The Historical Evolution of Self-Employment Models
The world of work has undergone significant changes over the past few decades. Historically, most jobs were fixed, full-time positions, but the 1990s saw a shift toward greater use of the independent contractor model.
Source: OECD stats.oecd.org ALFS summary tables & country specific labour indicators
However, in the late 2000s, many large companies pulled back from this model. You can see this shift above in the rate of self-employment as a % of total employment since 2007, where with the exception of the USA, in many countries it has decreased as a % of the total workforce. In the case of the US, much of the increase has been attributed almost exclusively to the transportation-specific gig economy (i.e. Uber, Lyft, etc.) so is not representative of a broader shift towards independent contractors in other sectors. There are many factors behind this shift including governments pushing people out of the grey economy, the growth of multinationals providing full-time employment as well as employment preferences amongst individuals (e.g. full-time employment provides greater social security and other benefits, amongst others). However one of the factors driving the above has been the evolution of contractor misclassification risks. Some companies even today refuse to engage in the model of employing independent contractors. But there’s a reason to look deeper at the reasons for considering independent contractors as part of your hire from anywhere strategy.
Africa, Asia, South, Central America and the Caribbean: Critical Talent Hubs Of The Future
A recent World Economic Forum article dived deep into where the talent hubs of the future lie and how countries can find ways to attract them. This is driven by a growing global population that is growing and is simultaneously becoming more educated. The geography of global talent pools is shifting. It talks about how “the supply of internationally mobile talent will be greater than ever, but it will be found in new places”. Which begs the question, how will companies of the future adjust to this?
The Trend Toward An Agile, Globally Distributed Workforce
Many companies today are exploring new work models with a particular focus on implementing an agile, globally distributed workforce. According to Mercer research, in the future, companies will focus on agile, flexible skills rather than fixed, permanent roles. This perspective raises the question of how many companies have insight into the skills they have internally via their employees/contractors and externally via a pool of potential talent (both employees and contractors).
Source: Mercer Annual Skills Survey
Mercer’s research suggests that in the future, approximately 30%+ of tasks will be filled by flexible/fractional talent, rather than fixed/rigid roles. For example, if a company needs to hire an M&A specialist for a 12-week project, it may be more cost-effective and more advantageous to engage them compliantly as an independent contractor rather than as a full-time employee. With this in mind, the future points to one where there will be much greater use of independent contractors.
To a degree this is already happening. You can see from this recent Economist article backed by the Atlanta Fed survey that companies in the US, at least those covered by this survey, are already shifting to a more agile model that avails of the flexibility offered by work models that make greater use of independent contractors. According to this survey, 18% of companies surveyed indicated that they were using more independent contractors than in the previous year. On top of that, 13% relied more on leased workers, compared with 1% who reduced this reliance.
MBO Partners, a workforce-management firm, estimates that the number of American workers engaged in independent work for at least 15 hours a week increased from 15m in 2019 to 22m in 2022. This all speaks to a structural shift in the nature of work models and how more companies, especially with the advent of remote work, are likely to make greater use of independent contractors in the future, provided of course that they can keep in control of the related risks.
What are the Key Risks of Employee and Independent Contractor Misclassification?
The biggest contractor misclassification risk is essentially the risk that the individual has been incorrectly classified as an independent contractor when they should have been classified as an employee. Let’s dive further into the key contractor misclassification risks that need to be actively monitored as part of any Hire From Anywhere operating model:
- Legal penalties and fines: Companies that misclassify employees as independent contractors may face significant legal penalties and fines from government authorities for non-compliance with labor laws, tax regulations, and social security requirements. These penalties can vary depending on the jurisdiction but can be severe and costly for businesses.
- Back payment of payroll taxes and social security contributions: If you have a case of misclassification, companies may be required to pay back historical taxes, social security contributions, and other payments that should have been made for employees. This can go back years.
- Permanent establishment risks: If you have a misclassified employee, you also need to be aware of PE (Permanent Establishment) risks, specifically agency PE risks. This can have very serious consequences as creating PE in a country means you are risking the local tax authorities taxing those activities at the local corporation tax rate, amongst other challenges.
