You know who we are talking about.  He works in your office, he has access to your intranet, he volunteered to be your fire warden, and he is always the life of the Christmas party. 

He is that temp you engaged five years ago, who you could just never let go.  Or  someone's great idea, when the Global Office demanded that you toe the line with head-count restrictions which made sense in the USA  /  or some other country, but not in the Lucky Country.

He has never complained. Not yet anyway.

But like every good horror story, things go to hell in a hand basket very quickly.

Maybe it happens when he pulls his back and the lure of easy workers' compensation benefits becomes too great, or, more likely, when he is shown the door with empty pockets whilst people he considered to be his colleagues receive generous redundancy benefits.

That's when he will turn against his master, and you will hear those words which strike apoplectic fear into every employer:

"I AM EMPLOYEE AND I LIVE !!"

No amount of crazy villagers brandishing pitchforks and fire will be able to turn him away. That's when you will regret your decision to mess with the weird legal science of creating artificial contractors.

Ducks, Roosters and Acrobats

You can't turn an employee into a contractor just by entering into a contractor agreement.  The Courts have repeatedly warned employers that they will  focus on the substance of the relationship rather the form in which the parties dress it.  His Honour Justice Gray of the Federal Court summed it up very well in the decision of  Re Porter: re Transport Workers Union of Australia (1989) 34 IR 179:

"As Mr Black put in the present case, the parties cannot create something which has every feature of a rooster, but call it a duck and insist that everybody else recognise it as a duck."

The problem with conversion is the "independent"  in "independent contractor".  At the very core of independent contractor status is a person who conducts a truly independent business of providing services to a section of the public.  A business does not grow overnight.   It usually has things like clients, business cards, letterheads, advertising, and offices.

Contractors are also usually engaged to achieve a particular result, and their fees are usually linked to the result.  The classic example is a plumber who is engaged to unblock your toilet. You don't care how he does it and how long it may take.  He will only be paid if he gets your pipes flowing.  Contractors pick up their expenses, provide their own tools, and run the risk of making a profit or loss on each job. 

In contrast, the employment relationship is one of dependence.  The concept of employment grew from the master-servant relationship.  Employees still "serve" and by this we mean that they are subject to the general direction and control of the employer (their master).  They are usually engaged to fill a role (rather than perform a specific task) and may perform a variety of tasks as required by the employer.

The distinction is not always an easy one to make, particularly when it comes to the issue of supervision and control. The key decision in this area involved a trapeze artist, Mr Zuijs, who suffered a nasty accident whilst on the job.  He asserted that he was an employee of the circus, so that he could access workers compensation benefits.  A key problem for Mr Zuijs was that the circus owners did not and could not exercise any direct control as to how he performed his act.  He was, of course, an artist.  However, the High Court still found that he was an employee because Mr Zuijs was subject to control in all other aspects of his act, such as the costumes he wore and where he got dressed, when and where he conducted his rehearsals, and what safety measures had to be observed.  The High Court held that the critical issue was whether the circus owner had the right to "command" Mr Zuijs, to the extent that there was scope for it.  This decision is critical when considering the status of experts with specialised skills, such as IT technicians, where the employer may not have a practical ability to assert control.

If you are interested in determining whether or not you are engaging a contractor or an employee, please click here.

Recently, the Australian Taxation Office established on its website a checklist which assists employers determine whether they are engaging a contractor or an employee.

The Horror of Miscreation

Be warned:  The mischaracterization of a contractor as an employee can have serious implications.

First, you will be exposed for claims for the back-payment of minimum employment benefits.   These may include benefits under the National Employment Standard and industrial instruments (such as an award or enterprise agreement). We are talking minimum wages, overtime rates, allowances, penalties, unpaid expenses, annual leave pay, personal leave pay, long service leave, notice benefits and redundancy benefits PLUS interest.  An employer may also be fined for breaching these instruments, and fines could be substantial.

Second, where you have published to your workforce at large that you will provide certain additional employee benefits, then it may also be possible for a reformed contractor to assert that they are entitled to these benefits as a matter of contract.  For example, there have been cases where claims have been made by reformed contractors for benefits under share and options schemes and also enhanced severance benefits under redundancy policies.

Thirdly, there are the dreaded tax and superannuation issues.  As an employer your organisation would have been obliged to deduct tax from the miscreant's fees and also make superannuation contributions.  The ATO can actually pursue unpaid taxes from the employer directly, and the employer may suffer large penalties for failing to make deductions and superannuation contributions. You should also note that under tax administration laws which have recently been amended, your directors may be liable for PAYG withholding tax and the employee superannuation guarantee charge if these liabilities are not paid by the company within three months of their due date. Directors owe a positive obligation to ensure that these payments are made.  Under these laws, where a director receives a director's penalty notice, the director must either pay the penalty or ensure that the company goes into voluntary administration or begins to be wound up.

