Contractors are a valuable tool for most businesses. However, there often comes a point where, for either business or legal reasons, companies need to consider how to convert contractors to employees.

Here we set out the key steps you need to take if you wish to convert an independent contractor into an employee.

Convert contractors to employees with Horizons.

Why Hire an Independent Contractor in the First Place?

The hiring of contractors (or ‘freelancers’ — the terms are often used interchangeably), rather than employees, has been growing exponentially in recent years. This is somewhat related to the growth in the ‘gig economy’ as a crucial component of the world’s workforce.

Upwork, the world’s biggest freelancer/contractor marketplace, carries out surveys every year examining the state of the freelancing market. According to Upwork’s 2019 ‘Freelancing in America‘ study, 35 percent of the US workforce are freelancers. In a more recent Upwork survey, 61% of surveyed enterprises indicated that their businesses lack the people or skills to achieve their goals. As a consequence, 52% of teams have indicated that they have needed to delay or cancel projects. There is a significant chance this type of gap would be filled by companies hiring contractors or freelancers, given that the gaps are often temporary and in need of immediate filling.

Finding the right mix between contractors and employees for your business is an ongoing challenge for growing businesses, especially for those who seek international expansion.

We discuss the appropriate mix between contractors and employees further in What Are the Best Tools for International Human Resource Management?

What is the Difference Between a Contractor and an Employee?

The precise distinction between ‘contractor’ and ’employee’ can be confusing. After all, don’t employees usually have employment agreements or ‘contracts’ in place? The distinction between the two relies not on the existence of a contract, but on the relationship between the two parties. In broad terms:

The work of an employee is closely connected to the operations of the business itself.
Where an employment relationship exists between the business and the employee, both sides owe each other duties under employment law. For example, in most countries, discrimination against employees on the basis of ‘protected characteristics’, such as gender, ethnicity, age and disability, is prohibited;

The work of the contractor is at ‘arm’s length’ from the business.
As a purely contractual relationship, both sides ‘stand as equals’ and are only required to act as specified in the contract between the two. Any duties are freely negotiated in the contract, rather than enforced by employment and labor laws.
Read more about how to supervise the work of contractors at 8 Tips for Managing Contractors.

There is no ‘one rule’ which determines whether an individual is a contractor or an employee. Rather there, are a range of factors which, when considered as a whole, would lead the authorities to determine that an individual is an employee rather than a contractor. Besides the relationship between the two parties, these ‘tests’ take into account the degree of financial and behavioral control present in the relationship.

While there are some differences in how tax authorities classify workers in different countries, many countries adopt a similar test, including the United States, Australia and the United Kingdom.

For further information about this distinction, see What’s the Difference Between Employees and Independent Contractors?

Why Convert Contractors into Employees?

There are several reasons that it might be desirable to switch from a contractor to an employee. We set these out below.

The Contractor is Misclassified

Employee misclassification occurs where an individual is classified as a contractor by a client, but the relationship’s true nature is one of employment.

Read more about “What does employee misclassification mean?”

Misclassification is often a breach of employment and tax laws. The authorities are interested in stopping misclassification for several reasons:

Efficient tax collection
Taxes of employees are usually withheld and submitted to authorities by employers (often referred to as ‘payroll taxes’). By contrast, contractors are usually responsible for paying their own taxes. This means it is more difficult for authorities to collect the right amount of tax where a contractor is misclassified;

Under-taxation
Contractors are often permitted to deduct a range of expenses from their gross income that employees are not allowed to (for example, transport and office equipment). This may mean that misclassified contractors are paying less tax than they ought to;

Lack of benefit payments
Employers are often required to make compulsory benefit contributions that must be made (such as health insurance or pensions). Failure to pay these benefits both deprives individuals of essential services, and increases the social welfare burden on the government.

Regulators around the world are increasingly interested in pursuing businesses that misclassify their workforce. For example, in 2020, a Federal Court of Australia case found that two truck drivers, who had worked for a company for 35 years, were employees, rather than independent contractors (See In Jamsek v ZG Operations Australia Pty Ltd [2020] FCAFC 119). This meant potential liability of 35 years worth of employee benefits (as well as potential regulator penalties).

The Contractor is At Risk of Becoming Misclassified

An individual may have been originally classified appropriately as a contractor, but circumstances have changed, or are about to change, making this inaccurate. There is a risk of this occurring, for example, where an individual started out doing independent, piece-meal projects, but where they have now become an integral part of the business’s operations.

In these cases, it may become necessary to switch the arrangement from contracting to employment.

Permanent Establishment Risk

Tax authorities need a mechanism for taxing businesses operating in their country who are not incorporated there. Otherwise, businesses could simply incorporate in a very low-tax jurisdiction (a so-called ‘tax haven’) and pay zero taxes in the countries that they actually carry out their business in.

The mechanism that is used by tax authorities is known as ‘permanent establishment’ or ‘PE’. It is generally defined as the “fixed place of business through which the business of an enterprise is wholly or partly carried on”. The existence of a permanent establishment is used to ground corporate tax (and sometimes ‘valued-added tax’) liability.

The definition of permanent establishment is set out in the OECD’s Model Tax Convention on Income and on Capital.