- Employee claims and lawsuits: Misclassified workers may bring claims or lawsuits against the company for unpaid wages, overtime, benefits, and other entitlements they would have been eligible for as employees. An independent contractor arrangement might work well for both parties when times are going well, but what if the parties leave on bad terms? This has happened to some companies during Covid, where for example an independent contractor was hospitalized with Covid for a few months, and successfully sued the company claiming misclassification, meaning some companies having to fit expensive hospital bills, aside from the payment of back taxes and social security contributions.
- Loss of intellectual property protection: Independent contractors often retain the rights to any intellectual property (IP) they create, whereas employees typically assign their intellectual property rights to the company. Misclassification can lead to disputes over ownership of valuable IP, potentially jeopardizing a company’s competitive advantage, so it is crucial to ensure any contract with an independent contractor is watertight with regards to your company’s IP rights and ownership.
- Damage to company reputation and brand: Public allegations of contractor misclassification, especially if picked up by the local press, can damage a company’s reputation and lead to negative publicity, as well as lead to increased scrutiny from local tax and labour law regulators amongst others.
Government Guidelines and Penalties for Misclassification
One of the challenges with contractor misclassification is that different countries have varying ways of interpreting the definition of contractor misclassification.
Strict Contractor Misclassification in the UK under IR35
The UK is an example of a country with strict definitions around this topic, especially since the IR35 rules have been introduced. These rules are designed to ensure that contractors who are essentially operating as employees pay the correct amount of tax and National Insurance contributions. The UK’s tax authority, HM Revenue & Customs (HMRC), has been actively enforcing these rules, and companies found to be in breach can face significant fines and penalties. There have been some famous cases in recent months including football pundit Gary Lineker and TV personality Eamonn Holmes.
The ABC Contractor Misclassification Test in the United States
In the USA, the ABC test is used to determine whether a worker is an independent contractor or an employee. This test considers three factors:
- the worker is free from the company’s control in performing the work,
- the work is outside the usual course of the company’s business, and
- the worker is engaged in an independently established trade or occupation.
In California, the state’s Supreme Court established the ABC test in the landmark case Dynamex Operations West, Inc. v. Superior Court in 2018. Since then, other states have adopted similar tests, and companies must be vigilant in the US in ensuring they classify workers correctly to avoid fines and penalties.
Bear in mind that some countries have their own contractor misclassification checklists, such as the IRS SS-8 form in the USA.
Contractor Misclassification in Other Countries
In addition to the UK and the USA, other countries also have strict rules around contractor misclassification. For example:
- In Germany, the Federal Employment Agency enforces the rules around “Scheinselbstständigkeit” or “pseudo self-employment.” Companies found to be in breach of these rules can face significant fines and may be required to pay back taxes and social security contributions.
- In Australia, there is the concept of “sham contracting” which is illegal under the Fair Work Act 2009
There are other factors that can influence the independent contractor model in different countries and also evolving legislation, such as Dac 7 rules around marketplace operators, that might also impact the evolution of how both the marketplaces and independent contractors report their revenue.
The Future of Worker Classification: How the Gig Economy Is Shaping the Landscape
The rise of the gig economy has also put contractor misclassification risks into sharper focus, especially when you see companies like Uber have faced fines, penalties and back taxes of over $100m in the US alone for misclassifying their workers as independent contractors rather than employees. In the UK, Uber was required to classify its drivers as “workers” rather than independent contractors, which meant the company had to provide its drivers with minimum wage, holiday pay, and other benefits. This underscores the need to be considered about which countries you decide to engage independent contractors in and what operating model you decide to use to engage them as part of your hire from anywhere strategy.
Common Signs of Misclassification: Red Flags to Watch Out For
So how do you Identify misclassified employees and independent contractors? There are several steps companies can take to identify high risk scenarios for contractor misclassification. The first one is to get a clear understanding of where you have independent contractors engaged in countries that have very strict contractor misclassification laws. However even in countries that do not have very strict contractor misclassification laws, you still need to perform a number of crucial steps to identify whether you have any risks that could come back to bite you. These include:
- Review contractual agreements: Carefully examine the contracts of all independent contractors to ensure that the terms and conditions accurately reflect the nature of the working relationship. Look for inconsistencies, vague language, or clauses that may indicate an employment relationship rather than a contractor arrangement.