Fourthly, the Fair Work Act contains various provisions which may come into play where a mischaracterisation occurs.  This Act prohibits an employer from representing that a contract of employment is a contract for services.  The only defence is where the employer did not know this to be the case and was not reckless.  Employers may also be liable if they have misled employees in their attempts to convert them into contractors, or, even worse, threatened to terminate their employment in order to engage them as contractors for substantially the same work.

This is the stuff of Halloween.  We repeat that there may be significant liabilities, particularly when the issue of mis-characterisation tends to be raised at the end of the relationship, after many years of service and there is a pool of like "contractors".  Employers may be able to set off contractor benefits against some employee entitlements, but by and large the Courts have not accepted that an employer can set off one benefit, such as fees, against an employee entitlement of a different nature, such as annual leave.

Let's talk about Kevin, and middle-men

One method which organisations commonly use to avoid employer obligations is to engage workers through a "middle man" such as a family company or a labour hire company.  However, the Courts have been prepared to look behind the company curtain, where all indications suggest that the true agreement is with the worker.  These arrangements are not fool-proof and employers should be particularly wary when they transfer groups of employees to a labour hire company, only to have them contracted back to the employer to perform the same work.

In a recent Draft Taxation Ruling TR 2012/D4, which principally dealt with cross-border arrangements, the Australian Taxation Office specifically addressed circumstances where workers were transferred to a labour hire agency.  The ATO posited that the "substance over form" approach may lead to a conclusion that the true employer is not the labour hire entity (i.e. the entity which is specified in the written contract of employment with the employer) but  the client of the labour hire agency.

This may occur where:

  • the conduct of the parties is not consistent with the terms of the written contract of employment or another contract with the third party, including instances where such terms are ambiguous; or
  • under the contractual terms, the true nature of the relationship(s) between the parties is misrepresented or disguised.

The ATO gives an example of a construction company (Construct Co) who transfers an employed engineer, named "Kevin", to a labour hire company.  The labour hire company engages Kevin on similar terms and pays Kevin on time sheets provided to both the labour hire company and Construct Co.  Under a separate contract Construct Co pays the labour hire company the amount of Kevin's remuneration, travel expenses, and other employment benefits and charges plus a labour hire fee.   Construct Co has the right to determine whether, where and when Kevin will work, and provides Kevin with the necessary tools and equipment to complete these tasks. 

The moral to this example is that for tax purposes Kevin's employer will remain Construct Co because "in substance and reality, the relationship between Kevin and Construct Co has not been altered by the interposition of Hire Co."

The ATO's position reflects the decision of the Full Court of the Federal Court in Damevski v Giudice [2003] FCAFC 222. In this case, the Full Court of the Federal Court found that despite the existence of a written contract between a company and a labour hire entity which provided cleaning services, the true agreement was between the employer and an individual cleaner.  This was because the labour hire agency did nothing more than receive wages while the employer continued to direct the cleaner.

In normal circumstances, the "middle man" would assume and fulfil (pay) the usual employment obligations and you can usually rest soundly.  However, don't be surprised if the "middle man's" workers come knocking on your door, if the "middle man" does not comply with an award or makes proper superannuation contributions, or simply goes bust, or you provide your employees with more generous benefits (e.g. redundancy benefits).  It is critical that you ensure that any "middle men" you engage can and do fulfil their obligations to workers which you use.  More on this below.

Urban Myths about Contractors

Some time ago, pre-iPhone, it must have made sense to prefer contractors over employees, but as the years have gone by the returns are diminishing.  These days, decisions to engage contractors are often laced with misunderstandings and misconceptions.  Here are several facts which may surprise you.

You must make superannuation contributions to certain contractors

If you have engaged a person under a contract  principally for that person's labour, then you will be liable for a superannuation guarantee charge in respect of that person's earnings unless you make superannuation guarantee contributions.  This obligation arises regardless of whether of not that person is a contractor or employee.  This rule commonly catches out organisations who engage freelancers.  Freelancers may provide services sporadically as compared to employees, but at the end of the day, they sell the same product - their personal service.  If on the other hand, the contracted fee includes the payment for goods or materials from the contractor, the contractor does not perform the work personally, or the contractor's fees are tied to the achievement of a result, then the obligation is unlikely to apply.

