Surprise: Your "contractors" may be de facto employees

2 May 2012
Hiring contractors when expanding abroad: A common scenario

Company X, a U.S.-based high tech startup, was growing fast and saw untapped market potential for its products and services throughout Europe. The management team decided to hire a handful of sales representatives in a few countries to test out the market. With its lack of language barrier, familiar culture and proximity to the European Union, Company X chose the UK as its first destination.

This is a common scenario — companies expanding internationally want to “dip their toes” into the market with low commitment, and perceived low risk, by hiring a few workers on the ground initially, without creating a formal legal entity and having to pay local taxes.

However, the company  may through its activities trigger a local tax presence, or permanent establishment. Any business activity that generates revenue in a country can create a permanent establishment, also called PE. As a result, it's important to know related key risk indicators.

In our scenario, Company X attempted to avoid triggering a permanent establishment by calling its sales rep in the UK a "consultant," and having him involved in prospecting and negotiations, but not actual contract signing. Unfortunately, UK tax authorities could easily make the case for PE by looking at the following:

  • Level of employee participation. The on-the-ground rep shepherded sales contracts from the start, and was involved throughout, up until the actual signing. By all measures, the rep helped generate revenue in the UK.
  • Locale of contract conclusion as a technicality. Without the formal ability to conclude contracts in-country, Company X had the US parent “rubber stamp” documents and sign off on them. However, this did not change the fact that the UK-based rep was substantially involved in identification of the customer and negotiation of the contract.

It's important to understand that these circumstances are not unique to sales reps. If Company X later put software developers on the ground in the UK to further expand business, the company would deepen its permanent establishment risk, since the developers would create intellectual property to be sold for a profit.

Even one international employee may create liability

Don’t fall prey to the assumption that paying a single employee represents no risk. Company X made that assumption and was later forced to set up a legal entity and pay UK authorities back taxes and penalties for non-compliance.

Can a company avoid complicated employment laws by hiring contractors?

Company X found itself on the hook for significant tax liability when it hired a sales rep in the UK without setting up a legal entity. Even though the company had just one employee on the ground to begin exploring the market, that triggered a permanent establishment as a result of revenue-generating activities.

Unfortunately, Company X’s issues with international operations did not end with the question of permanent establishment. To simplify hiring and avoid local employment obligations, the company opted to hire the sales rep as a contractor rather than as a benefits-eligible employee Soon, Company X had multiple contractors working as sales reps and software developers on the ground in several countries outside the UK, including Germany, Belgium and the Netherlands.

If they act like employees, they're employees, regardless of the contract language

Employment law in most countries is pretty straightforward and consistent with regard to hiring contractors. In almost all jurisdictions, it doesn’t carry much weight if a company labels its workers as contractors. If the worker in question behaves like and is treated as an employee would be treated, then that person is de facto employee. This means the worker is protected by local employment laws, entitled to statutory benefits and should have taxes withheld from their paychecks. 

When classifying a worker, keep in mind that a true contractor under most employment laws:

  • Is free to work for other companies
  • Does not have company business cards
  • Can be substituted
  • Uses his or her own equipment
  • Is not usually granted stock options

Everyone else is an employee.

Company X found itself in some hot water when it thought it was bringing on contractors, but really was hiring employees. Some of the issues they faced included:

  • In Germany, the company had a small group of software developers working on new products. However, the country’s strict intellectual property rules left them in the lurch because the developers, not the company, retained the rights to their inventions.
  • Contracts in Belgium included stock options for workers as an incentive to sign. But, as no one thoroughly investigated the consequences of this benefit, the employees were upset to find they suddenly owed money to the government, as tax is due on options at issuance.
  • The Netherlands staff of Company X included sales reps that created a permanent establishment. Since a proper entity had not been established in the Netherlands, year-end came with no taxes being taken out of employee paychecks, creating major complications for both the company and its staff.
The lesson: Be sure your “contractor” isn’t a de facto employee

Though it may seem like the simpler solution, staffing your international operations with contractors may end up causing you more problems than going through a formal entity set-up and employee-hire process. As evidenced by Company X’s story, the consequences are many and can be costly.