Dear Founder: Your workers aren’t contractors just because your agreement says so

It’s fairly common knowledge among founders that hiring employees comes with certain obligations and impacts, from both employment standards and tax perspectives. Unfortunately, all too often companies (whether growing or established) attempt to sidestep these issues by slapping the label “contractor” on new hires, considering the problem solved, and carrying on oblivious to the increased risk they have just created. This article discusses the importance of considering substance over labels, why that matters to your company, and the guardrails you can put in place to avoid messy outcomes.

If a question ever arises as to whether a worker is properly classified as a contractor or an employee, the party determining such classification (be it a tax authority, employment standards tribunal, workers’ compensation board, judge or other adjudicator) will look ‎beyond ‎whichever label you used in the engagement agreement to the specific facts and actions at play in the relationship. It’s great that your standard form contract is titled “Independent Contractor Agreement” but are you paying your worker on an annual salary, granting them options, providing vacation pay, and telling them when and how to complete their work? Even worse, do they have an executive title such as CTO or something similar, that is integral to your company’s business? If so, you should take a minute to consider whether they are properly classified.

Notably, a new classification of workers has also arisen from the prevalence of app-based services, which has led to quasi-employment like protections being afforded to workers who would have previously been considered on the fence between employees and contractors. Links to further resources on these topics are available at the end of this article.

Issues arising in misclassification

Understanding whether a worker is actually working as an employee or contractor is a fact-based determination that most often arises after the start of the relationship in one of three major scenarios: termination of the relationship or failure to comply with employment standards; misclassification for tax purposes; and creation of cross-border permanent establishment.

Termination and employment standards

Employees are generally entitled to additional levels of protection and obligations from the employer as compared to contractors. Depending on the jurisdiction, these may include: notice of termination in accordance with statutory (and likely, common law) requirements ‎when ending the working relationship; ‎workers’ compensation; payment of minimum compensation requirements including overtime and public holiday as well as vacation time and pay; availability of time off for various leaves (sick, parental, etc); and payment for tools or reimbursement for expenses incurred in completing work. Generally, a company with employees is also required to comply with certain statutory employee policy requirements, to which any contractors who were misclassified would also be entitled.

When a company has simply labelled workers as contractors, but in fact treated them more along the lines of an employee, there is an inherent liability which continues to accrue. The company may be liable for all of the foregoing. This will commonly come up when the working relationship of a “contractor” is terminated, often with little or no notice, and the individual then seeks legal counsel who points out the fact that they were likely misclassified and owed not only payment in lieu of reasonable notice on termination, but potentially other rights they were entitled to during their tenure as a misclassified employee, such as vacation pay, overtime pay, holiday pay, and other back pay. Directors and officers may be held personally liable for certain unpaid amounts owed to a misclassified employee by the company.

Most jurisdictions in Canada also recognize a third category of “dependent contractor”, which sits comfortably (or ‎uncomfortably) in the middle of the independent contractor vs. employee continuum. Dependent ‎contractors are generally contract workers like independent contractors ‎but have an exclusive and/or economically dependent relationship with the company for ‎whom they provide services. ‎Dependent contractors will be entitled to reasonable notice of termination, just like employees, which can result in significant liabilities for the company.

In light of the potential liability that can exist due to misclassification, we often see the misclassification issue come up in the context of due diligence for a potential transaction. Where a company is seeking a financing or acquisition, the other party may be independently evaluating the company’s documentation, and identifying improper employee/contractor classifications and practices is a common issue. When this risk is flagged, either with respect to a specific contractor who has made a claim, or with respect to all contractors who may have been misclassified, investors or purchasers will often require a special indemnity or other risk allocation, which can potentially cost the company or sellers more than anticipated.

Employee misclassification for tax purposes

Companies are also obligated to deduct and remit federal and provincial income taxes, Employment Insurance premiums, and Canada Pension Plan premiums with respect to their employees, as well as to pay an employer’s health tax on all remuneration paid to employees in the province. When a company has misclassified a worker and treated them as a contractor, the CRA or other taxing authority may well determine that the company failed to comply with its tax deduction and withholding obligations and as such is liable for all amounts that should have been deducted and were not. Importantly, directors may also hold personal liability in this instance.

