The growing need for workforce flexibility and to reduce business costs means that the line between an employer/employee relationship and a principal/independent contractor relationship is often blurred.
It is important for businesses to correctly classify their employment relationships, given the marked difference in employer obligations when engaging an independent contractor rather than an employee.
This article examines how a business makes this determination for tax purposes. It considers the relevant key indicators outlined in Taxation Ruling TR 2005/16 and provides illustrative examples. This article does not consider payments to directors or officeholders, or labour hire payments and alienated personal services payments, nor does it consider payroll tax or WorkCover obligations.
Generally, a principal/independent contractor relationship is referred to as a “contract for services”, whereas the employer/employee relationship is referred to as a “contract of service”. An independent contractor typically contracts to achieve a result, whereas an employee contracts to provide their labour, which in turn enables the employer to achieve a result.
Broadly, where a business has common law employees, it has PAYG withholding obligations as set out in s 12-35 of Sch 1 to the Taxation Administration Act 1953 (TAA 1953) and superannuation guarantee (SG) obligations as set out in the Superannuation Guarantee (Administration) Act 1992 (Cth) (SGAA).
The term “employee” takes its ordinary meaning. Therefore, whether a person is an employee is a question of fact. It is determined by examining the terms and circumstances of the relationship between the parties as a whole.
Section 12 of the SGAA extends the definition of “common law employee” for SG purposes. The statutory meaning broadly includes:
- a member of the executive body or body corporate (eg a board of directors) who is entitled to payment for performances of their duties;
- an individual contracted for labour; and
- a member of the Commonwealth or State Parliament, or Territory Legislative Assembly.
Superannuation Guarantee Ruling SGR 2005/1 provides guidance on determining whether an individual is an employee for SG purposes and also considers the indicators for common law employees.
TR 2005/16 outlines the key indicators of whether there is an employer/employee relationship or a principal/independent contractor relationship. It is the Taxation Commissioner’s view that no single factor can be determinative on its own, so the totality of the particular parties’ relationship must be considered to make the determination.
A business only needs to work out if there is an employer/employee relationship if it hires an individual. In most cases a company, trust or partnership is unlikely to be an employee unless the arrangement is considered to be a sham or a mere redirection of the employee’s salary or wages.
The ATO generally considers all apprentices, trades assistants, labourers and trainees to be employees.
Control: the authority to command
The “classic test” for determining the nature of a contractual relationship is the extent to which the employer can control various aspects of the work. This includes the levels of control over how, when, where and by whom the work is performed.
The level of control can vary according to the particular industry. For example, where a high degree of direction and control is common in certain contracts for services, the mere fact that a contract includes detailed terms regarding completion of the tasks does not necessarily imply an employment relationship. In fact, with the increasing use of skilled labour and decreasing role of supervision, the importance of control lies in the employer’s right to exercise control, rather than the actual exercising of control.
The ATO acknowledges that control remains an important indicator, but says it is not the sole indicator for establishing an employer/employee relationship.
Task or time: the basis of payment
Where the substance of a contract is to achieve a specified result, this is a strong (but not conclusive) indication of a principal/independent contractor relationship. Contracts for services also generally involve payment based on a negotiated contract price, and sometimes include periodic payments on achieving milestones.
Conversely, where an individual is paid at an hourly rate it is generally an indicator of an employer/employee relationship. However, the manner of payment structure does not necessarily exclude genuine results-based contracts. It is still important to consider the relationship between the parties as a whole to establish whether there is an employment or contracting relationship.
The ability to delegate or subcontract
A contract for services focuses on the performance of agreed services, namely the achievement of a result. Therefore, the ability to delegate or subcontract (ie to engage others to do the work) is a significant indicator of whether an individual is an employee or independent contractor. Having unlimited power to delegate is a strong indication that the person is an independent contractor.
The position of a common law employee who frequently delegates tasks to others is fundamentally different to that of a contractor who has the ability to delegate by subcontracting. The common law employee’s delegation is not considered consistent with a contractor’s delegation.
An employee generally bears little or no risk of the costs arising out of injury or defect in carrying out their work. An independent contractor, on the other hand, tends to bear the commercial risk and responsibility for injury and defects. An employee continues to be paid when they are rectifying any defect in their own work. A contractor is generally expected to bear the cost of rectifying such defects. In practice, contractors often carry their own insurance and indemnity policies.
Responsibility for tools, equipment and business expenses
Where an individual provides the tools and equipment to undertake the work, and their payment of business expenses is substantial in nature, the individual is likely to be considered an independent contractor.
Where the customs and practice of the particular work mean that tools of trade or plant and equipment are not needed to perform the work, this fact does not, by itself, mean the individual is an employee. The weight or emphasis given to this indicator depends on the specific circumstances and the context and nature of the contractual work.
Employees are generally reimbursed by the business when they incur expenses on behalf of the business.
Contract of services versus contract for services: the integration test
In addition to applying the key indicators to establish whether an individual is an employee, the Commissioner reviews the fundamental question of whether the individual is operating their own business or operating within the payer’s business. The existence of a continuing relationship between the individual and the business is a common attribute of an employee relationship, as is the general restriction of an individual’s activities to providing services to a single employer.
An individual is not necessarily a contractor just because they present their payer with an ABN.
Illustrative example: subcontractor
Donna is a software programmer. She enters into a contract with a retail business to design, develop, test and install a new software program. The contract stipulates that the program must be operational within six months, with specific stages of the project to be completed by set dates, and must meet the retail business’s requirements and specifications.
Donna has control over how the work is completed. The contract focuses on achieving a specific result. Donna can pay someone else to complete the work.
Donna will be paid based on an agreed fee quote. She will receive progress payments upon completion of specific stages of the project.
Donna predominantly uses her own computer equipment and software. At certain stages of the project she will be required to use the retail business’s computers for short periods.
If the software program does not meet the retail business’s agreed requirements or does not perform to specification, Donna will be required to correct the problem at her own expense.
Donna has her own website which promotes her services. She has another unrelated project lined up after the completion of her contract with the retail business. Donna has control over her decisions about whether she undertakes future projects for the retail business.
Illustrative example: employee
John is a plumber. He works for a plumbing business on an ongoing basis and carries out any plumbing work instructed by the business.
The business has advised John that he will be installing pipes and connecting housing units to the water mains at a local real estate development over the next 10 weeks.
John is required to be at the development area from 9.00 am to 5.00 pm, Monday to Friday. Each morning the supervisor on the job will instruct him on his tasks for the day. John is paid an hourly rate for the time he works each week and uses the employer’s tools, equipment and materials to perform the work.
If there is a defect in the work, the plumbing business is responsible for the defect. The business will instruct John to fix the problem and he will do it during his standard working hours. The plumbing business will continue to pay him during the hours he spends fixing such a defect.
In most cases it is self-evident whether a contractual relationship is an employment relationship or a principal/independent contractor relationship. In circumstances where the terms or intentions are less clear, a business’s failure to correctly classify whether their workers are employees or contractors for tax and super purposes could be a costly mistake.
The ATO has released an online decision tool for businesses to use in working out if an individual worker is an employee or a contractor. While the decision tool provides some guidance about the ATO’s position, it only provides limited protection against incorrect assessments, so it is prudent for businesses to be familiar with the key indicators of whether an individual is a common law employee or an independent contractor. Call Carrick Aland in Dalby, Toowoomba or Chinchilla on 07 4669 9800 as a first step.