A human resources professional posted a query on an InternetHR bulletin board that asked: “Our company is looking to have independent contractors rather than employees work for us throughout Latin America. I wanted to know if the laws in those countries are just as strict as in the U.S.”
The short answer is simple: No, they are even stricter. Fixing independent contractor classification problems can be substantially more expensive outside the U.S. since working outside an employment-at-will environment can lead to extra areas of potential exposure.
Multinationals often take their first steps into a new overseas market not by hiring an in-country employee but by engaging a local representative nominally as an independent contractor — a consultant, freelancer or entrepreneur.
The contractor approach offers an enticing shortcut around expensive local payroll obligations, benefits mandates, employment laws, corporate registration rules and tax requirements. It’s especially attractive where a multinational still has no local subsidiary or other corporate presence, and where local bureaucracy is slow.
Yet the independent contractor alternative to traditional employment is dangerous. The risk is real, not theoretical. Independent contractor status is fragile, with nominal “contractor” designations constantly getting attacked in foreign courts and agencies.
Meanwhile, multinationals keep engaging nominal independent contractors even when the actual relationships appear like employment.
The international classification conundrum of genuine independent contractors versus misclassified de facto employees can be examined through six areas of discussion.
- The Four Corners of The Contract
An independent contractor by definition is party to a contract with a principal. There is a persistent myth of the “killer app” contractor agreement — the perfectly drafted form containing all a local jurisdiction’s legally blessed boilerplate provisions, all its bells and whistles and all the right magic words that shield the parties’ designation as an independent contractor.
But few, if any, legal systems defer to parties’ own classification as contractor and principal. Laws most everywhere elevate substance over form to scrutinize the parties’ actual relationship. This reduces the contractor agreement document to a mere starting point in the classification analysis.
The 2007 British employment tribunal decision Ministry of Defence Dental Services v. Kettle reaffirms the near-universal rule that these cases require looking “outside the four corners” of the parties’ agreement.
Of course, where the text of a poorly-drafted contractor agreement betrays a misclassification, then a nominal contractor should be regarded as a de facto employee. But where the contract makes the parties’ independent contractor relationship seem airtight, the analysis merely shifts to the facts of the parties’ actual relationship.
Even so, there are a few classification issues that affect the drafting of an overseas independent contractor agreement:
▪ Special jurisdictions: Courts most everywhere look beyond the four corners of an agreement to assess the legitimacy of contractor status, but a handful of countries give substantial weight to certain special provisions, which become vital. For example, in India an independent contractor agreement should say the contractor has a “permanent tax account number” and withholds and pays his own taxes.
In Israel, an independent contractor agreement should note that the contractor has registered as a self-employed “consultant” and in Russia the agreement should say the contractor has registered as an “individual entrepreneur.
An independent contractor agreement in Turkey should expressly invoke the Turkish Code of Obligations and in Indonesia, the Indonesian Civil Code, rather than those countries’ labor codes.
▪ Contractual backstops: While not strictly related to classification, there are some backstops that, when included in a contractor agreement, might act as a disincentive to a contractor later claiming to have worked as a de facto employee. Consider indemnities, set-asides, hold-harmless provisions and remedies that kick in if a contractor is ever held to be the principal’s employee.
In Israel, include an apportionment clause to recalculate paid contractor fees (after any misclassification determination) as salary and benefits. Check local-law enforceability and consider collectability.
▪ Business-to-business contracts: Whenever a contractor can do business through a corporate entity, the principal gets an extra layer of protection by contracting only with that corporation. This business-to-business independent contractor structure offers other advantages.
For example, in the Netherlands it should be possible to terminate a contract with a corporation without having to seek permission. The Dutch Labor Relations Decree of 1945 requires permission from a court or the Dutch Centre for Work and Income to terminate an employee, including a misclassified individual contractor.
- When a Nominal Contractor Gets Held a de facto Employee
If a U.S. court or the United States Internal Revenue Service determines a misclassified American contractor had worked as a de facto employee, liability should be confined to six categories: back tax withholdings, back Social
Security contributions, back state unemployment/workers compensation insurance, back overtime (for non-exempt positions), back benefits due under the terms of certain employer plans and interest and penalties.
Abroad, outside employment-at-will, a misclassified contractor triggers additional liabilities — the same six grounds as in the U.S. plus four other, potentially more expensive grounds: back vacation and back holidays; back mandatory benefits (profit sharing, 13th-month pay, mandatory bonus, payments to state housing funds and state-mandated unemployment funds); severance pay, notice pay and liability for unfair dismissal; and fines (for example, Spain’s Law on Violations and Sanctions on Social Matters imposes fines in this context plus a percentage of unpaid withholdings and a penalty for “very severe” violations).
In one exceptional case, a U.S. multinational’s former independent contractor sued in a Latin American labor court, claiming to have been a de facto employee and demanding US$40 million. Countless labor court judgments from even Third World countries award misclassified contractors hundreds of thousands, sometimes millions of dollars.
