Disguised employment: what it is and how to avoid it

Speed is one of the key success factors in global expansion. Businesses that want to establish a presence in a new target market need to be faster than their competitors, including when it comes to sourcing and hiring local talent.

Since hiring abroad can be a long and tedious process that usually involves establishing a foreign legal entity of some sort, many businesses opt to work with independent contractors instead. The problem is that the rules regarding contractor classification differ from country to country, and businesses that are too careless when classifying their workers risk entering a disguised employment relationship.

What exactly is disguised employment? What are the risks for employers and workers? And what can businesses do to protect themselves against disguised employment risks?

Disguised employment is when a business hires freelancers or independent contractors to fill positions that should really be filled by hiring full-time employees. In other words, the contractors perform the work of employees and are also treated as such, but their employment status remains that of an independent contractor.

There are different reasons why businesses decide to enter a disguised employment relationship. These reasons include time savings when expanding into new markets as well as cost savings in payroll taxes and employer-paid social security contributions. It is also possible for businesses to unknowingly contribute to disguised employment because they lack the necessary knowledge and expertise to handle employment compliance overseas.

Other terms that are often used interchangeably with disguised employment are employee misclassification, dependent self-employment, forced entrepreneurship, and false self-employment.

Let’s take a look at the following disguised employment example. A UK-based start-up wants to expand into Germany to get access to a new market for its products. In order to start creating a local presence for its brand, the company wants to build a local marketing and sales team.

To speed up the hiring and onboarding process and keep their legal and administrative footprint in the new target market to an absolute minimum, the start-up decides to work with local freelancers and contractors instead of hiring full-time employees.

Since there is so much work to do, the business hires the workers under the condition that they work for the business full time, adhere to a fixed schedule implemented by the company and closely follow the instructions they receive. With this agreement, the start-up unknowingly creates a disguised employment relationship, since the agreed terms go against the rules that govern employee classification in Germany.

Disguised employment doesn’t always happen on purpose. Although businesses may be unaware of misclassifying their workers, they are not protected from the legal consequences. Depending on the scale and gravity of the infringement, the repercussions of employee misclassification can be severe.

Every country handles disguised employment differently. In general, however, businesses that violate employee classification rules will most likely face one or several of the following consequences:

• Negative impact on the company’s reputation,

• Retroactive payment of payroll taxes for the entire duration of the disguised employment relationship (possibly even with interest), 

• Additional fines which are usually calculated as a percentage of the total payroll, and

• Potential criminal offense charge.

The only way to avoid disguised employment is to be careful when determining a new hire’s employment status. What makes things complicated for internationally expanding businesses is that the rules for classifying employees and independent contractors differ from one country to the next.

For instance, the legal framework surrounding disguised employment in the UK is the IR35, also known as off-payroll working rules. In the US, disguised employment is the responsibility of the Internal Revenue Service (IRS). The IRS provides specific information on the correct classification of employees and independent contractors.

Companies need to do their due diligence and conduct some thorough research on local classification rules. However, there are a few common principles that can help businesses get a rough idea of how a worker would most likely classify. These principles include:

• Workload and exclusivity: Contractors who work exclusively for one company in a weekly capacity that nearly reaches or equals 40 hours are likely to be considered employees.

• Benefits and perks: Providing benefits, such as complementary insurance coverage or sick pay, or other perks to self-employed workers could be considered an indicator for disguised employment.

• Equipment and place of work: Contractors and freelancers should use their own equipment for work and only work on company premises in a reduced capacity.

• Behavioral control: One of the main criteria when checking for disguised employment is the level of behavioral control the business exercises over its contractors. In contrast to employees, contractors and freelancers are free to organize their workload as they see fit and carry out tasks independently in the time and manner that suits them.

• Substitution: A contractor or freelancer shouldn’t hold a role in the company that includes tasks that cannot be taken over by someone else. It must be easy to replace them if they fall sick or become unavailable.

Even when being very thorough in their research on local employee classification rules, companies that lack the necessary expertise are at risk of contributing to disguised employment and facing penalties for it. In order to mitigate risks, businesses should work with external employment law and compliance experts. That’s where global employment and contractor management solutions like Lano come into play.

With Lano, businesses can compliantly hire, manage, and pay full-time employees and contractors in over 170 countries worldwide. Get access to localized contractor agreements that protect your business from disguised employment risks and use our international contractor management services to provide a great team experience and pay invoices in 28 different currencies with a single click.

Thanks to our global employment solution, converting freelancers to full-time employees is a frictionless process that can be completed in a matter of days. Book a demo with one of our global employment experts to learn more.