What is an independent contractor?
An independent contractor (IC) is someone who is self-employed. ICs are sometimes called consultants, freelancers, self-employed and even entrepreneurs or business owners. Unlike an employee who works for one employer, ICs typically work for several different clients. They tackle specific jobs or projects that require special expertise.
ICs are subject to certain parameters in order to maintain the proper principal/contractor relationship. The general rule of thumb is that an individual is an IC if the paying principal entity has the right to control or direct only the result of the work – and not what will be done nor how it will be done.
In terms of taxes, there are often special requirements for both contractors and their clients. For example, clients in the United States (U.S.) are legally required to issue 1099-MISC forms to their contractors if they pay them over a certain amount. Subsequently, contractors must keep track of their earnings and include every payment received from clients in their reporting to tax authorities.
When should a company look to hire an independent contractor?
Companies turn to ICs when they require the specific services and knowledge of professionals offering the right mix of special expertise and availability. Typically, the work is paid for following the completion of a project. However, if a retainer is in place, a company pays the IC based on a set period of time. For example, a company may engage the IC as part of a monthly retainer.
What are the risks associated with hiring an independent contractor?
Each country has its own employment regulations around ICs so capabilities, applications and limitations vary across markets. If talent is found to be misclassified as an independent contractor rather than an employee, companies risk misclassification fines, intellectual property theft and compliance audits
The regulations surrounding ICs can evolve over time so any company engaging a contractor should stay current and ensure they are maintaining the principal/contractor status. For example, the rules for engaging ICs in the United Kingdom (U.K.) changed in 2021 after updated guidance was added to IR35, the anti-avoidance tax legislation.
What parameters define an independent contractor?
The definition of an independent contractor varies across jurisdictions but common parameters include:
- The IC assumes risks for profits or losses.
- Payments to IC are made through accounts payable, under a separate account from payroll.
- The nature of the commercial relationship is temporary.
- The IC’s services are not an essential part of the business.
- The IC invests in the materials and/or equipment required to complete their work.
- The IC maintains control over how the work gets completed.
- The IC’s business can succeed outside of a single client relationship.
Refer to our table below for a summary of key differences between an employee and independent contractor:
Should I have independent contractors sign contracts?
Companies should have independent contractors sign a contract. Regardless of how minor the project at hand is, a contract will avoid any potential disputes between the contractor and the principal company. Importantly, a contract will ensure both parties are on the same page, clarifying the relationship between the contractor and the principal company.
However, even with a contract in place, both parties must adhere to the clauses in the contract in their actions. This adherence will protect the principal company should labor regulators question the nature of the relationship.
Is a contract sufficient in protecting my company from risk of reclassification?
A written contract will not always fully protect a principal company against issues that arise out of a principal/contractor relationship. Notably, labor regulators will give more weight to the actions surrounding the relationship over a written contract. The actions must support the principal/contractor relationship as outlined in the contract. Namely, these actions must demonstrate that a contractor is indeed autonomous – and that the principal company does not control how and when the work is done.
What if I have improperly classified a worker as an independent contractor?
If a company believes it has improperly classified workers, voluntary disclosure may be a solution to correct past errors and minimize penalties. To compliantly complete a voluntary disclosure, companies should consult with a local expert who fully knows the labor laws of the jurisdiction.
What are the top requirements for maintaining a principal/contractor status?
The following can help companies maintain a principal/contractor status with ICs:
- Avoid an exclusive relationship. Specifically, an IC should have multiple clients other than your company.
- The IC should not perform a key activity of your business.
- An IC should not have a fixed work schedule.
- The IC should not receive job training or supervision from the company.
- Do not require regular reporting on tasks or metrics for the work performed by the IC.
- Do not provide supplies or tools to the IC.
- Pay the IC agreed-upon payments but do not provide benefits that can be construed as employee benefits.
- Do not reimburse any incurred costs, unless stipulated in the IC contract and allowed by law.
How are independent contractors paid?
ICs should be paid through accounts payable and payments should be based on invoices sent to the principal company by the IC. Companies hiring ICs should allocate an account for this expense, separate and apart from the payroll account that compensates employees. This way, the total cost paid out to the contractor can be accurately tracked and reported. This also helps to maintain the necessary principal/contractor status.
What taxes are the company responsible for?
The company should not withhold any of the IC’s taxes but should still send a copy of total earnings at the end of the tax year to the contractor. Requirements for this reporting and documentation vary across jurisdictions. Essentially, the IC is responsible for making their own tax payments.
It is recommended to specify in the contractor agreement the IC’s duty to comply with local tax requirements. It is also a standard practice for some companies to request a proof of tax compliance from their contractors.
What benefits can I provide to independent contractors?
If your company hires the services of an IC, you are usually not legally allowed to provide them with any benefits such as healthcare, paid time off, sick leave, paid maternity leave, etc. In jurisdictions where this is the case, providing such benefits will constitute an employer-employee relationship. This will effectively invalidate the principal/contractor status. The IC will then be deemed misclassified, which could trigger legal challenges and generate tax liabilities for the principal.
On the flipside, it should be noted that some jurisdictions do require principal companies to offer benefits to contractors. Notable examples of these include Spain and France, where the principal company is required to provide the contractor with benefits under certain conditions.
What is the cost and impact of recharacterization/reclassification?
The impact of recharacterization/reclassification is potentially expensive expensive and could include:
- Tax and insurance payments (both current and arrears)
- Social security, pension and retirement plan contributions (current and arrears)
- Labor relations fines and penalties
- Civil or even criminal fines, including jail time
Is there a single rule or test to determine the status an independent contractor relationship?