- Assess the level of control: Evaluate the degree of control that the company exercises over the contractor’s work, including work schedules, deadlines, methods of completing tasks, and reporting requirements. If the company has significant control over how the contractor performs their work, this may indicate an employee relationship.
- Examine the nature of the work: Determine whether the work performed by the contractor is integral to the company’s core business operations. If the contractor’s work is essential to the business and their role is similar to that of employees, this may be a sign of misclassification.
- Watch out for high Permanent Establishment (PE) risk activities: If any contractor is engaged in high PE risk activities, make sure to assess these on a case by case scenario and at the very least minimize the risk of corporate tax exposure explicitly stating that the contractor lacks authorization to make any representation, agreement, or negotiate contracts on the company’s behalf, and by forbidding the contractor from asserting to others that they have such authority.
- Evaluate the contractor’s financial risk and independence: Assess the extent to which the contractor is financially invested in their own business and is responsible for providing their own tools, equipment, and resources. Contractors should generally bear more financial risk and operate independently from the company.
- Analyze the duration and exclusivity of the relationship: Consider the length of the working relationship and whether the contractor works exclusively for the company. Long-term or exclusive relationships may suggest that the contractor is more like an employee than an independent contractor.
- Investigate the method of payment: Independent contractors are typically paid on a per-project or commission basis, while employees are paid a regular salary or hourly wage. If the contractor receives regular, ongoing payments similar to an employee, this could indicate misclassification. With this in mind, it’s worth considering the payment structure for the contractor and whether this is a signal for misclassification.
- Seek expert advice: Consult with legal and tax professionals who specialize in employment law and contractor classification to review your findings and provide guidance on compliance. This step is crucial, as misclassification can have significant legal and financial consequences for your company, including fines, penalties, and back payments of taxes and benefits.
How to Correct Employee Misclassification and Avoid Penalties
If you find that you have misclassified workers, it is not advisable to simply terminate the relationship and hope the issue resolves itself. You remain accountable for compensating the employee (and possibly the government) for benefits, taxes, and other entitlements. The only way to rectify employee misclassification is by ensuring that both the employee and the government are adequately compensated. This includes paying any outstanding back taxes, benefit contributions, pension contributions, and potential fines related to the problem. While you might be inclined to end the relationship with the employee and hope the issue disappears, such an approach can lead to severe consequences. Governments tend to impose stricter penalties on companies that intentionally violate misclassification laws.
Best Practices For Correcting Employee and Independent Contractor Misclassification
- Conduct an internal audit: Review your worker classification practices to identify any instances of misclassification
- Consult with legal and HR experts: Seek advice from legal and HR professionals to understand the implications of misclassification and potential corrective actions
- Correct the misclassification: Reclassify the affected workers as employees, providing them with the appropriate benefits, protections, and compensation
- Notify the affected workers: Inform the affected workers about their reclassification and the changes to their employment status
- Pay any owed back wages, benefits, and taxes: Calculate and pay any unpaid wages, benefits, and employment taxes associated with the misclassification
- Update employment contracts and agreements: Revise worker contracts and agreements to accurately reflect the worker’s correct classification and related terms
- Implement a compliant worker classification system: Establish a system to properly classify workers as employees or independent contractors, based on applicable laws and regulations
- Train management and HR personnel: Educate management and HR staff on worker classification laws and best practices to prevent future misclassifications
- Regularly review worker classifications: Periodically assess your worker classification practices to ensure ongoing compliance with relevant laws and regulations
- Address any legal or regulatory consequences: If necessary, resolve any legal disputes, government investigations, or penalties resulting from the misclassification
Calculating Compensation for Misclassified Employees: Key Factors to Consider
Determining compensation for an employee who has been misclassified can be a complex process, as what applies in one country may not apply in another. Regardless of the country, you’ll typically need to compensate employees for any benefits and social contributions they would have received if they had been correctly classified. If you find that an employee has been misclassified, you can estimate the amount you will owe by taking into account the following factors:
- How long has the employee been misclassified?
