What Is Disguised Employment?

Key Takeaways

1. Disguised employment definition: Disguised employment is when a business labels a worker as a contractor for legal or tax purposes when the worker is actually an employee.

2. Disguised employment can also be known as ‘sham contracting’ ‘fake freelancing’ ‘forced entrepreneurship’ or ‘employee misclassification.’

3. Governments require workers to be classified in the correct way to ensure that tax is paid on time. Subsequently, if a company is found to knowingly or unknowingly have hired a disguised employee, they may suffer large penalties, damages, and have to re-pay taxes owed.

4. Factors that the authorities may consider when establishing the working relationship between a company and an individual may include: Whether the worker is subject to schedules that are laid out by the employer; the use of company equipment; having holiday entitlements, and the type of instructions that have been imposed by the company.

In short, “disguised employment” is when an individual worker is hired as a contractor or freelancer but is actually treated as an employee without receiving the usual benefits that an employee would receive from an employer.

An independent contractor or a freelancer is someone who provides a service(s) to multiple clients and is paid based on the particular service they provide. They may work in-house, or they may work as a remote contractor. By contrast, an employee is someone who is solely working for one employer in exchange for a fixed salary. In some circumstances, the line between employee and contractor can blur and this is where the issues of disguised employment can arise.

If a contractor provides services through their own company, they will usually be taxed differently to those who are directly employed by a company. In some cases, workers have tried to get around tax laws and have misclassified themselves as contractors rather than employees in order to receive tax advantages.

Whether or not a company is aware that they are hiring a disguised employee, if the relationship between a company and a contractor is more like an employer/ employee relationship, they could suffer serious consequences.

In employment law, there are generally clear boundaries between salaried employment, self-employment, and contractor businesses. There are some exceptions to this, where the laws of a country make it vague whether an individual is an employee or a contractor, such as in the recent change to labor laws in Vietnam

Ultimately, if a working relationship between a business and a contractor is incorrectly labeled, this can mean that the contractor has not been receiving employee benefits and that potentially, incorrect tax contributions have been calculated and considered. Not only will individuals not be benefiting from what they should be entitled to as employees by law, but the government will also be missing out on tax payments. This is why governments are trying to crack down on disguised employment.

Read more about the differences between employment and genuine contracting at  What Is the Difference Between Employees and Independent Contractors? 

What is disguised employment?

Disguised employment is when a business labels a worker as a contractor for legal or tax purposes, when the worker is actually an employee. Governments require workers to be classified in the correct way, otherwise this can result in huge tax revenue losses.

A business may or may not knowingly engage in disguised employment. The reasons that a company may hire someone as a contractor instead of an employee are mainly related to convenience and financial considerations. It is often easier to find a service provider than it is to go through a recruitment process, taking up time and resources. This risk occurs in hiring in all types of businesses whether hiring for an NGO, a startup, or a large enterprise.  

Employees are also entitled to certain monetary benefits such as pension or insurance contributions, sick pay, and holiday leave, which are extra expenses for the company. These entitlements must all be listed in the indvidual employee’s payslip or pay stub. Furthermore, if a company wants to terminate an employee’s employment, they need to go through a process approved by employment laws, whereas ending a contractor’s contract is often a lot easier. 

Court rulings have confirmed that the relationship between a business and an individual is not necessarily judged by the written contract that is in place, as this may not always reflect the reality of the situation or the intentions of the two parties. More specifically, the expectations and duties that are required of the contractor will be important in establishing the working relationship. Factors that may be considered when establishing the working relationship may include:

    1. Whether the worker is subject to schedules that are laid out by the employer;
    2. The use of company equipment;
    3. Having holiday entitlements, and;
    4. The nature of the instructions that have been imposed by the company.

Ultimately, the agreement between the two parties will be considered on a case-by-case basis.

The specific rules on disguised employment vary across jurisdictions around the world. In some countries it is known as ‘forced entrepreneurship,’ in the USA, it is usually called “employee misclassification”. In Australia, the deliberate misclassification of an employee is called “sham contracting”. Spain uses the term ‘fake freelancers’ or ‘Economically Dependent Self-Employed Workers’. Spain’s laws allows such contractors to fall into this category if they are providing 75% of their services to one company. They can then receive heavy penalties for misclassifying themselves.

What are the consequences for a company of disguised employment?

Overall, misclassification has high risks for businesses, and a failure to correctly classify workers can result in back taxes, penalties, or damages.

If someone is deemed to be a “disguised employee” depending on the country, different penalties may apply. According to UK labor law, if a company is identified as having “deemed employees” or disguised employees, they may have to pay back the taxes and National Insurance contributions that they owe based on the salary, along with additional penalties. 

What are the consequences for a freelancer/contractor of disguised employment?

In the UK, a tax law has been implemented around off-payroll working in an attempt to combat tax avoidance by contractors. The off-payroll working rules can apply where a contractor “provides their services through their own limited company or another type of intermediary to the client.” An “intermediary client” is considered as the worker’s own service company or partnership.

The rules are in place to ensure that workers, who would be classed as an employee if they were providing their services directly to a client, pay similar Income Tax and National Insurance contributions as employees would. These rules are sometimes known as Inland Revenue 35 or ‘IR35’. As of 6th April 2021, the UK government has placed the onus on employers to decide if the IR35 rules apply to their agreements and therefore whether a worker should be classified as a contractor or employee. However, if the contractor is providing services to a small business, the onus is put on the contractor themselves. If HMRC finds that someone is being treated as an employee, they may impose heavy fines and tax implications.

The reason why it is important to correctly establish whether a person is a contractor or an employee is because the individual’s employment status for tax is dependant on whether they are self-employed or employed.

According to a recent case (Platt v Future Cleaning Services Ltd), the judge had to identify the “true agreement” between a company and an individual. The company originally hired Platt as an employee, but before the contract had commenced, Platt asked to structure the agreement so that he was classified as a contractor and set up a Limited company especially.

In this case, it was stated that the agreement referred to “the legal obligations rather than the parties’ private intentions.” When determining whether the individual was an employee or not, it was found that the agreement was accepted by both parties with the intention of taking the relationship outside of the IR35 legislation. Other factors were found to demonstrate a more employee-type relationship such as entitlement to holidays, the work schedule, and the fact that the company was the contractor’s main client.

It was found that the arrangement was made to allow Platt to benefit from the financial and tax advantages of that status, but that the relationship was actually that of an employer/employee.

Conclusion

As mentioned, for businesses to avoid disguised employment, it may not be enough to simply provide a written independent contractor agreement to prove that an individual is a contractor or employee in a court ruling. It is therefore important to outline the exact specifications of the relationship including the working conditions, the work schedule, and compensation, along with other factors.

New Horizons is able to hire employees through PEO/umbrella companies to avoid disguised employment. If you would like to seek further assistance, please do not hesitate to contact us and we will be happy to help.

Frequently Asked Questions (FAQ)

It is against the law to incorrectly classify someone as a contractor or freelancer when in actual fact, they are being treated as an employee. Depending on the country, penalties may be imposed. It is therefore important to check the laws of a particular country before hiring a worker. Depending on the jurisdiction, the responsibility may fall on the company or the contractor, or both to establish the correct working relationship.

Employee misclassification is another way of saying disguised employment. It is more commonly known as misclassification in the USA.

Mis-classified employment is when a business labels a worker as a contractor for legal or tax purposes when the worker is actually an employee. A government requires workers to be classified in the correct way otherwise this can result in huge tax revenue losses.

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