The CRA can impose a penalty equal to ten percent of the amount required to have been withheld, which can increase to 20 percent if there was a failure subject to penalty more than once in the year. An employer is liable for the amount that should have been remitted, regardless of whether the employer did not withhold deductions or if it makes deductions but does not remit them.

Since tax liability holds a longer statute of limitations period than other commercial matters, this liability could hang on a company (and the directors) for around six years from the failure to deduct and remit. This is another issue which will frequently arise in M&A, at a time when founders are negotiating for the best deal they can get and would wish most to have their best foot forward.

Creation of permanent establishment in cross-border expansion

Many companies understand that hiring an employee in another country will likely give rise to additional obligations (both from an employment and tax perspective) similar to those that arose when they began hiring employees within Canada. To avoid the extra overhead and headache, they often simply engage a “contractor” through the Canadian company and go on their merry way, thinking once again that the problem is solved. While this approach can work in certain limited or transitional instances, there needs to be certain guardrails in place to avoid the additional risk of potentially creating a permanent establishment of the Canadian company for tax purposes within the US (which we’ll focus on as the largest land border for ease in this article).

In the US, as in Canada, a permanent establishment for tax purposes can be found in more obvious situations like when a company has a physical office location in the other country. However, it can also be created based on the status or activities of workers that are predominantly located in the US or that habitually exercise actions with respect to the Canadian company while physically present in the US. Creating a permanent establishment for a Canadian company is typically worth avoiding, or at least being cognizant of, as this can lead to the Canadian company’s obligation to file tax returns at the state and federal level (and potentially pay taxes) in the US with respect to income allocable to the local operations. While the payment of taxes in some cases may not be required if certain tax treaty rights are applicable, failing to file and being found to have established a permanent establishment at a later date can cause the Canadian company to lose its ability to rely on tax treaty provisions which may have otherwise limited actual payment obligations or can have other adverse implications, such as the denial of deductions against gross income, which can result in taxation on a gross basis.

The cleanest alternative if a company wishes to expand in a meaningful way to the US is to create a US subsidiary. This would allow the company to hire the US-based contractors or employees itself. The US subsidiary would then enter into an intercompany services agreement covering the services provided back and forth, including licensing of IP between the related companies, provision of back-office support, the use of a sales or development team, and importantly the transfer pricing applicable to such services. This set up does not eliminate the need for a number of the guardrails discussed below as the autonomy between the two companies must still be set up and observed, but it does enable a structure more likely able to mitigate these risks.

How to mitigate risks

As noted, the line between contractor and employee is fact specific, depends on a variety of factors, and can often get blurred over time. Accordingly, we find it is most useful to consider and put into place certain guardrails. These include policies which create a structure most likely to avoid initial misclassification, limit the risk of misclassification occurring over time, and allow you to confidently stand behind your decision to classify a worker as a contractor or employee.

Treat contractors like contractors to avoid a misclassification of employees 

When the relevant authority is trying to determine whether you are treating a worker like an employee or a contractor, they will generally consider the following factors: how much control the company holds over the worker, how the worker completes their work or sets up their day, how integral the work completed is to the primary purpose of the business itself, and what benefits are generally provided to the worker. The longer the worker works for the company, the more closely the worker’s duties are connected to the purpose of the business, and the more the company directs the worker’s activities and controls their tools and materials, the more likely it is that the relationship is one of employer/employee.

Some practical guardrails to consider in treating your contractors like contractors are as follows:

• Contractors should be free to complete the work requested in the time period, amount of time, in the manner and with the tools preferred and made available by the contractor, without much direct supervision.
• Contractors should not receive employment-like benefits like vacation, bonuses, options or similar incentive plans, health or dental insurance or benefits, etc. Instead, contractor pay may be increased to reflect the fact that this worker must obtain these similar benefits on their own.
• Contractors should not be controlled by company administration (human resources, payroll) or be subject to performance management or discipline in the same manner as employees.
• Contractors should not be restricted from working outside the company or competing to a reasonable degree (though they may still be subject to confidentiality, conflict of interest and non-solicitation obligations).
• Contractors should not have statutory deductions taken from their fees. Instead, contractors should be required to remit and pay their own tax obligations, obtain and pay for their own licensing, and obtain their own insurance or similar policies covering their work.
• Contractors should submit their own invoices and be paid therefrom and should not be paid on a salary basis or work full time for the company. Preferably, contractors should be engaged only for a fixed-term or on a project or task basis.
• Contractors should not be given employee like (or any) titles or email addresses with the company and should not hold themselves out as employees of the company on any social media, company websites or business cards.
• Contractors should work pursuant to an agreement and separate polices that are tailored to a contractor and not to an employee relationship.
• Contractors should be engaged through a corporation rather than individually, and expressly agree to be an independent contractor in all applicable agreements.

