Beware the contractor tax trap

SMEs provide employment for approximately 30% of the Australian workforce, with an increasing number of people being hired on a contractual basis. 

While some employers may think hiring individuals as contractors will mean they are no longer responsible for employee tax obligations such as PAYG withholding, superannuation, WorkCover and payroll tax, then they’ve just received a wake-up call.

A recent case in which a business was found to have failed to meet his tax deduction and superannuation obligations as an employer of an individual that he maintained was a contractor for several years highlights the importance of understanding the definition of an employee, and that confusing employees with contractors is not a defence the ATO will accept.

It’s fairly clear-cut that contractors who provide services through their own company or trust structure are responsible for meeting their own employer payment obligations. However, there are many other situations where SMEs get caught out for not meeting these obligations when a contractor is deemed as being an employee.

To ensure you meet these obligations it’s important to understand when a contractor is deemed to be an employee and what your payment obligations are in relation to them.

Employers must withhold PAYG from payments made to employees, company directors, office holders, independent contractors you have a voluntary agreement with and individuals under labour hire arrangements.  This includes withholding PAYG from termination payments and compensation, sickness or accident payments you make.

You must also withhold an amount from payments you make to other businesses if they don’t quote their ABN to you on an invoice or other document if required.

Contractors usually retain the right to control how they perform their services, are contracted to provide a specific result rather than fulfil an ongoing role with the company, are paid upon the successful completion of the assignment, provide their own equipment and tools and are responsible for carrying commercial risk associated with completing the assignment.

However, contractors may be subject to PAYG withholding if they are deemed to be engaged under a contract of service in which the company they working for has substantial control and direction over how the contractor performs that work and the manner in which the work is done. 

Simply labelling a worker as a contractor does not relieve an employer of this obligation to contractors.

Employees must also make quarterly Superannuation Guarantee Contribution (SGC) payments for employees.

A minimum 9% SGC contribution is payable on the employees earnings base calculated in accordance with ordinary time earnings (OTE). OTE include director’s fees, sick leave, annual leave and long service leave, allowances, bonuses calculated in reference to work undertaken and casual loadings.

If you hire your contractors under a contract that is principally for labour, you have to pay super for them – even if the contractor quotes an Australian Business Number (ABN). These contractors are considered your employees for super guarantee purposes.

Payroll tax is payable on employee payments and contracted services unless one of six exemptions applies:

1. The contractor provides services to the SME for no more than 90 days in a financial year.
2. The contractor engages others to perform all, or part, of the work pursuant to the contract with the SME and the contractor carries the risk for that work.
3. Services provided under the contract are not ordinarily required by the SME and the contracting company normally provides those services to the public.
4. The services under contract are ad-hoc services required by the SME for less than 180 days in a financial year.
5. The provision of materials or equipment is the main object of the contract and the provision of labour is secondary to the supply of this materials or equipment.
6. The Commissioner of Taxation also has the discretion to exclude certain payments from payroll tax if none of the other 5 exemptions apply.

Finally, WorkCover insurance coverage must also be provided for employees or contractors deemed to be employees and you pay, or expect to pay, more than $7,500 a year in rateable remuneration.

Payments to a contractor will be subject to WorkCover if they are deemed to be working under a contract of service and the tests to determine this are similar to those previously mentioned.  Similar exemptions to those for payroll tax will also apply.

Obtaining clarity around the definition of an employee is paramount to ensuring you meet your obligations as an employer. The ATO provides some tools and calculators to help determine whether you are dealing with an employee or a contractor. 

Employers face significant penalties, ranging from fines to criminal sentencing for not meeting their employer obligations, so when in doubt seek the assistance of your accountant to be crystal clear on your obligations and deadlines for meeting them.

Marc Peskett is a partner of MPR Group a Melbourne based firm that provides outsourced accounting services to businesses, as well as tax advice, business advisory and financial services to fast growing small to medium enterprises.