Beware: It’s Risky to Misclassify an Overseas Consultant

Substantial Risks Exist for Misclassifying an Overseas Consultant as an Independent Contractor

Part of a series on issues related to Manufacturers, Distributors and International Trade

With both the IRS and the Department of Labor targeting the misclassification of U.S. employees as independent contractors, many companies are re-examining their worker classifications. While most U.S. companies are aware of the costly consequences of such misclassification, they may not be cognizant of the considerable dangers of misclassifying foreign workers as independent contractors.

Frequently, U.S. companies choose to engage local representatives in their overseas markets as independent contractors rather than employees in order to avoid compliance with foreign employment laws, withholding tax requirements and social welfare/insurance contributions. In many countries, these obligations may be considerably more onerous than they are in the United States.

However, the consequences of misclassifying a foreign worker as an independent contractor are frequently more costly as well.

For example, in Germany an employer is obligated to remit social security type payments for its employees that are equal to about twenty percent of the employee’s compensation to German social welfare and insurance agencies. The employer is also required to withhold from the employee’s compensation the employee’s social security obligations which are also equal to about twenty percent of his/her compensation.

If an employer fails to withhold the requisite amount from the employee’s wages, the employer becomes liable for the employee’s social security obligations. The employer many not seek reimbursement for this amount from the employee, regardless of any contractual agreement that provides for such reimbursement. The look back period for collection of these social security payments is thirty years in some cases.

Often, misclassification of a worker as an independent contractor does not surface until the engagement with the worker ends. At such time, the foreign worker may file a complaint with a local labor board, claiming employment benefits such as pre-termination notice, severance pay, accrued vacation and holidays, etc., as well as liability for unfair dismissal.

Such an action could also trigger liability on the part of the U.S. company for back tax withholdings, back social security contributions, back insurance obligations, interest and penalties. In order to avoid these considerable dangers, companies with international operations need to carefully structure their international engagements.

Knowledge of Jurisdictional Laws

Each country has specific laws that may affect the designation of a worker as an independent contractor. Knowledge of these laws is essential in structuring an agreement.

For example, in some countries, such as Belgium, there is a rebuttable presumption that an agreement concluded between a principal and an intermediary, however it is described, will be considered an employment agreement. However, this same presumption does not apply if the intermediary is a company.

Therefore, consider contracting with a business entity that is properly registered as a company and with the local tax authorities in the country where it conducts business rather than with an individual. An agreement should reference these registrations.

Draft an Agreement that Shows Independence

Although the designation of the parties will not determine independent contractor status, the agreement should be drafted to establish the independence of the contractor under the laws of the foreign country. Therefore, the agreement should not have “subordinate” provisions, such as a detailed reporting duty, the obligation to follow detailed instructions, scheduled work hours, paid vacation, payment of a pension or other provisions that suggest an employment relationship.

In some countries, a non-compete provision may create a presumption of an employment agreement. Providing or paying for an office indicates an employee relationship and could create a taxable permanent establishment in the foreign country for the U.S. company.

Actual Performance of Agreement Should Reflect the Independence of the Contractor

A court will look beyond the four corners of the agreement to determine if the contractor exhibited independence in the performance of the agreement. Therefore, the contractor should have the independence in structuring tasks set forth in the agreement, with no scheduled works hours, detailed reporting duties or limitations on performing services for others.

Take into Consideration any Independent Contractor or Sales Agency Laws/Regulations

Many countries outside of the United States have specific laws that protect self-employed sales agents. For example, the European Economic Community adopted Council Directive 86/653 EEC of 18/12/86, which provides protections for self-employed commercial agents. The Member States of the European Union have adapted their own regulations to the requirements of this Directive. A commercial agent is defined as “self-employed intermediary who has continuing authority to negotiate the sale or purchase of goods on behalf of another person, … or to negotiate and conclude such transactions on behalf of and in the name of that principal.” The application of these regulations cannot be modified by the parties contractually or by a choice of law clause.

Additionally, there may be specific laws or regulations in some countries that affect an engagement with an independent contract. For example, in Spain independent contractors who are “economically dependent” are entitled to 18 days of holiday per year and the right to be covered by insurance against work-related accidents and business termination that is not due to cause. “Economically dependent” self-employed workers are those who receive at least 75 percent of their income from services performed for one client.

Planning

The potential consequences of misclassifying a worker as an independent contractor could be devastating. Therefore, it is critical to understand the laws of the country where the independent contractor will perform its services and structure the relationship to avoid such a misclassification from the outset.

Posted by Attorney Marcia S. Orgill. Orgill concentrates her practice in the area of business and personal taxation—especially complex domestic and international tax strategies.