Classifying workers as employees or contractors

It is important for a business that engages workers to correctly determine which kind of arrangement it has entered into which is known as ‘worker classification’, as the tax obligations for an employee and independent contractor can vary greatly.

The Australian Taxation Office (ATO) has released Taxation Ruling TR 2023/4 and Practical Compliance Guideline PCG 2023/2 on 6 December 2023 to provide an updated guidance for determining a contractor’s status as an "employee" in the context of PAYG withholding and the ATO’s compliance approach in making distinctions between employees and independent contractors. 

These products replace the previous ATO guidance that were released in December 2022 (TR 2022/D3 and PCG 2022/D5) following extensive consultation with industry and professional bodies, however, they remain fairly consistent with the previous draft rulings (with a few exceptions).

Once again, the High Court decisions in relation to the CFMMEU v Personnel Contracting and ZG v Jamsek cases have altered the approach of determining whether a worker should be considered an employee or a contractor. In light of this, the ruling states that to determine a worker’s classification “an examination of the totality of the relationship must be undertaken by reference solely to the legal rights and obligations which constitute that relationship.This examination of the established contractual relationship is undertaken through the focusing question of whether the worker is working in the business of the engaging entity.” 

Additionally, the TR 2023/4 clearly maintains that the old 'multifactorial test' is no longer necessary nor appropriate for this process, as tested in the two High Court decisions previously mentioned.  

Identifying the 'totality of the relationship' between a worker and engaging entity

It is understood that the assessment of the contractual relationship's nature relies solely on the terms of the contract, whether explicitly stated or implied. Some key points that can be taken away from the Taxation Ruling TR 2023/4 are as follows:

• The initial stage is to identify the contract between the parties to determine whether an employment relationship exists. Employment contacts may take the form of wholly in writing, wholly oral or a combination of both and terms implied from conduct. 
• The contract of employment must be construed in accordance with the established principles of contractual interpretation.
• Step two involves identifying the terms of the contract. This refers to the legal right and obligations between the parties, whether written, verbal or a combination of both.
• The ATO also notes that where a contract is wholly written, it is essential to establish whether the contract serves as a comprehensive representation of all the agreed-upon terms between the parties, or if there are additional oral and implied terms that form part of the contract.  Where the worker and the engaging entity have comprehensively committed to the terms of their relationship via a written agreement which has not been challenged as a sham, nor the terms otherwise varied, waived or discharged, the legal rights and obligations in the contract alone are relevant to determine whether the arrangement constitutes an employment relationship.
• Merely labelling the worker as a contractor is not enough to satisfy the relationship is not one of an employee and employer.  The legal rights and obligations which constitute the relationship are relevant, and labels inconsistent with these have no meaning.
• In circumstances where a written contract is not comprehensively committed to writing, evidence of how the contract was performed must be considered to the extent that such evidence identifies the contractual terms agreed between the parties.
• A useful approach to determine an employment relationship is to assess whether the worker is working in the business of the engaging entity as stipulated in the contract. 
• The ATO have stated the various indicia of employment as identified in case law around control, specified result, risk, delegation etc. remain relevant but are to be considered only in respect of the obligations and legal rights between the parties.  We explore these below:
  • A key indicator may be the control and the contractual right to control the employer or engaging party retain over the worker.  Upon reflection of the final ruling, it appears the ATO have placed greater reliance on an entity’s ability to control or the right to exercise control over how, when and where the worker personally performs the work under the contract.  The higher the control, the view is this is likely to demonstrate the worker being an employee.
  • The ruling states the existence of an entirely unrestricted right for a worker to delegate, subcontract, or assign their tasks to others, barring any conflicting factors, gives an indication that the worker is not an employee of the engaging entity. The ATO have shifted their view from the draft ruling on this stating the workers ability to delegate, subcontract or assign work is generally to be viewed as inherently inconsistent with an employee relationship.
• The 'label' that parties use to depict their relationship in contracts does not hold significance in determining or characterising the relationship correctly.
• In situations where assets, equipment and tools are provided by a worker might suggest that the worker is an independent contractor. However, a worker using their own tools does not inherently conflict with an employment relationship; the nature, scale, and cost of the tools and equipment must be considered.
• Where a worker and engaging entity enters into a contract to achieve specific results and the worker’s remuneration is a fixed amount for achieving a specific outcome, there is a strong indicator of an independent contractor relationship. 

The definition of “employee” and “employer” for the purposes of the Superannuation Guarantee (Administration) Act 1992 (SGAA) continue to have both their ordinary meaning and extended meaning.  Consideration of the ordinary meaning of employee in the ruling should be given to ascertaining whether there is also a superannuation obligation for the worker. 

The ATO’s approach to investigations and audits under PCG 2023/2

The ATO has provided an updated risk assessment framework for worker classification arrangements. The risk assessment framework is made of seven criteria between very low, low, medium, and high-risk zones based on the actions taken by the parties when entering into the arrangements.  This would provide guidance to parties who would like to understand the likelihood of the ATO applying compliance resources to review their arrangement.  The seven criteria are as follows:

1. Evidence both parties intended for the worker to be classified in the same way;
2. Existence of a comprehensive written agreement;
3. Evidence the parties understood the tax and superannuation consequences of the treatment;
4. No significant deviation from the written terms of the contract (i.e. parties operating in the manner stipulated);
5. Tax, superannuation and reporting obligations being met;
6. The engaging entity obtaining specific written advice; and 
7. Consideration of the expanded definition of employee under SGAA and communication of the outcome to the individual worker.

The ATO has highlighted “If an arrangement does not have its contract terms in writing, or a written contract between the parties fails to comprehensively capture the legal rights and obligations between the parties, there may be a greater risk that the arrangement has been misclassified once all oral and implied contract terms are considered.” 

It is also noted under PCG 2023/2 that a review of the worker classification arrangements can be a triggered through a “proactive case selection” or a query/complaint received from a worker due to superannuation underpayment as a result of incorrect worker classification. 

To significantly mitigate the risk of an ATO audit or investigation, businesses that engage workers should ensure that they meet all the requirements in relation to the contractual agreements and correctly classify their workers as set under the Taxation Ruling TR 2023/4 and Practical Compliance Guideline PCG 2023/2. 

Where to from here 

Given the significance of these updates and the recent increase in audit activity, we recommend businesses undertake a review of their existing contracts with employees and independent contractors to ensure they are comfortable with the current positions adopted.  

Where your business continues to engage contractors, particularly for labour intensive services, it is pertinent to ensure your contractor risk processes are updated to include changes in interpretation, as outlined in recent cases and these publications.  Consideration may also need to be given to existing contracts and how they stipulate the payment being inclusive of applicable employment taxes.

RSM has developed technology to allow employers to get a quick high-level view of their contractor exposure across PAYG Withholding, Superannuation and payroll tax.  

FOR MORE INFORMATION

For more information on classifying workers as employees or contractor issues, please contact Rick Kimberley or Gina Nedeljkovic.

Important notice

This document does not constitute an offer to purchase any shares or assets in the company described.

The information contained in this document has been provided to RSM Corporate Australia Pty Ltd by the Company and no enquiries as to the accuracy of the information have been made. This document contains certain statements and estimates with respect to the business of the Company which have been based on the assumptions of management of the Company. No representation is made as to the accuracy of such statements or estimates.