Employee v contractor – tax problems if you get it wrong

21 June 2018

In follow up to our recent article titled Independent Contractors or Employees, while it’s one thing to know the difference between employees and independent contractors, an important issue to consider is the consequences for getting the classification wrong.

Chief among the problems for treating employees as if they are independent contractors is the significant negative tax consequences.

It should also be noted that the implications for getting this wrong are not limited only to the company through which the business may be operating – directors may be personally liable for the penalties arising (which is a significant risk difference compared with other business liabilities, including other taxes).

The two major tax problems that arise from treating employees as independent contractors are that withholding obligations most likely have not been met and the employer has not paid compulsory superannuation contributions on behalf of the employees (with associated lodgements).

Employers are under an obligation to withhold amounts from employee salary and wages under the Pay As You Go (PAYG) system. Such amounts need to be remitted to the Australian Taxation Office (ATO), usually at least quarterly (more regularly in some circumstances), and are normally done through the Business Activity Statement (BAS) process. Withholding needs to be done in accordance with the relevant schedule that the ATO releases every year.

In most cases where an employee has been treated as an independent contractor, these withholding obligations would not have been met. The amount of the penalty varies depending on the circumstances, but may be as much as the amount of the payment that was not withheld. Importantly, this may be imposed on the directors personally under the director penalty notice (DPN) regime.

Employers are required to pay 9.5% of the relevant remuneration for employees as compulsory superannuation contributions. Payments are due on a quarterly basis.

It should also be noted that some independent contractors are also entitled to compulsory superannuation contributions. This arises where the contractor is engaged for their personal labour. If the nature of the contract is unclear in this regard, advice should be sought before any arrangements are put in place.

Not paying these superannuation contributions for workers who are later found to be employees exposes the employer to penalties.

In relation to the superannuation owed itself, non-payment or under payment will result in the employer being liable to the superannuation guarantee charge (SGC). This is a penalty that is equivalent to the amount of compulsory superannuation that was not paid and is not deductible for income tax purposes. Interest is charged on the amount of superannuation not paid, currently at the rate of 10% per annum. There is also an administration fee of $20 per employee per quarter, regardless of the amount of under payment.

The superannuation guarantee is a self-assessment system, which means that the employer is required to recognise that they have not complied with their superannuation obligations and report this to the ATO. This includes undertaking the relevant calculations and remitting the appropriate SGC by the due date. Non-compliance with either the lodgement or payment requirements exposes the employer to further penalties.

In the case of the employer being a company, the directors may be made personally liable for the unpaid superannuation via the DPN regime.

The ATO has also stated that collection of SGC debts is a priority. While the ATO has a stated policy of working with employers to rectify any problems at first instance, where the ATO concludes that the employer is refusing to co-operate or is otherwise unresponsive to these efforts, it is prepared to use its powers to issue garnishee notices. This is where the ATO can order a third party, such as a bank, to direct monies the third party owes to the employer to the ATO instead as a means of recovering the debt.

Where the employer has not paid superannuation because they have mistakenly classified workers as independent contractors, it is also highly likely that the employer has not complied with the choice of fund rules. This is due to the employer not recognising that they would be required to do so.

Where a standard choice of fund form has not been provided within the required timeframe after the employee commenced, the employer is exposed to further penalties as part of the SGC regime.

These consequences are in addition to other non-tax related implications, such as underpayment of WorkCover premiums.

Therefore, if you believe that your business is engaging its workers as independent contractors, be sure to have your structures reviewed by an expert to make sure this is the case. The consequences of getting this wrong can be very expensive.