Employee or Contractor? An important distinction

I often hear businesses questioning whether they should hire a worker as an “employee” or a “contractor”, and what the different implications are.

Income Tax Assessment Acts 1936 and 1997 are both silent on the definition of an “employee”. To determine the nature of a relationship, the common law and ordinary meaning of an employee are applied.

The general concept derived from the common law is that the relationship between an employer and employee is a contract of service, however, the association between an employer and an independent contractor is a contract forservice. An important distinction.

The Commissioner of the Taxation Office explains in the Superannuation Guarantee Ruling SGR2005/1 that when an individual is considered to be an “employee” under s12 of the Superannuation Guarantee (Administration) Act 1992. SGR2005/1 discusses different measures the courts have considered in establishing whether a person engaged is an employee within the common law meaning.

An Employee works for an employer’s business to build their employer’s goodwill and make the employer’s business more profitable and successful. The engagement could be on a full-time, part-time or casually basis and an employee has to work as directed by the employer. Termination of employees needs to be done in accordance with the relevant industrial relations law and the constraints of their contract. An employee is governed by industrial law.

If the worker is an employee, the employer has the obligation to:

• withhold tax (PAYG Withholding) from employees’ salaries and wages per s12-35 of Sch 1 of the Taxation Administration Act 1953, and report and pay the withheld amounts to the ATO.

• pay superannuation guarantee, at least quarterly, for eligible employees s 12 of the Superannuation Guarantee (Administration) Act 1992.

• report and pay any fringe benefits tax (FBT) if the employee is provided with any fringe benefits. Fringe Benefits Tax Assessment Act 1986 employee definition includes any current, past or future employee who receives or has a right to receive salary and wages.

AnIndependent Contractor is an individual contracting out their labour in addition to their business, often with the intention of building their own business goodwill. An independent contractor, generally:

• is required to obtain an Australian Business Number “ABN”, works the necessary hours to complete a task, and has more control over the performance of the work,

• looks after their own tax obligations,

• is responsible for their own superannuation contributions,

• holds their own licences and insurances and will be responsible for any costs associated with remedying defects in their work,

• aims to further the success and profitability of their own business and is free to accept or refuse work,

• can generally be dismissed within the constraints of their contract and without consideration of any relevant industrial relations law, with no employment entitlements of annual leave, sick leave and long service leave.

The business engaging the contractor does not withhold taxes unless the contractor fails to quote their ABN, or there is a voluntary agreement to withhold tax and there are no FBT obligations on the payer.

An independent contractor is governed by commercial law.

Disguising Employees as Contractors

It is illegal when a payor or a business disguises its employees as contractors to lower its labour cost, for example avoiding paying superannuation, WorkCover, payroll tax, ETP or FBT. Businesses doing so risk receiving penalties and charges, including PAYG withholding penalty, for failing to deduct tax, superannuation guarantee charge, interest charges and administration fees.

Where a contractor operates through an entity such as a trust or a company and to some degree, a partnership, a contractor cannot be deemed to be an employee. This is because the contract is with an entity rather than an individual. However, it is important to note that the Personal Services Income could be applied to the income received as the regime contained in Pt 2-42 of the ITAA 1997 is not determinative of whether an individual is an employee.

Conclusion:

It is critical for businesses to correctly classify the relationship between an employee and a contractor, a difference especially imperative when considering employment rights and taxation matters. The totality and the substance rather than the form of the relationship between the parties should be carefully considered.

In the 2011 matter of On call Interpreters and Translators Agency Pty Ltd v Commissioner of Taxation, Justice Bromberg described the following test to help determine if a person was and independent contractors:

Justice Bromberg stated that if the answer is yes, the person is likely to be an independent contractor. If no, then the person is likely to be an employee.

The Australian Taxation Office provides Employee/contractor decision tool to help work out if your worker is an employee or contractor.