- What compensation has the employee received?
- What would a full-time employee at your company, performing similar tasks, earn?
- What company benefits would typically be provided to an employee at that level of seniority?
- How much would the employer have paid in taxes on behalf of the employee?
- How much in taxes would the employee have been accountable for?
- What are the government’s guidelines for penalties related to misclassification?
Additionally, you should consider whether you discovered the misclassification on your own. If so, you might be able to avoid the most severe penalties and fines. However, if the government detected the issue or the employee filed a complaint, you could potentially face the maximum penalties.
How Employers of Record Can Help With Contractor Misclassification
Employers of Record can be helpful allies when it comes to assessing the risks of contractor misclassification. If you’re already engaged with an Employer of Record, try reaching out to them to see if they operate in the country you’re targeting and whether they have in-house knowledge of the specific contractor misclassification risks in that country. Some Employers of Record even have contractor misclassification tool, others such as CXC Global provide enhanced contractor misclassification tools. What is very helpful about Employers of Record is that they onboard both independent contractors and employees who can be hired via the Employer of Record. We have covered the pros and cons of Employers of Record more generally in this article we wrote. What we have seen from the Employer of Record industry is that some companies have in the past encouraged companies to onboard independent contractors, which is a fairly cost-effective solution for companies, only to then, after a period of time, flag that those same contractors are misclassified, which would then trigger their clients to move to their higher margin Employer of Record employee model. This is why it’s important to go into the Employer of Record assessment with eyes wide open. However the Employers of Record in general can be quite helpful and many will be able to answer your questions if you try to reach out to them.
How Do I Manage Contractor Misclassification To Compliantly Hire Internationally?
When implementing a hire from anywhere strategy, you’ve first got to decide whether the independent contractor model is one you want to avail of. For some companies, perhaps for company culture reasons, or for others it might be because of the risk associated with this model, it might not be the right fit for them. But if you do decide to embrace this as a pillar of your global expansion strategy, you will need to consider the risks we mentioned above associated with contractor misclassification. Use this information to evaluate when to focus on hiring via legal entities, when to hire via an Employer of Record, and when to engage independent contractors. From a very practical perspective, companies need to identify what countries they want to consider as part of their Hire From Anywhere strategy, specifically what countries they see as low, medium or high risk (e.g. high risk => we will never hire there).
China: Extremely Risky to Hire an Independent Contractor
Countries that have a high risk status for independent contractors would be countries such as China where it is quasi-illegal or at least extremely difficult legally to hire via independent contractors.
Countries with Low Risk of Contractor Misclassification
Countries that are low risk would be countries that are quite open to independent contractors (i.e. not strict contractor misclassification laws) and where you have the right business and legal case to use an independent contractor (e.g. looking for a particular in-demand, hard to find skillset for a period of time). Countries that are medium risk would be ones that fall in between and are essentially countries that you would assess on an ad hoc basis. In all cases you’ve got to be cognizant of permanent establishment risks to ensure that no independent contractors are engaged in activities that are deemed high PE risk (e.g. sales-generating roles, senior roles, etc.). Likewise Intellectual Property and data privacy and security are other considerations that may impact how you assess which countries you’re open to, amongst others.
Decision Making Framework For Employing an Independent Contractor
Once you have your list of countries you’re open to using the Independent Contractor model in, you need to have a clear decision-making framework in place. Below is an example of how you can approach this:
- Build your company-specific and/or country-specific checklist or criteria that allows you to identify the key contractor misclassification tests. If you’re a small startup, you might decide to start with a generic checklist and as you scale, it’s critical that you adapt it where there are countries where you frequently engage contractors.
- Adapt any independent contractor arrangement to meet the most stringent criteria possible within the relevant country. Aim to satisfy as many factors as feasible within your contractor misclassification checklist. Most importantly, allow the contractor to retain control over the majority of the details concerning the work to be executed.
- Specifically on the contract, do not assume that just because you structure the relationship as an independent contractor legally, that this alone will suffice. In many jurisdictions, they take a substance over form approach, whereby they look at the day-to-day execution of the arrangement rather than just what it says in the contract.