Certain contractors can challenge and seek variations of the independent contractor agreements on grounds of unfairness

Under the Independent Contractors Act a contractor who is an individual has the right to seek the variation of their agreement or seek to set it aside to achieve fairness.  This right also extends to a corporate contractor where the person performing the work is a director or the directors are family members.  In conducting its review, the Federal Court or Federal Magistrates Court  will consider such factors as the relative bargaining positions of the parties, undue influence, and whether the total remuneration received by the contractor is less than an employee who performs similar work.  It is notable that employee rights to challenge there employment contracts on fairness have been extinguished by federal law.

You owe the same obligations of health and safety to your contractors as you do your employees

You cannot outsource this obligation. The new Work Health and Safety Act 2011 (NSW) makes it clear that your obligation is to ensure the health and safety of all workers who you engage, cause to be engage, or you may direct influence or control.  A "worker" is defined to include a contractor, a sub-contractor and their respective employees.   It is true that contractors will owe their own obligations under this legislation, but these obligations are independent and concurrent. They will not reduce your obligations.  In fact, the new Act expressly requires you to consult with your contractors on work health and safety issues, and coordinate and cooperate with the discharge of your respective duties - even when the contractor is experienced in these matters.

Contractors have Adverse Action rights

A number of the general protection provisions under the Fair Work Act 2009 extend to contractors and prospective contractors.  This means, for example, that you cannot victimise a contractor who claims superannuation benefits, seeks the rectification of poor health and safety standards, or asserts that they are entitled to employee rights.  A contractor could also sue you under these provisions if you terminated their contract or reduced their work levels because of a concern that they could claim employment benefits.  There is no cap for compensation.

Contractors have rights under discrimination law

State and federal anti-discrimination laws extend to contractors and contract workers.  You could be liable if they suffer discrimination on the grounds of sex, race, age disability etc. and also if they are harassed on these grounds.  You may also be liable if a contractor subjects your staff to inappropriate behaviour.  A contractor who is the victim of bullying can also complain under work health and safety legislation.

You may need to ensure workers compensation cover for your contractors

Under New South Wales law, where the contractor engages employees  you will be liable to pay workers compensation if the contractor does not have a workers compensation policy in place at the time of injury.  It is therefore critical that you ensure that contractors have in place a current workers compensation policy.  Where the contractor is an individual, you must cover them where the work they are performing is not part of a trade or business regularly carried on by them under a business name or their own name and where they are not delegating the performance of work.

Contractors still need to pay tax

The perceived tax benefits of contractor status have largely dissipated due to the personal services income rules, the PAYG instalment system and in some cases, the PAYG withholding system (if the contractor does not provide an ABN).  For example, if a worker provides personal services to you through a middle man company and that company derives  80% or more of its income through this work, this income may be treated as the wage of the worker, and the middle man company would have to deduct PAYG tax and make superannuation contributions from this income.

However, some benefits still remain for true independent contractors.  True contractors are not covered by modern awards, and this does provide greater flexibility arrangements, particularly in terms of remuneration and working hours.  Generally speaking, it is also easier to terminate contractor engagements.  Contractors cannot access unfair dismissal rights and are not entitled to redundancy benefits.  There is also generally less administration in these engagements.

If you are interested in what you should insert into your independent contractor agreements to minimise these risks, please click here.

Benefits of Employment

There are certain key benefits in engaging an employee which also should not be forgotten at a time when businesses are under threat of losing clients and business.  This benefit relates to the core of the master-servant relationship, the obligation of loyalty.  Unlike contractors, employees owe implied obligations of good faith and fidelity which oblige them to act in the best interests of their employer.  If work is likely to result in the creation of business critical intellectual property, extensive access to core confidential information, or close dealings with key clients - then the commercial imperative of protecting your business may dictate the creation of an employment relationship.

We are not suggesting that you cannot build these obligations into a contractor agreement, but these obligations would be regarded as indicia of employment, and again, may push you over the edge of mischaracterisation.

Ultimately, the status of the worker should fit the job.  If the job involves the performance of a role or office within your reporting structure, or a high degree of control over the worker, or the management or supervision of your employees, or representing you to clients or the public at large, you should elect employment.

Kill the Beast

Well! What next ?

Maybe you should draw some lessons from Halloween, and confront your worst nightmare.  You will always be better off speaking to your Frankenstein's contractor whilst the relationship is going well, as opposed to waiting until the relationship has soured at the end of the relationship.  At this early stage you are likely to find some common ground because the contractor may have his or her own concerns about the taxation implications of converting back to employment status.  The contractor may be amenable to restructuring the working relationship to reduce the risks of mischaracterising.  For example you may be able to restructure how the contractor is paid and provide for greater flexibility in the working relationship.  If this is not possible, you may instead wish to consider making back-payments for employment entitlements due to the worker and also self-disclosing to the ATO (as for everything, it has a form).  If you do this, there is a greater chance that your circumstances may be treated more favourably by the authorities.