Permanent establishment is incorporated into tax treaties around the world, and is enshrined into domestic law in many countries (including countries that are not members of the OECD). A permanent establishment can be created in various ways. One way in which it can occur is through a ‘dependent agent’ permanent establishment. This means that the existence of a contractor that is sufficiently dependent on an enterprise, could be enough to establish a permanent establishment in a country.

In short, the presence of a contractor in another country (whether or not they call themselves ‘independent’) may unintentionally give rise to a taxable presence of your business in that country.

When an enterprise converts contractors into employees, it clarifies the presence of an enterprise in a country, removing the risk of inadvertent creation of a permanent establishment.

For more information read What is Permanent Establishment and Why Does it Matter?

The Contractor is At Risk of Becoming Misclassified

In these cases, it may become necessary to switch the arrangement from contracting to employment.

Permanent Establishment Risk

The definition of permanent establishment is set out in the OECD’s Model Tax Convention on Income and on Capital.

When an enterprise converts contractors into employees, it clarifies the presence of an enterprise in a country, removing the risk of inadvertent creation of a permanent establishment.

For more information read What is Permanent Establishment and Why Does it Matter?

A Contractor Has Requested a Switch to Employment

There are many aspects of employment that individuals may find appealing. These include:

Employee benefits
Generally, benefits such as health insurance, pension contributions and paid vacation are only available to employees;

Legal protections
There is a range of legal protections (such as fair dismissal rules and minimum wage) that may only be available to employees.

Broader benefits
Individuals often find proof of employment beneficial for a range of personal reasons, such as accessing mortgages or applying for visas.

How to Calculate a New Compensation and Benefit Package

Once you (as the client) have made the decision to convert a contractor into an employee, you will need to reconsider that individual’s compensation package. Some matters to consider when making this calculation include:

It is common for contractors to have a significantly higher hourly rate or monthly fee than an equivalent employee
This recognizes, among other things, that the contractor does not receive employee benefits, must attend to their own invoicing and taxes, and takes on greater financial risk in the case of client non-payment;

Your contractor may not be paying taxes on their income
If based overseas, especially if traveling, the individual’s tax residency might be unclear. Or, the contractor may wilfully be taking the risk of not paying income taxes. By contrast, in employment, in nearly all cases, taxes must be withheld by the employer. This may mean that the employee expects a compensation package which recognizes their reduction in ‘take-home’ income;

The individual may lose flexibility
It is relatively common for employment contracts (especially indefinite or permanent contracts) to contain ‘restraints of trade’ which prevent the individual from working for competitors. An individual may expect an acknowledgment in their compensation of this foregone potential income.

Converting Independent Contractors to Employees: How to Proceed?

The answer to this question depends on whether you are converting a contractor domestically or internationally. We consider each case in turn.

Convert a Contractor to an Employee Domestically

When switching a contractor to an employee within your own country, the process is relatively straightforward. In many cases, you can directly employ that individual by offering them an employment contract or agreement, and terminating the prior contract for service.

If you are not interested in taking on the administrative and taxation tasks associated with employment, you might consider using an ‘umbrella company’, which can carry out those tasks on your behalf. Note, however, that there is an increased regulator focus on inappropriate umbrella company arrangements in the United Kingdom.

In a country with multiple legal jurisdictions (such as states, provinces or territories), the law may require that a business be incorporated in the state in which it employs an individual. In this situation, it is recommended that you engage a Professional Employer Organization (PEO) to employ that individual on your behalf.

In a PEO arrangement, the client company (i.e., your business) retains full day-to-day control of workers as if they were your employee, while the PEO takes care of tax and benefits administration, as well as the administrative and HR tasks of the employer.

Convert a Contractor to an Employee Internationally

If your enterprise is located in a different country to the country where your contractor is based, or is likely to be based, it usually isn’t possible to employ that individual directly. Employment and tax laws usually require that the employer be incorporated in the country in which the employee is located.

There are two key options for dealing with this situation:

Establish a local entity
You could establish a local legal entity (such as a subsidiary company) in the country in which you intend to employ. Note, however, that this can be an expensive and time-consuming process;

Engage a Global PEO
Global PEOs are international employment experts. They operate in most countries and become the legal employer or ‘Employer of Record’. The employee in turn continues to work under the day-to-day direction of the client company, wherever they are based. The Global PEO becomes completely responsible for employee tax, benefits administration, and full compliance with employment law.

To find out more about the pros and cons of local legal entities and Global PEOs see Should You Switch from a Local Legal Entity to a Global PEO?

Conclusion

There can be many good reasons to consider converting an individual from contractor to employee. One of the most important reasons is for a business to avoid ’employee misclassification’ risk: These are the legal and tax liabilities that can arise from misclassifying an individual as a contractor when they should be classified as an employee. When deciding to switch a worker from contracting to employment, a business needs to work out an appropriate compensation package, as well as ensuring that the right mechanism is in place to hire that individual. Horizons is a Global PEO that knows how to convert contractors to employees, on your behalf. Horizons becomes the ‘Employer of Record’ for your worker taking care of all tax and employer responsibilities. In turn, your enterprise retains full control of the employee and is free to focus on its core business.