There is usually no single test to determine a principal/contractor relationship. Instead, a range of markers will be used and the factors are examined in relation to the others. Some of these factors include degree of business integration, level of instruction, sequence of work and right of termination.
Each jurisdiction operates on different criteria but the goal is generally to establish how much control the company has over the IC. In the U.S., for example, three categories (known as Common Law Rules) are considered in qualifying principal/contractor status.
If my company hires an independent contractor internationally, does it protect my company from the regulations of permanent establishment?
A permanent establishment (PE) is a fixed place of business, generally giving rise to income or value-added tax liability within a particular jurisdiction. The term is defined in many income tax treaties and trade agreements between countries. For example, the European Union maintains specific rules of PE to determine taxation in situations of cross-border employment.
Significantly, when a foreign company engages a local contractor, there is a risk that the local government will consider the company operational in the country. Notably, depending on the jurisdiction, PE can be triggered by signing any form of a contract within the country. This can hold true even if the contract duration is short and temporary.
If a company incidentally establishes PE through a contractor relationship, they are exposed to added tax liabilities and potential legal implications.
If I hire an independent contractor and require him/her to travel, who handles the travel and immigration matters?
ICs are responsible for handling their own travel and immigration matters, including the required costs and paperwork. Where there are company resources involved or reimbursements are made to the contractor, the principal company runs the risk of misclassification.
What happens if an independent contractor works only for my company?
In many countries a contractor who works full-time exclusively for one principal is considered a de facto employee. Moreover, it is important to bear in mind that a long-term relationship between a principal and a contractor also can help to define an employment relationship. If a relationship is ongoing and full-time, the principal/contractor status might be nullified. Then the IC would be recharacterized/reclassified as an employee, subjecting the principal company to additional liabilities.
Can I have an independent contractor sign a non-compete or non-solicitation agreement?
Apart from the main contract establishing the principal/contractor status, activating other contracts with an IC can be delicate. In some countries, an IC who a signs a non-compete or non-solicitation agreement can, by default, be reclassified/recharacterized as an employee. This happens because such agreements are evidence of the employer’s control after termination. For this reason, principal companies should seek consultation prior to signing any additional contracts with a contractor.
What are my alternatives to hiring independent contractors?
GoGlobal’s EOR services provide an alternative option for hiring ICs compliantly and efficiently. We can support your company in engaging talent in a new country, without having to set up a local entity or risk violating local employment regulations. This saves your company from the added costs of PE and complications of misclassification.
Furthermore, each case of employee or independent contractor recharacterization/reclassification requires a careful assessment prior to acting. GoGlobal can help make quick and accurate determinations of the most suitable employment conditions for any circumstance. With our deep understanding of relevant local regulations and practices, we can ensure your company is safely navigating any regulatory environment.
Country Specific IC Regulations
Notably, the U.S. Supreme Court has stated there is no single definition or test that solves all challenges in determining an employer-employee relationship under the country’s Fair Labor Standards Act (FLSA). Hence, an individual can be considered an employee under state law even if they are not considered employees under federal law.
To that end, several states have more strict definitions for ICs than what is prescribed by the IRS. Furthermore, there have been several landmark changes in state laws regarding ICs in recent years. For example, in 2021 alone, five states updated how they define ICs. In this environment, companies engaging ICs in the U.S. are highly advised to seek consultation to ensure they are maintaining a lawful principal/contractor status.
France applies a designation called the ‘portage salarial’ for self-employed freelancers who operate autonomously. This designation is based on a three-way relationship between the worker (called a ‘salarié porté’), a specialised ‘entreprise de portage’ (the worker’s company) and the company that wants to benefit from the work (called the ‘entreprise cliente’).
Notably, when the arrangement is implemented correctly, the salarié benefits from full social security protection as if they were an employee. This includes paid holidays, unemployment and incapacity benefits, as well as professional third-party liability insurance. Principal companies should take note of this exception, as France is one of the few countries that allows and mandates principal companies to provide ICs with certain benefits.
Spain makes a special designation for dependent self-employed workers, who are called ‘trabajadores autónomoseconómicamente dependientes.’ Companies should take note of this designation because it may change how they interact with a contractor, namely when it comes to providing benefits.
To be considered a dependent self-employed worker in Spain, the contractor must be economically dependent on one client. This means that more than 75% of their income comes from the principal company. This designation also entails not having any employees and not subcontracting any of the work out to another individual.
Some of the benefits a principal company must provide to a dependent self-employed workers are 18 rest days per year (paid or unpaid, depending on the contract), parental leave benefits and additional compensation if the client breaches conditions of the contract.
In India, there are some cases where the engagement of contractors is prohibited by the country’s employment laws. For this reason, employers must obtain a special ‘principal employer’ license to engage contractors.
The Indian courts prescribe two tests for determining whether an individual is an employee or an IC. The control test primarily aims to discover if the employment relationship between the principal company and the individual is a ‘master-servant’ relationship. Namely, it identifies if the employer controls the nature of the work at hand and whether or not they determine how the employee performs their duties. Additionally, the integration test serves to identify if the worker is fully integrated and cared for by the principal company. Essentially, in the end, this test determines whether or not a worker enjoys the necessary absolute independence to be considered a contractor.
ICs in India pay their own taxes and usually withhold value added taxes (VAT), remitting the same on behalf of the principal company that engages them.
Next Steps: How can my company avoid contractor misclassification?
The misclassification of contractors can present global businesses with enormous damage in terms of added tax liability, fines, legal troubles and reputation. In some markets, misclassification can even restrict a company’s right to operate. At GoGlobal, we work with clients to ensure proper classification compliance across the entire workforce – from current team members to new hires.
For more information or advice on determining the status of a team member in a specific country, please contact the GoGlobal experts.