- How Likely is a Claim?
When engaging an independent contractor abroad, many a multinational crosses its fingers and hopes the relationship flies under the radar. And it may, for a while. But when the relationship inevitably ends, the contractor agreement’s termination provision looks stingy in comparison with what a wrongly fired local employee wins under local employment law: pre-termination notice, severance pay, wrongful dismissal damages, accrued benefits including holidays, vacation and overtime.
If the independent contractor agreement offers a typical 30 or 60 days’ pre-termination notice, any nominal contractor would feel tempted to turn to a local labor court and demand a fired employee’s full entitlement. Foreign labor courts prove surprisingly sympathetic.
Because the text of the independent contractor agreement does not determine classification, the obvious defense — the claimant’s signature on his own agreement concedes contractor status — usually goes nowhere. Nor does it take a disgruntled ex-contractor to raise a misclassification claim. Tax and Social Security agencies worldwide increasingly target contractor classification in their audits, exploiting better technology to make audits more frequent and thorough. And whistleblowers expose misclassifications to authorities.
- When is a Contractor Not a Contractor?
The very real likelihood of exposure emphasizes the importance of the threshold question: When can a multinational legitimately engage an overseas services provider as an independent contractor, and when is it necessary to hire as an employee or leased employee/secondee? (That is, have a local company hire the employee on its payroll and contract with the company for that employee’s services.)
In other words, what is the difference under applicable foreign law between a genuine independent contractor and a de facto employee? The answer turns on local law where the service provider works. (Clauses in independent contractor agreements regarding choice of foreign law rarely divest the mandatory application of local employment laws, because of the public policy of protecting fundamental employee rights).
Most every country’s local law offers some list of factors to distinguish genuine contractors from de facto employees. Even within a single country, contractor versus employee factor lists can differ.
For example, the U.S. Internal Revenue Service test has 20 factors (IRS Revenue Ruling 87-41), while American common law is usually said to include 13 factors. Speaking broadly, though, lists of contractor versus employee factors from country to country end up looking surprisingly similar.
In fact, contractor classification happens to be one of the very few points of employment law where useful generalizations across jurisdictions can be made (see sidebar on page 42).
For a reality check in assessing whether an overseas services provider might be legitimately engaged as an independent contractor, just ask if structuring this position as an independent contractor is such a great idea, then why not engage U.S. counterparts as independent contractors, too? If the answer is that this would never fly with U.S. authorities, then it probably won’t fly abroad.
- Action Steps to Insulate Contractor Classification
It is easy to engage a one-off overseas independent contractor for a discrete task — for example, no one ever questions the legitimacy of a short-term, part-time independent contractor with many other clients. Problems arise in the grey areas. Where a multinational signs up a long-term foreign sales agent to work full-time and exclusively, classification is a huge issue.
To avoid misclassification, consider three vital, if difficult, action steps:
▪ Consider hiring as an employee or leased employee/secondee. Doing so could cause administrative headaches, but it will hurt less than the pain a nominal foreign contractor inflicts after being deemed a de facto employee.
Where the principal is not registered in-country and cannot issue payroll, consider engaging the services provider as a leased employee/secondee, where some other local business (affiliate, business partner, manpower/staffing agency) hires the person as an employee onto its local payroll and contracts with the principal to provide his services.
This approach does not resolve permanent establishment problems and it raises the issue of dual/co-/joint employment. But the leased employee/ secondee structure completely eliminates the threat of a de facto employee determination because it classifies the services provider, from the beginning, as an employee.
▪ Draft an agreement that establishes real independence. Although the text of the independent contractor agreement by itself will not immunize the parties’ contractor classification, the agreement should lay the groundwork for real independence.
In drafting the contract, loosen the reins. Avoid the temptation to have it both ways, controlling the contractor like a subordinate servant. Reject non-compete clauses, bonus pay provisions, paid vacation, scheduled work hours and any term that smells like employment. Include provisions that grant the contractor freedom to structure tasks.
▪ Structure the day-to-day work relationship to establish real independence. In daily practice, respect the contractor’s structural independence as spelled out in the contract. Keep the contractor off organization charts. Let him compete. Refuse to provide a title, an office and company business cards. Do not schedule hours and do not invite the contractor to training sessions or office parties.
- Strategy
Engaging an independent contractor overseas rather than hiring as an employee may seem, on the front end, to offer attractive advantages. But these arrangements may ultimately open Pandora’s box. Challenges are frequent and liabilities run high.
Where a multinational principal is not registered to do business in an overseas jurisdiction, the issues extend beyond employment law and trigger corporate and tax problems.
Know when a nominal independent contractor threatens classification as a subordinated de facto employee under local foreign law. When necessary, hire up-front as an employee or as a leased employee/secondee on someone else’s payroll, or at least engage as a business-to-business contractor, contracting with the contractor’s own company. Otherwise, take action steps before engaging any overseas independent contractor.
This article first appeared in Financial Executive magazine.