As companies evaluate whether to expand into a particular country, it’s common for them to use independent contractors to test the waters as a more nimble alternative to hiring a full-time employee. For example, many of my US clients hire contractors in the EU to explore the European market potential for their products and services as an alternative to committing to hiring an employee.
At first glance, this approach makes sense because it aligns with how businesses tend to view global expansion—limiting their investment of resources until they determine the viability of expansion. When you consider how complex hiring full-time employees overseas can be, a contractor can seem like a natural fit. Often, however, that’s simply not so. In fact, hiring contractors can be one of the trickier parts of overseas hiring. Today’s blog walks you through common pitfalls associated with contractor overseas hiring, as well as the legal distinctions between contractors versus employees.
What qualifies as an independent contractor overseas?
Because every country makes different determinations for how an independent contractor is defined, it’s impossible to list all the criteria in a single list. Therefore, your first step in understanding these distinctions and nuances is to thoroughly research the country in which you’ll be hiring.
That said, here are some of the most common legal criteria that many countries use to differentiate between independent contractors versus employees:
Autonomy. Independent contractors typically have complete autonomy over their work and how it is carried out. That means that they can dictate their own working hours, determine the process for executing the assignment, and assign the work to someone else.
Time and project specific. Independent contractors are also usually engaged for a short period of time for a specific project. They are not hired over the long term and don’t have undefined or overly broad responsibilities.
Invoice instead of salary. The payment process is another key distinction. Companies do not pay Independent contractors a regular salary. Instead, they invoice the company and bill for their services on a monthly or quarterly basis. Thus, their pay often varies.
No benefits: Independent contractors don’t receive any of the benefits that you would otherwise provide employees. These include vacation leave and enrollment in benefit insurance plans, such as private health insurance and company-sponsored pensions.
Misclassifying independent contractors overseas: 5 most common pitfalls
One of the most common mistakes when hiring independent contractors is to assume that US rules apply to overseas contractors. It is critical to understand the country-specific legal and regulatory requirements for hiring independent contractors versus employees. Here are some of the most common pitfalls that having country-specific expertise can help you avoid.
Pitfall #1: How you pay your contractor
In an effort to make recruiting easier, many clients mistakenly offer contractors compensation that inadvertently leans towards an employee relationship. For example, one client was looking to engage a software developer contractor in the Netherlands. The company offered the contractor an annual salary, vacation pay, and a performance-related bonus that was in line with the company’s employee bonus plan. Unfortunately, when the company tried to terminate the contractor’s engagement, the individual claimed that they were a ‘de facto’ employee because they were paid and treated akin to other employees in the company. The Dutch Authorities agreed with that argument and, as a result, the company had to pay the individual a significant sum of money because the authorities determined that the company had failed to terminate the contractor as an employee.
Pitfall #2: How you manage your contractor
Remember that this is an “independent” contractor. That means that you, as the employer, are only able to control the outcome—not the process or the conditions by which that outcome is achieved. Thus, independent contractors manage themselves and how they execute the work. This includes how it is performed, when, where, and by whom.
Pitfall #3: Which activities your contractor performs
You must hire Independent contractors to perform specific tasks. That means that a contractor cannot perform work outside of the engagement terms. Therefore, typically, contractor arrangements are project-based, relating to a specific defined role (e.g., installing a specific suite of software applications). In addition, contractors should not perform certain types of sales activities in the country where they are based or be in a position to sign contracts on behalf of the company (to avoid creating a permanent establishment risk or a Commercial Agency risk). A permanent establishment would trigger costly corporate tax and robust compliance obligations for your company. Further, if Commercial Agency Regulations apply, individuals will be entitled to enhanced protections including minimum notice periods and compensation terms.
Pitfall #4: How long you employ your contractor
Similar to how your company must employ independent contractors for very specific activities, they must also be hired on a defined and time-limited basis. Your company engaging a contractor for a long period of time often supports any argument that local authorities (or the individual) make about the contractor being a de facto employee because employees are also employed on a longer-term basis.
Pitfall #5: Being out of compliance with GDPR regulations
The GDPR is the EU’s very stringent data privacy law, and it includes very strict requirements for who can access employees’ personal and medical data. If your company engages an independent contractor as a de facto employee, then the personal data you collect may not permitted under the GDPR. Because the penalties for any GDPR breaches are significant, this can be a costly mistake.
Penalties for being out of compliance with overseas legal requirements
If local authorities determine that you are using independent contractors who should be classified as employees, you risk facing fines, tax liabilities and—worst case—criminal penalties. These liabilities can be classified into two groups: financial penalties and tax classification.
Financial penalties, including back payment of employee social security contributions:
If authorities determine your company misclassified an employee as an independent contractor, depending on the country, you’ll be liable for anything ranging from fines to back pay, social security, and benefits. Please keep in mind that social security payments for employees in other countries are often much higher than in the US.
Creation of a Permanent Establishment:
Permanent Establishment (PE) is arguably one of the most serious risks of misclassifying an employee as an independent contractor overseas. In this case, the types of activities that your contractor is conducting in that country (for example, having someone work in a direct sales role) can send a flag to the authorities that your business has a tax presence in that country and therefore require you to pay corporate tax and meet the local compliance obligations.
How to mitigate risk when hiring
Start with accurate market intelligence. You should have a thorough understanding of what legally constitutes an independent contractor in the country. Only then will you have a clear understanding of the difficulties and complexities involved in complying with that country’s independent contractor legal requirements and criteria. It may turn out that it’s not feasible for you to hire in that country because your desired contractor activities and local regulations are at odds. Make sure that you have the most current information and data for hiring both contractors and employees. Lastly, be sure that you also fully understand the level of complexity for establishing an entity if required. Because in-country regulations often change, be sure to have the latest market intelligence.
Design an iron-clad, country-specific independent contractor agreement. If you do hire a contractor, make sure that the independent contractor agreement is robust and specifically written to be fully in compliance with that country’s unique legal requirements. Don’t simply take a US agreement and repurpose it for a different country. If you are challenged by the authorities, this document is a key part of your defense to prove that you are in compliance with the law. In Japan, for example, the agreement must be written in the local language and refer to specific services to be performed, as well as the timeline for those services.
Be proactive about consulting a global expansion expert. One of the best ways to mitigate risk is to hire a trusted global expansion expert who can provide end-to-end support and guidance, from market intelligence to in-country payroll, HR, accounting, and legal services. Using an expert BEFORE hiring will help both avoid costly pitfalls but also determine where expansion is feasible for your company.
Conclusion
HSP is an end-to-end global expansion solutions provider focused on helping companies scale their operations overseas effectively and efficiently. We are the only global expansion expert to offer growing companies a full suite of end-to-end solutions designed to help them scale to any size, in any country.
Our in-country experts have delivered the full spectrum of global expansion solutions—from EoR to entity set-up and management—across more than 100 countries (and counting). HSP brings full payroll, accounting, tax, legal, compliance and HR services to corporate teams, integrating with in-house staff to both guide and execute across every domain. Contact us today so that we can start delivering your custom solutions.
