the individual paid a salary? Where the payment is determined by the time worked, not by the service provided, the individual is more likely to be an employee.
The UK: There are also two main questions relevant to whether an individual working in the UK is an employee: (a) Is there “mutuality of obligation”, i.e. is there an obligation on the company to provide work and on the individual to carry out that work?, and (b) In performing the services, is the individual subject to the control of the company?
Factors that are relevant when considering whether these tests have been satisfied in each of the jurisdictions include:
- Does the company give instructions to the individual regarding the form/content, time and place of work?, i.e., does the company effectively supervise the day-to-day work of the individual?
- Is the individual integrated into the company’s organization?
- Do employees of the company perform roles comparable to that of the individual?
- Does the company pay the individual for vacation, reimburse expenses or allow the individual to participate in employee benefit programs?
- Is the fee payable to the individual based on time rather than output?
- Does the individual only work for the company?
- Are the services performed on the company’s premises?
- Does the company procure, and bear the expenses of, the raw materials and equipment used to perform the services?
Positive responses to the questions indicate an employment relationship in all three jurisdictions.
(ii) Consequences of Incorrect Classification
There are many professions in which companies engage consultants to produce work products or perform services. Particularly in difficult economic times or during hiring freezes, companies often engage individuals as self-employed “consultants” or “freelancers”, when in reality those individuals should be regarded as employees.
De facto employers may find themselves facing claims for wage taxes, social security liabilities, paid leave, sick pay, maternity leave and pay, and participation in benefit plans. They may also face claims from third parties for the actions of the de facto employees for whom they may be vicariously liable. One of the most common circumstances in which a person’s status as an independent contractor is questioned is when the contract under which their services are provided is terminated. The person concerned may claim that they were in fact employed by the service recipient and therefore that the termination of their services is in fact an unfair dismissal.
The question may also arise if the local tax or social security authorities claim that the company should have paid employer’s social security contributions on the fee paid to an apparently independent contractor, and that it should have withheld income tax and employee’s social security contributions from that fee. In the event of incorrect classification, the employer is liable to the authorities for both the employee’s and the employer’s social security contributions, and for the income tax it should have deducted from the fee, and the fee will be deemed to have been “grossed up” if these amounts are not reimbursed by the de facto employee. In the UK, HM Revenue & Customs may claim backpay (and interest and possibly penalties) for the past six years; in Japan, the social insurance authority may look back two years and the tax authority will generally claim for the past five years; but in Germany this lookback period can be up to 30 years!
In Germany, the works council representing company employees may also dispute an individual freelancer’s status. For example, it may claim for certain rights that depend on the number of employees it represents.
(iii) Mitigating the Risks
Although the question of an individual’s employment status is one of fact and not of contract, the drafting of the contract is still relevant, as the factors indicating an employment relationship can be excluded (the performance of the contract would, of course, have to be consistent with this!). In addition, the language used to describe the relationship should avoid the implication that the individual is an employee. Careful drafting of the contract, while not determinative, is important. In Germany, a company seeking certainty may wish to ask the tax and social security insurance authorities to conduct a “status procedure” to determine an apparent freelancer’s employment status, but this will generally not be conducted unless the parties have already entered into an agreement. Latham & Watkins can assist with this process.
In the UK, it is common for contracts with independent contractors to contain an indemnity for the company in these circumstances, but of course such an indemnity is only as valuable as the solvency of the person giving it. However, this solution will not work perfectly in Germany, as the German courts will not enforce such indemnities in relation to social security contributions (and wage taxes may be claimed from the employee without such an indemnity) — and therefore indemnities such as this are uncommon in German freelancer contracts. In Germany, the employer only has a three month window following the reclassification within which to deduct the employee’s social security contributions from the fee paid to the employee. In Japan, indemnities such as these are also not commonly used, but the employer has a longer period to deduct, or claim for reimbursement of, social security contributions and tax that should have been withheld from employees’ fees.
In the UK and Germany, one way to reduce (although not extinguish) the risk of claims that individuals are in fact employees of the company would be for the individual to form his own personal services company (a PSC) and put in place an employment contract between himself and that PSC. The PSC would then enter into the consultancy contract with the company, specifying the individual as the person who will perform the services on the PSC’s behalf. The UK tax authorities, or the individual, would then need to prove that the contract between the PSC and the company is a sham before the company could be deemed to employ the individual. In Germany, these principles generally also apply. However, the onus is on the company to prove that there is no employment if the German authorities serve them with a demand for unpaid wage taxes or social security contributions. This approach will not mitigate the risk in Japan.
As set out above, the question of whether an individual is an employee or an independent contractor is fact-specific, but timely advice can mitigate the risk of a service recipient being deemed to be an employer of such a person.