Are You Unwittingly Contributing to Disguised Employment?

Erez Greenberg November 29, 2021
Globe and magnifying glass

Hiring abroad is full of pitfalls to watch out for, and disguised employment is one of the largest. If you opt for a contractor arrangement in a new location to ‘make things easier’ and to get workers on the ground quickly, you might find yourself falling foul of compliance and legal regulations, and putting your worker at risk, too. Here’s what you should be aware of.

Disguised Employment – the Basics

Disguised employment is not to be confused with disguised unemployment, which is traditionally a term used to describe overstaffing; basically any workers who are underproductive in their roles, or who are working in part-time or low-impact roles despite not being officially marked as unemployed.

In contrast, disguised employment is another way of talking about the misclassification of workers, where contractors or freelancers are hired to fill a role, but treated much like employees in the way in which they complete their work.

Occasionally known as forced entrepreneurship, companies often take on employees under the guise of contracting, either to save costs in tax or employee contributions, or to speed up the process of onboarding new employees, especially in a new location. Whether on purpose or in error, if your contractor’s status is judged to be more like that of an employee, both you and your workers can be in serious trouble.

Working Out if You’re Guilty of Disguised Employment

We all know the old adage, if it walks like a duck and quacks like a duck – it’s a duck!  But in the absence of feathers, what are the identifiers of a contractor exactly? Here are some of the main questions to ask yourself about your worker, which can help you to figure it out.

Behavior: Do they make decisions on when and where they complete their tasks, and how much they get paid?

Exclusivity: Do they have the freedom to work for other clients?

Notice: Can the worker leave without notice, and does the business consider the arrangement to be ad-hoc, rather than fixed/permanent?

Benefits: Is the worker exempt from employee benefits, including anything from equipment to sick pay, and vacation days?

You want to confidently answer yes to all of these questions. If any of these are a no, you could be contributing to disguised employment in your business.

Why does Disguised Employment Matter?

In many countries, governments are attempting to crack down on disguised employment to support workers who are being given a raw deal. After all, if your workers are being treated like an employee, and they don’t have the freedoms and control of one who is self-employed, they should get the benefits of employment too!

Whether maliciously or otherwise, companies should be paying their employees all the necessary social benefits such as a pension, insurance, minimum wage, overtime pay, and more – and disguised employment can allow these important rights to fall through the cracks.

Disguised Employment Around the World

Different countries will have varying penalties and laws around disguised employment, but an increasing number of governments are looking to legislate against this challenge.

Penalties for Misclassification in the US

In the US, the responsibility falls on the employer to make sure that disguised employment or misclassification does not occur. If the IRS judges there to be an employer-employee relationship, then the employer will need to pay at least $50 in fines for every Form W-2 that was not filed, 3% of their total wages, up to 40% of the FICA taxes which should have been withheld from the employee’s pay checks, and 100% of the matching FICA taxes that the business was responsible for paying.

This is a best-case scenario, if your disguised employment was found to be in error. If the IRS suspects that you misclassified intentionally to save costs or to get started quickly in a new location, the penalties will be even higher.

In addition, certain states in the US are implementing laws which allow them to push “stop work orders” that immediately force businesses to cease their work on sites where misclassification has been identified. New Jersey in particular has put an aggressive legislative package into place.

Australia’s Sham Contracting Laws

In Australia, disguised employment is known as sham contracting, and is defined as employers knowingly or even coercively asking an employee to work as an independent contractor. This is an illegal practice even if some elements of the relationship are the same as in a genuine freelancer relationship, for example if these disguised employees are invoicing and being paid like a contractor.

If a company is found to be guilty of sham contracting, corporations can be fined as much as $66,600 for every misclassified worker. See our Australian payroll guide for more info.

The United Kingdom’s IR35 regulations for Deemed Employees

While the responsibility used to be on the employee to classify themselves correctly, the UK has been working on new regulations that put the responsibility on the employer, especially for agency or intermediary work. IR35 is aimed at independent contractors who perform their work through a ‘middleman’, either their own business, or via an agency.

Any companies working in the public sector, plus medium and large-sized private sector businesses need to provide a status determination document that explains how they have decided that their workers should be classified as independent contractors. If businesses are found to have “deemed employees” (similar to disguised employment), they will have to pay back all the taxes and contributions, plus a penalty of up to 100%. The less care the business appears to have taken in classification – the higher the fine will be. See our U.K payroll guide for more information

Fake Freelancers in Spain

Interestingly, in Spain, the government has a specific category that independent contractors can use if they find themselves as disguised employees – known as Economically Dependent Self-Employed Workers, or more colloquially – fake freelancers.

They can opt to fall under this category if they receive 75% or more of their income from one client, and this will allow them to demand certain rights, such as unemployment benefits, maternity leave, and even 18 days of vacation, although this is unpaid.

This may be beneficial to contractors if they would like to work up to 25% with other clients, but are worried about putting all their ‘huevos’ in one basket.

However, if your employees do not sign this contract, and you’re found to be misclassifying them as disguised employees, the penalties can be up to 10,000 Euros per employee, plus a potential criminal offence. See our Spain payroll guide for more info.

Germany’s Re-characterization Laws

German authorities are known for wanting to address the issue of disguised employees, and employees themselves are encouraged and supported in alerting the government to any potential misclassification. If this is found, these contractors need to be re-characterized as employees, which comes with heavy penalties for the employer.

Not only does the business need to pay the outstanding social security with 12% interest, for anywhere from 4-30 years depending on whether the misclassification was intentional, but they will also need to pay fines of at least 1% per month. In some cases, employers are subject to criminal proceedings, including imprisonment or heavy financial penalties. See our German payroll guide for more info.

Avoiding Disguised Employment when Expanding Globally

With the varying regulations and complexities of disguised employment around the world, companies need a truly superhuman knowledge of global employment law, compliance mandates, and ever-changing regulations to hire in new locations. Taking on contractors instead of hiring full-time employees moves from being a “quick win” to being a “huge risk.”

To meet this challenge, many companies have started leveraging innovative employment methods to help them hit the ground running in a new location without setting up an entity, one of which is Employer of Record solutions.

When you utilize an Employer of Record (EoR), you can skip a lot of the initial hurdles of hiring full-time employees in a new country, for example registering your business, getting the requisite permits, or opening bank accounts and establishing a local presence. Instead, you hire new employees via a local in-country partner, who take on the legalities of hiring on your behalf. On paper, your employees work for the Employer of Record, but in practice, you manage their day to day tasks, pay their salary, and dictate their benefits and package.

If you work with a global payments and payroll provider like Papaya Global, this is an easy option when you’re expanding into a new location. At Papaya, we already have established relationships with local partners in 160+ locations around the world, so you can start hiring full-time employees as fast as you could onboard a new contractor, wherever you’re looking to do business.

After this quick win, in the background you can validate the potential of this new location, and start the process of setting up an entity when the time is right, ensuring full business continuity without any gaps.

Papaya Global is the only provider that offers a global payroll and payments solution for all the potential kinds of workers, including contractors, EoR workers and part and full-time employees. We also have a unique Center of Excellence model where we bring together expertise on global employment, compliance, taxation, and other specific legal regulations all over the world. As a result, we are well-placed to advise you on misclassification risk, and provide quick and simple solutions to alleviate disguised employment when it occurs.

Ready to discuss your unique business context for global expansion? Let’s set up a call.

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