Wednesday, July 1, 2015

When is a Contractor not a Contractor? A Cross-Border Approach to Classification

By Donald C. Dowling, Jr., Partner, K&L Gates LLP, New York City

Independent contractors play a big role in the cross-border business context, particularly when a multinational tiptoes into a new overseas market. Often a multinational takes baby steps into some new market by engaging an in-country representative as an independent contractor (or “consultant,” “freelancer,” “entrepreneur” or “agent”). This approach is especially attractive where the multinational still has no local subsidiary entity or other in-country corporate presence positioned to issue a legal local payroll. The default way to classify these non-traditional work relationships is by using some type of arrangement that, under law, amounts to an independent contractor, and so the independent contractor alternative is an attractive and popular structure in jurisdictions around the world. But contractor classification can be dangerous: Contractor status is fragile and is constantly under attack in courts and agencies from Europe to Latin America to Africa, Asia/Pacific and beyond.

But the overseas independent contractor classification conundrum bedevils even major multinationals. Engaging an independent contractor overseas (rather than hiring a foreign services provider as an employee) may on the front end seem to offer attractive advantages. But dubiously classified foreign contractor arrangements open up a Pandora’s box of legal problems. Challenges are frequent and liabilities can run surprisingly high. And where a multinational principal is not registered to do business in the overseas jurisdiction, the challenges extend beyond classification under employment law and trigger the corporate and tax problem of permanent establishment.

Figure out when, under local foreign law, a nominal independent contractor is likely to get classified a “subordinated” (dependent) de facto employee (or, in special jurisdictions like Canada and Colombia some unique local breed of services like a “dependent contractor” or “independent worker”). Where necessary, hire the services provider up front as an actual employee, or at least engage him as a leased employee (secondee on someone else’s payroll). Or else engage him as a “business-to-business” contractor through his own closely held corporation.

Address the threshold question in international contractor classification analysis: When can a multinational legitimately engage an overseas services provider as an independent contractor or so-called consultant, freelancer, entrepreneur? That is, under applicable foreign law, what separates a genuine independent contractor from a de facto employee? In short, when is a contractor not a contractor?

Obviously this central question turns on local law―the law of the place where the service provider works. Be sure to look to local host-country law as well as any legal regime set out in a choice-of-law clause in the independent contractor agreement. Choice-of-foreign-law clauses in independent contractor agreements rarely divest the mandatory application of local host-country employment laws, because employee classification analysis implicates the public policy of protecting fundamental employee rights. Choice-of-foreign-law clauses do bring the selected regime’s laws into the analysis, but they are usually powerless to turn off host-country employee protections or to stop the mandatory application of a host jurisdiction’s more protective employee classification rules. (E.g., Ruiz v. Affinity Logistics Corp., 667 F.3d 1318 (9th Cir. 2012)

Most every jurisdiction’s local law offers up a list of factors (in Australia called a “multi-factorial test”) distinguishing genuine independent contractors from de facto employees. (Cf. Tattsbet Ltd. v. Morrow, 2015 FCAFC 62 (May 2015), ¶¶ 5, 53) These lists of factors differ from jurisdiction to jurisdiction—even within a single country, lists of contractor-versus-employee factors can differ. For example, the U.S. IRS test has 20 factors (IRS Revenue Ruling 87-41) while American common law is usually said to impose 6 to 13 factors in a so-called “economic realities test.” (See, e.g. Nationwide Mutual Ins. Co. v. Darden, 503 U.S. 318 (1992)) Speaking broadly, countries’ lists of contractor-versus-employee factors end up looking surprisingly similar across jurisdictions. In fact, contractor classification might be the only area of international employment law where we can actually offer some useful generalizations about substantive legal rules across most all jurisdictions of the world. The overarching legal issue behind all the various tests and factors is the core concept that overseas gets called “subordination”—whether the contractor is dependent. Most every country would uphold the parties’ designation of independent contractor status if the would-be contractor is independent (not “subordinate”) enough truthfully to answer “yes” to these ten questions:

1 Exclusivity and independence: Can you, and do you, have other paying clients—and do you market your services to the public? (Exclusive independent contractors pose a special risk in jurisdictions like Myanmar, Nicaragua and Taiwan. Peru applies a rebuttable presumption that a full-time exclusive contractor is a de facto employee. In Germany, contractors should avoid becoming “economically dependent” on the principal.)

2 Short-term: Is your relationship explicitly temporary and short term? (In Sweden a contractor relationship of more than six to nine months risks challenge. In the Dominican Republic, serially renewed independent contractor agreements risk challenge.)

3 Self-supervision: Do you have the power to perform your tasks the way you want to—free from the principal instructing you on process, free from discipline, free from work rules, free from performance evaluations and free from other supervision and control?

