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Global HR Hot Topic – September 2007: Overseas Independent Contractor – or De Facto Foreign Employee?

September 2007
Global HR Hot Topic
Donald C. Dowling, Jr.


Challenge: Engaging an independent contractor overseas rather than hiring a foreign employee may seem to offer efficiencies and advantages — but can open Pandora's Box.


A human resources professional recently posted a query on an internet HR bulletin board: "Our company is looking to have independent contractors rather than employees work for us throughout Latin America. Are the laws in those countries just as strict as those in the US?" Short answer: No. They are much stricter — or, at least, compliance can be much more expensive.

Multinationals often feel tempted to engage overseas staff as independent contractors — abroad called "consultants," "freelancers," "entrepreneurs" or the "self-employed" — especially in countries where the company has little other presence and no locally incorporated subsidiary. Signing up someone abroad as an "independent contractor," rather than "employee," seems an easy shortcut around complications like local payroll, withholdings, mandatory benefits, employment law compliance and tax obligations. But there is one problem: Legal systems tend not to defer to parties' self characterizations as "independent contractor" and "principal." Whether a would-be contractor really is a genuinely independent business, as opposed to a de facto employee, rarely turns purely on the text of the parties' contract. Elevating substance over form, local laws look to whether the parties have an employment relationship in fact. For example, in Ministry of Defence v. Kettle [2007] EAT, a UK employment tribunal reaffirmed that English law requires looking beyond the four corners of a contractor agreement and accounting for realities of the actual job. In a few countries, such as under incoming 2007 laws in Spain and Peru, contractors who work for just one client are deemed employees, or (in Spain) special-status "economically dependent independent contractors."

What happens if an overseas contractor gets held a de facto employee?
If a US court or the IRS holds a purported US independent contractor was a de facto employee, liabilities of the principal/employer are mostly contained to six categories:

  • Back tax withholdings
  • Back social security contributions
  • Back unemployment/workers compensation insurance
  • Back overtime (for non-exempt positions)
  • Back benefits due under the terms of certain employer plans
  • Interest and penalties
       

Abroad, though, when an independent contractor gets mischaracterized, liabilities can run much higher, because outside the US there is no employment-at-will. Engaging an overseas independent contractor whom local law deems an employee subjects a multinational to liabilities on these same six grounds as in the US — plus on four potentially more expensive grounds:

  • Back vacation and back holidays
  • Back mandatory benefits like profit sharing, thirteenth-month pay, mandatory bonuses and payments to state housing funds and state-mandated personal unemployment funds
  • Severance pay, notice pay and liabilities for unfair dismissal
  • Fines (for example, Spain's law on Violations in Social Matters can impose fines up to €3006, plus 20 — 35 percent of unpaid taxes/withholdings, etc.)
       

These four extra grounds add up. In one admittedly exceptional case, a US multinational's former independent contractor, suing in a Latin American labor court, claimed to have been a de facto employee — and made out a claim for $40 million.


Pointer: Know when a would-be independent contractor is too likely to be held an "employee" under local foreign law. When necessary, hire as an employee.


How likely is a claim?
When engaging a single contractor in some foreign city, it is tempting to hope the arrangement will fly under the radar. And it may, for a while. Unfortunately, though, when a long-term relationship with a foreign independent contractor finally ends, the contract's termination provisions typically look meager in comparison to local employment severance pay and back benefits: A contractual provision for 30 or 60 days' notice motivates a "contractor" to run to local labor court, claiming to have been a de facto employee — notwithstanding the signature on the contractor agreement. And while foreign labor courts can be surprisingly sympathetic here, it does not take a disgruntled ex-contractor to raise the claim: Overseas tax and social security agencies specifically target "fraudulent independent contractors" in audits.

When is a contractor not a contractor?
The potential exposure and the likelihood of a challenge raise the threshold question: When can an overseas service provider legitimately be engaged as an independent contractor, and when should a foreign service provider be hired as an employee? Because local law almost invariably looks beyond the text of the contractor agreement and uses a "totality of the circumstances" test, the realities of the business relationship predominate, so the question becomes: What is the difference, under foreign law, between an independent contractor and an employee?

This question turns on local law in the place the service provider works. (Choice-of-foreign-law clauses in contractor agreements rarely control, because public policy of fundamental employee protection is at stake.) Every country's local law offers up some list of factors distinguishing contractors from employees. Even within one country, these contractor-versus-employee factor lists can differ; for example, the US IRS test has 20 factors, while American common law is usually said to include 13 factors. But speaking broadly, countries' lists of factors are surprisingly similar, from nation to nation. This is one of very few areas in international employment law where broad generalizations across jurisdictions can actually be useful. Most all countries uphold independent contractor status if the service provider can truthfully answer "yes" to five questions:

  • Do you have "authoritative control" to do your work the way you want to — free from instruction on process, free from discipline, free from work rules, free from your principal's "supervision and control"?
  • Are you free to set your own schedule and hours?
  • Do you provide your own office and supplies, pay your own business expenses, and hire your own assistants?
  • Do you get paid only for work done, such as hourly/task pay (no paid vacations/holidays)?
  • Can you, and do you, have other paying clients — and do you market your services to the public?
       

After making the overseas contractor-vs.-employee distinction, there are a number of refinements, special issues, tips and pitfalls which will be addressed in next month's Global HR Hot Topic.


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©2007 White & Case LLP