Operating guidelines to avoid US-based contractors leading to a tax authority’s finding that the Canadian company has created a permanent establishment in the US

A Canadian business solely accepting unsolicited purchase orders from customers who are located within the US is likely not enough to be considered carrying on trade in the US. As noted above, companies can create a permanent establishment in the US by setting up a US fixed place of business or physical presence (office, branch, factory, or warehouse location for example). While this may be an obvious action to avoid in attempting not to create a permanent establishment for the Canadian company in the US, there are other ways in which a company can create a permanent establishment, leading to the requirement for the Canadian company to file (and potentially remit) taxes for the Canadian company in the US.

Two other ways a company may create a permanent establishment in the US are: having services performed by an individual or employee who is present in the US for more than 183 days in any 12-month period; and carrying on business through an employee or agent who is resident in the process and has general authority to and does habitually contract for the company. Assuming US contractors are residing in the US more than half the year, the question becomes whether they are conducting business on behalf of the company while in the US.

Like misclassification from an employment perspective, classification and treatment from a tax perspective is also fact specific and may be considered on a retroactive basis.

Below we set out certain operating guidelines to ensure that a US-based contractor does not create a permanent establishment for the Canadian company in the US:

Negotiating and concluding contracts: ‎To the extent possible, US-based contractors should not have the ‎authority to ‎negotiate nor conclude contracts on behalf of the Canadian company. Any material terms of customer contracts discussed with US-based contractors should be ‎non-binding and ‎subject to the final approval of a duly authorized employee of ‎the Canadian company that is based in Canada. This should be reflected in the terms of ‎the US contractor agreements.‎ To the extent possible, all customer contracts should be approved/executed by a duly ‎authorized ‎employee of the company while physically present in Canada.‎

Management functions: ‎

• US-based contractors should not perform any management functions on behalf of the Canadian company; ‎all ‎management decisions should be made by employees of the Canadian company based in ‎Canada.‎
• The Canadian company should demonstrate that the highest level of decision-making (e.g., director ‎meetings) ‎takes place on a regular basis outside of the US.‎
• Individuals resident in the US should not instruct directors of the Canadian company but may ‎provide ‎recommendations or advice.‎

Employee misclassification: ‎US-based contractors should follow the same guidelines as the Canadian-based contractors to avoid potential for misclassification.

Workspace / Fixed place of business: ‎To avoid a fixed place of business permanent establishment, the Canadian company should neither own nor lease any premises in the US and instead should have the US-based contractors be responsible for providing their own workspace, which should not be in the control of the Canadian company or regularly ‎available to the Canadian company at large. Further, the workspace should in no way be held out nor in any way represented as the Canadian company’s workspace ‎and no reimbursements for such workspace (nor any ‎related expenses) should be provided to the US contractors by the Canadian company.‎

As one can easily see, there are a number of considerations to take into account when considering whether slapping the name “contractor” on a worker is actually the right fit. Although companies may feel it is the best option available, liabilities and risks in misclassification abound and can be much worse under common law or due to tax penalties than they otherwise would have been had the company originally structured workers under properly protective agreements.

It is also worthwhile to continually review your company’s approach to, and classification of, certain workers’ status over time and as the relationship and scope of work evolves to ensure that the risks of misclassification have not increased or changed over time. This does not have to be an extensive exercise to begin and can instead focus on a discussion or survey of how the above factors could have shifted in the course of engagement and company growth.

As flagged above, this article does not address a newer class of workers providing services through digital platforms (think ride sharing drivers or food delivery providers), who are being granted certain statutory protections in some provinces under employment standards and workers’ compensation laws, regardless of their classification as contractor or employee by the company engaging them. More information on the new quasi employment law protections being afforded to such digital platform workers in Canada can be found here and here.