4 Self-scheduling: Are you free to set your own schedule and work hours, with no attendance requirement?

5 Self-starting: Are you free to determine the order and sequence of your tasks, with no requirement to make regular progress reports to the principal?

6 Supplies and tools: Do you provide your own office and supplies, pay your own business expenses and hire your own assistants? (This factor is particularly important in jurisdictions including Canada and Romania.)

7 Task pay: Do you get paid only for work you actually do, such as hourly pay or task pay, with no paid vacations or holidays? (In the Dominican Republic, for example, a contractor should never receive a salary.) Is your pay free from employee-benefit executive compensation elements like bonuses, health/life/disability insurance and equity awards?

8 Business risk: Do you take business risks and bear the ultimate risk of profit or loss? Do you bear the risk of casualty loss (property/personal injury) and do you buy insurance? (This “business risk” factor is vital in Quebec, and also in Puerto Rico, where it is called the “economic reality” test—as well as in Beijing, per an August 2009 Beijing declaration on contractor classification.)

9 Tax/social security: Do you make tax/social security payments and withholdings like a business? (This is a vital issue in Ghana, India, Liberia, Sri Lanka, South Africa and many other jurisdictions.)

10 Business cards/letterhead/email/title: Do your business cards and letterhead clarify your independence from the principal, and do you use a title unrelated to the company? Are you kept off the principal’s organization charts and internal structure documents? Does your email address make clear you are not part of the principal’s organization?

These ten questions flushing out contractor dependence or “subordination” tend to predominate, but three other questions also frequently factor into classification analysis:

11 Restrictive covenants: Are you free from non-compete, non-solicitation and other post-termination restrictions?

12 Training: Do you refrain from attending the principal’s training sessions as a student?

13 Organization structure: Does your operation stay separate from the principal’s organization structure and work procedures? (In Peru, a contractor should not be “integrated” into the principal’s production or work “process.”)

Where a nominal contractor truthfully answers “yes” to all 13 questions, then perhaps every country on Earth will uphold contractor classification. Otherwise, though, the parties’ contractor classification gets weaker for each question that has to be answered “no.” Court opinions tend not to say so explicitly, but as a practical matter the classification challenge is toughest where a contractor answers “no” to the first two questions; that is, where the contractor is full time and long term. Classifying contractors rarely raises much risk where they are part time and short term.

For a “reality check” in assessing whether you might legitimately engage some overseas services provider as an independent contractor, ask: If structuring this position as an independent contractor is such a great idea, then why not go ahead and engage all this person’s home country counterparts as independent contractors, too? If a contractor relationship would fail the “smell test” in the headquarters country, expect it also to flunk the smell test abroad.

All this having been said, though, a handful of countries give substantial weight to certain special contract provisions, which therefore, in those particular jurisdictions, become vital to include when drafting an independent contractor agreement (as long as they are accurate). For example, in India, an independent contractor agreement should recite that the contractor has a “permanent tax account number” and withholds and pays his own taxes. In Israel, an independent contractor agreement should recite that the contractor has registered as a self-employed “consultant.” In Russia, an independent contractor agreement should recite that the services provider has registered as an “individual entrepreneur.” An independent contractor agreement in Indonesia or Turkey should expressly invoke the Indonesian Civil Code or the Turkish Code of Obligations as operative law, rather than those countries’ labor codes. In Haiti, independent contractor classification gets more defensible if the contract recites the contractor’s “patente” (taxpayer) number and declares that the contractor’s invoices will be subject to TCA (VAT), which the contractor agrees to remit to Haiti’s Direction General des Impots.

In addition, courts in some other jurisdictions—examples include Cambodia, El Salvador, Malaysia, Senegal, Thailand—ostensibly use the traditional analysis looking outside the four corners of the independent contractor agreement, but judges in these countries may prove somewhat more deferential to parties’ own classification as “contractor.” Australian courts will treat a clear contractual “acknowledgement” of contractor classification as one important factor buttressing contractor classification, as long as that acknowledgment “reflect[s] the real intentions of the putative employee.” (Tattsbet (2015), supra, at ¶¶ 65, 66) In these countries, where the text of an independent contractor agreement unequivocally has the services provider represent and warrant that he is self-employed, the parties’ contractor classification might actually withstand scrutiny. So vet an overseas independent contractor agreement with local counsel to capture any special local clauses and to take advantage of contractor status in jurisdictions that may be friendlier to parties’ selection of contractor status.

In short, figure out when, under local foreign law, a nominal independent contractor is likely to get classified a “subordinated” (dependent) de facto employee (or, in special jurisdictions like Canada and Colombia some unique local breed of services provides like a “dependent contractor” or “independent worker”). Where necessary, hire the services provider up front as an actual employee, or at least engage him as a leased employee (secondee on someone else’s payroll). Or else engage him as a “business-to-business” contractor through his own closely held corporation.