- This is why you need to ensure you record all terms and conditions of the arrangement and how the contractor is engaged on a day-to-day basis, as this is crucial for any legal dispute or administrative process in providing solid proof addressing any aspects relevant to misclassification. Get it in writing so that wherever possible you correspond through email or other written channels, and whatever you do, do not rely on just vocal agreement of key aspects of the relationship, otherwise this could backfire down the line in court.
- Ensure you have a risk-adjusted approach incorporated into your international hiring strategy with clear guidelines and defined triggers that kick-in (e.g. hiring more than 5 contractors in a low risk country should automatically lead to a risk assessment before going ahead).
- Lastly, make sure you have the right tools in place to monitor and assess these risks. In some cases, for very high risk scenarios, an employment lawyer may be required (e.g. to draft a country-specific contract). In others, technology can play a role here (we covered the technology solutions for Hire From Anywhere here).
The Benefits of Using Independent Contractors
Weighing all of the above up, what are the advantages of using independent contractors? Here are 5 that you can consider:
- Cost savings: Hiring independent contractors can lead to cost savings for businesses as they are not required to provide benefits such as health insurance, paid leave, or retirement plans. Additionally, employers do not need to pay payroll taxes, unemployment insurance, or workers’ compensation for contractors.
- Flexibility: Independent contractors offer flexibility in terms of workload, project duration, and working hours. Businesses can hire contractors on a project-by-project basis, allowing them to scale their workforce up or down as needed without the long-term commitment of hiring full-time employees.
- Access to specialized skills: Contractors often have specialized skills and expertise in their respective fields, which may not be available in-house. Hiring contractors allows businesses to tap into this expertise as needed without the cost of training and retaining full-time employees.
- Reduced administrative burden: Employing independent contractors usually involves less paperwork and administrative tasks compared to hiring employees. This can save businesses time and resources in managing their workforce.
- Faster hiring process: The hiring process for independent contractors is typically faster than for full-time employees, as there is no need to go through extensive onboarding and training processes. This can be beneficial when businesses need to quickly fill a role or complete a project.
The Limitations of Using Independent Contractors:
What about the disadvantages of using Independent Contractors? Below are the top 5 that we identified:
- Contractor misclassification risks: As mentioned earlier, misclassification of employees as independent contractors can lead to legal penalties, back payment of taxes and benefits, employee claims, loss of intellectual property protection, and damage to company reputation.
- Less control over work: Independent contractors have more autonomy in how they complete their work, which can result in less control for the company over the project’s progress and final outcome.
- Limited loyalty and engagement: Independent contractors may have multiple clients, which can lead to divided loyalties and a lack of long-term commitment to a particular company. This might affect the quality of their work and their level of engagement with the company’s goals and culture.
- Intellectual property concerns: As mentioned earlier, independent contractors often retain the rights to the intellectual property they create. This can lead to disputes over ownership and the potential loss of valuable assets.
- Potential inconsistency in work quality: Since contractors are not subject to the same performance management processes as employees, there may be variations in the quality of work delivered by different contractors. It may also be challenging to ensure that contractors adhere to the company’s standards and procedures.
Conclusion: The Importance of Compliance in a Changing Work Environment
In today’s increasingly global and agile work environment, companies need to be aware of the risks associated with contractor misclassification. By carefully evaluating their workforce needs, understanding the laws and regulations in different countries, and taking steps to ensure they engage workers compliantly, companies can successfully navigate the challenges of hiring from anywhere while minimizing the risks associated with contractor misclassification. If you are worried about your existing Independent Contractor footprint, feel free to reach out to use about our Global Footprint Health Check. If you are looking to implement technology to manage these risks on an ongoing basis, check out our Hire from Anywhere platform. If you’d just like to chat about how companies can approach Hire from Anywhere, you’re more than welcome to reach out to us and we’d be happy to chat.
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John is Co-founder of the Work From Anywhere team, a platform to help companies execute a hire or work from anywhere strategy. John is a Chartered Accountant who speaks 6 languages and was previously the senior finance leader of a €4 billion division of FTSE-listed CRH Plc. John and his family are passionate about travelling and his eldest daughter, Rosa, while only 5 years old has already travelled to 25 different countries.