Contractors v Employees – Understanding the difference and tax implications

23 November 2018

Contractors v Employees

Consulting remains a popular alternative to traditional employment arrangements and it is essential that organisations have clear and consistent processes in place, to correctly determine whether an individual should be treated as a contractor or employee - in order to understand and satisfy their statutory obligations.

The ATO continue to review and audit contract arrangements closely. Where they determine that a ‘contractor’ is actually an employee, they will expect the corresponding employer tax obligations to be satisfied. Where these are not being met, organisations can expect interest and penalties to apply, and will most likely be subjected to additional scrutiny going forwards.

How to decipher a contractor versus an employee

When it comes to determining a business’ obligations in relation to an arrangement, the key step is categorising whether the engaged party is a contractor or an employee. It is important to realise that simply calling someone a contractor, or ensuring that they are able to provide an ABN, is not enough to determine that someone is, in fact a contractor.

Determination under common law requires that a range of key factors and indicators be considered and assessed in order to determine the true nature of an arrangement. These are outlined by the ATO in Taxation Ruling TR 2005/16 (‘TR 2005/16’). The ATO views that whether a person is an employee is a question of fact which can only be answered through the consideration of the employment contract’s terms and circumstances. The key indicators include:

Factor Employees Contractors
Control The organisation controls the work the individual performs, hours, location of activity and how the work should be undertaken. Contractors are in control of what work they perform, their hours, location of activity and how they undertake the work.
Integration The individual works as part of their employer’s business. Contractors often operate on their own account
Exclusivity Employees typically work exclusively for their employer. Contractors often perform services for a number of different organisations.
Results’ contract A contract of employment has been drawn up. A contract has been drawn up to achieve a specified result
Power to delegate Employment relationships typically require the engaged party to perform the work themselves The ability of the engaged person to delegate or subcontract their work is a significant factor for consideration.
Commercial risk Employees have little to no formal responsibility to rectify poor work with their employer being held responsible. Contractors are typically be held responsible for their own work with an obligation to amend it should the results be substandard.
Provision of tools and equipment Employees perform their work using tools and supplies provided to them by their employer and are reimbursed for work related expenses. Contractors utilise their own tools and supplies and are responsible for their expenses.
Other indicia Employers have a right to suspend or dismiss. Employees are also entitled to additional benefits including annual, sick and long service leave. There are no additional benefits conferred on contractors beyond those specified in their contract.

Distinguishing between a contractor and an employee

Different obligations exist where an organisation engages a contractor, as compared to engaging an employee. Employment obligations, such as Employment Standards, Leave Provision, PAYG withholding, Superannuation, Payroll Tax under an employee contract are significantly more restrictive, and costly, as compared to those associated with a contractor.

PAYG withholding does not apply to payments made to genuine contractors - whereas PAYG withholding and reporting will apply to wages & salaries paid to employees. The provision of an ABN is not conclusive when deciding whether PAYG withholding is required, although PAYG is typically not required where a contractor is engaged through an entity such as a partnership, trust or company.

From a superannuation perspective employers are required to make superannuation contributions on behalf of their employees, as well as for individuals who work under a contract that is wholly or principally for the labour of the person. Whereas payments made to bona fide contractors are not subject to super contributions. A “contractor” who provides an ABN may still be caught under the superannuation provisions, although an individual who performs work through an entity (company or trust) will not be considered an employee for superannuation purposes.

With regard to payroll tax, most states across Australia recognise certain exemptions applicable to contractor payments. Therefore, the distinction between a contractor and an employee is essential so that employers do not incorrectly claim contractor exemptions for persons that are identified as employees under common law.

It may also be necessary to take out worker’s compensation insurance for individuals who are contractors.

What else to consider

The emerging ‘gig economy’ is further blurring the line between contractor and employee. As more companies use consultants, contractors or freelancers on a project basis, rather than hire full-time staff, they risk treating external service providers like employees. Many short-staffed companies are also relying heavily on contractors to fill the void, possibly treating them like employees. According to the 2018 Future of Work inquiry, almost a million self-employed Australians work on a freelance or project basis, rather than in permanent jobs. An examination of the factors to differentiate between employees and contractors is now more important than ever. Earlier this year food delivery company Foodora (Australia) faced allegations that it had engaged in sham contracting that resulted in the underpayment of workers who were classified as contractors instead of employees. The Fair Work Commission held that a Foodora driver who was unfairly dismissed, was an employee, not an independent contractor and entitled to compensation. The decision has wide-reaching consequences for Uber, Deliveroo and other businesses in the gig economy.

How BDO can help

This is a significant area of interest for the ATO, and errors can prove both costly and time-consuming to resolve for employers. Should you have any queries with regards to determining employee v contractor status, improving process efficiency or satisfying ATO compliance activities, please contact BDO’s Employment Taxes team to assist with navigating the complexity of this area.

Do you have the processes to identify contractors versus employees to satisfy statutory obligations?

Download our checklist to provide insight into your organisation’s understanding of contractor relationships.