The undercover employee

The Tax Office’s ongoing compliance efforts have some constant focus. One of these is the often flawed characterisation by businesses of an employee as a contractor.

The mischief from the Tax Office’s point of view is the avoidance of employer obligations relating to the Superannuation Guarantee (SG) and Pay As You Go (PAYG) withholding.

Characterisation is fraught with elements of complexity.  This is because of the differing definitions for tax and for superannuation purposes and the consequences which may follow if an incorrect classification is made.

For instance, entitlement to annual leave, sick leave and other benefits may arise. An employer’s liability to work cover and payroll tax in various states are also driven by this characterisation.

Notwithstanding these other issues, the actual employee/contractor characterisation relevant to PAYG and superannuation obligations are essential issues every business needs to be familiar with.

One staff member, two possibilities

The ordinary meaning of the word “employee” has been refined through a body of case law.

The distinction between an employee and a contractor can be encapsulated by the nature of the relationship these parties have to the organisation engaging them.  Such a relationship may be categorized in one of two ways:

Employer/Employee: The first category is that an employment relationship is described as a “master and servant” type relationship where the parties enter into a contract of services. In other words, the employee serves the employer.

Principal/Contractor: The second category is that a contracting relationship and is a contract for service, which basically means that two businesses enter into a contractual arrangement to achieve a given result.

The activities of the relevant entity providing the services should first be analysed to determine whether they are an “employee” at general law. The factors that indicate whether there is an “employer/employee” or “principal/contractor” relationship are summarised in the table below.

Characterising-an-employee

It is important to note that no single factor described in the table will be conclusive in determining whether the entity is an employee or contractor at general law. This determination is made by examining the whole working arrangement including the contractual relationship between the parties and the specific terms and conditions under which the work is performed.

In addition to the general law meaning of employee, the obligation to pay SG is extended to contractors where the contract is either entirely for the labour of a person or this is the main reason for the contract. Thus the terms of a contract, as well as all the facts surrounding a particular relationship, are important in establishing whether there is an SG obligation.

Look at the arrangement: Substance over form!

It is necessary to consider the formal contractual arrangement in light of each party’s actions and the substance of the relationship between the parties.

A business taxpayer cannot simply require that services providers with whom they contract have an Australian business number (ABN). The test is more stringent than that.

Further, a business taxpayer is likely to have PAYG and SG obligations in situations where payments for services provided are made to the individual who did the work instead of the business entity which is the counterparty to the formal contract. This individual is typically an employee of the business entity.  To illustrate this point refer to the figure below.

PAYGW-SG-liability

The liability for SG and PAYG withholding in the illustrated case would be with “Business entity B” but for PAYG withholding purposes, because “Business entity A” is making the physical payment to the individual, it is the one liable.

PAYG withholding and SG represent significant costs of doing business in Australia.  The importance of how a working relationship is characterised should not be ignored.