Employees vs Contractors – Significant new guidance from the ATO

The employment law and tax classification of whether a person is an employee or contractor is regularly the subject of TaxEd articles.

The current system where parties are largely left to self-assess the correct characterisation in “grey areas” is less than perfect, and results in a constant stream of litigation. In particular, litigation routinely involves determining whether a person is an employee or contractor for Fair Work and tax (Federal and State) purposes which is fundamental to matters such:

• award and leave entitlements;
• employer Pay As You Go, fringe benefits tax, payroll tax and workers compensation obligations; and
• superannuation entitlements.

On 22 December 2022, the Australian Taxation Office (ATO) released draft guidance, TR 2022/D3 ‘Income tax- pay as you go withholding – who is an employee‘ dealing with employee v contractor classification.

The ATO’s draft guidance follows significant High Court decisions in CFMEU & Anor v Personnel Contracting [2022] HCA 1 (Personnel Contracting) and ZG Operations Australia Pty Ltd & Anor v Jamsek & Ors [2022] HCA 2 (Jamsek).

Of particular interest however is the ATO’s simultaneous release of draft Practical Compliance Guideline, PCG 2022/D5.

The ATO’s longstanding view as set out in TR 2005/16 (‘Income tax – Pay As You Go – withholding from employees‘) was also withdrawn with effect from that date.

Draft Taxation Ruling – TR 2022/D3

TR 2022/D3 provides the ATO view of when an individual is an “employee” for the purposes of the PAYG provisions. It only applies in the context of PAYG withholding but is said to aid in understanding the ordinary meaning of “employee” for the purposes of the Superannuation Guarantee (Administration) Act 1992, although this aspect is not binding on the Commissioner.

As expected, TR 2022/D3 discusses the need to focus on the contractual arrangements between the engaging entity and the individual. In Personnel Contracting the High Court held that whether or not a worker is an employee of the entity is a question of fact to be determined by reference to an objective assessment of the totality of the relationship between the parties, having regard only to the legal rights and obligations which constitute that relationship. If the terms of a written agreement are not in dispute, characterisation of the arrangement is done by reference to the rights and obligations of the parties under that contract.

Generally, it is not necessary to look beyond the contractual terms unless:

• The worker and the engaging entity have not committed the terms of their relationship to a written contract;
• The validity of the contract has been challenged as being a sham; or
• The terms of the contract have been varied such that the contract no longer represents what is happening in practice.

The former Ruling looked at a number of indicia to determine if a worker is an employee. TR 2022/D3 includes the same indicia, although the analysis now needs to be done in the context of the contractual terms.

Importantly, it is not enough to look at the labels in the contract which attempt to describe the relationship.

Draft Practical Compliance Guideline – PCG 2022/D5

PCG 2022/D5 outlines the Commissioner’s compliance approach as to when (and how) compliance resources will be directed to reviewing arrangements for entities that engage workers and classify them as employees or independent contractors.

The approach in PCG 2022/D5 is new and welcome but needs to be fully understood and implemented correctly to ensure the possible benefits result as intended.

Which risk zone applies?

PCG 2022/D5 has 4 different risk zones: very low, low, medium, and high with different criteria set out for each risk zone.

To determine the appropriate risk zone, its necessary to consider whether:

• there is evidence to show that both parties agreed for the arrangement to have a given worker classification;
• there is evidence the parties both understood the tax and superannuation consequences of that classification and intended for that to be the classification, e.g., a record of discussion between the worker and engaging entity and any correspondence between parties on the intention and consequences of the classification;
• the performance of the arrangement has deviated significantly from the contractual rights and obligations agreed to by the parties;
• the party relying on this Guideline has obtained specific advice confirming that its classification was correct under both the common law definition of employee and the extended definition noting the advice must be professional advice from the engaging entity’s in-house counsel or an appropriately-qualified third party, such as a solicitor or tax professional, an administrative body or client-specific written advice from the ATO; and
• the party relying on the PCG is meeting the correct tax, superannuation and reporting obligations that arise for that classification.

All of the above factors must be present for an arrangement to fall into the very low risk zone.

Where an arrangement is assessed by the ATO as falling into the very low risk zone it appears the ATO will not apply compliance resources to reviewing the outcome (even where a person has contacted the ATO requesting a review).

Next steps

 As the ATO’s proposed approach is still draft it should be approached with some caution until finalised.

 However, the benefit in removing uncertainty regarding possible later challenge of arrangements that exhibit all of the very low risk characteristics should encourage employers to proactively identify ‘grey area’ employee /contractor arrangements and explore what may need to change for the very low risk zone to apply.

Fundamental to a very low risk characterisation is holding professional advice (or an ATO ruling) regarding the classification of workers in the arrangement under consideration.

In addition, the sign on/induction process must explicitly deal with the tax characterisation to be applied and the consequences thereof to ensure (and evidence that) the parties entered the arrangements fully understanding the consequences.

The approach in PCG 2022/D5 has the potential to remove uncertainty in the grey areas which must be welcome. We will keenly monitor and update our members on developments in future TaxEd articles.

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This article provides a general summary of the subject covered as at the date it is published. It cannot be relied upon in relation to any specific instance. TaxEd Pty Ltd and any person connected with its production disclaim any liability in connection with any use. It is not intended to be, nor should it be relied upon as, a substitute for professional advice.