Worker misclassification is a form of payroll fraud. If you are reported for misclassification, you will suffer steep fines and investigations of your business and workers. However, not every or even most cases of misclassification are intentional. Many businesses and independent contractors stumble into it due to a lack of knowledge of payroll law and compliance. Companies that hire international remote workers are at particular risk of worker or employee misclassification.
The most basic test of misclassification is this: when workers hired as contractors but treated as employees, they are misclassified. Misclassification is a form of tax evasion and employment law noncompliance.
What is Worker or Employee Misclassification?
Definitions of worker misclassification vary from one jurisdiction to another. Broadly speaking, when you hire someone as a contractor but treat them as an employee, you have misclassified them. This may not sound like a serious offence, but tax, insurance, and employment authorities aren’t forgiving. If you are reported for misclassification, your employment relationships will be audited to determine how independent your workers are. These tests consider:
- The employment contract
- The hours of work
- If the workers are provided training and tools
- How integrated they are into your team
- Their ability to make independent decisions about delivery of work
If workers opt to sue over misclassification, your employment relationships will also be tested in court.
What is the Difference Between an Employee and a Contractor?
Employees are team members who work for your company, are directed by you or one of your managers, and whose contracts have no set end date. Typically they
- Have set working hours
- Undergo a period of training
- Are provided whatever tools are necessary for their job
- Receive direction on how and when to achieve their goals
Employee pay is subject to various deductions including basic local payroll and social program taxes, with employers paying similar taxes. They are also eligible for employer-provided perks and benefits.
In contrast, independent contractors are outside resources contracted for specific project or function, often with a set end date. Contractors have a point of contact in your company who supervises their efforts but does not direct their day to day. Typically, they have irregular working hours, devoting whatever time and effort is necessary to meet their contractual obligations, and can subcontract aspects of their work. They enjoy a business-to-business relationship with you.
Contractor pay is not subject to employee or employer payroll taxes. Instead, contractors invoice you for their work and any applicable sales and services tax. Contractors are responsible for filing their own business and personal taxes and, in North America, securing Worker’s Compensation insurance.
While there are some clear differences between employees and contractors, sometimes the line is blurrier. Not having a deep understanding of local employment laws can lead to worker or employee misclassification. Especially for companies hiring international remote workers!
Accidental Misclassification
Misclassification can be either purposeful or accidental. Typically, accidental misclassification happens in companies that lack experienced HR personnel or an employment lawyer. Start-ups, small businesses, and companies hiring remotely are at particular risk of misclassification. They tend to put off building out an internal or local HR team, which can leave them exposed!
Purposeful Misclassification
If you knowingly hire a worker as a contractor but treat them as an employee, you have comitted purposeful misclassification. Companies use this tactic to avoid paying employer taxes and benefits, and to offload their responsibility toward their workers. This form of misclassification is common in low wage and part time work across many different industries.
However, workers can also initiate misclassification. Some workers believe that the tax advantages of being an independent contractor are worth the risk of being caught for tax evasion. They look for positions where their contract deems them a contractor, even while they’re treated as an employee. (The extent to which being categorized as a contractor is an advantage for workers, is debatable.)
How Does Worker Misclassification Impact your Business?
Regardless of why or how it happened, the consequences of worker misclassification can be serious for both workers and employers. Penalties can include the payment of back taxes and wages, fines, audits and other investigations, and even criminal charges.
Misclassification is a serious misstep that can leave workers without access to employer-provided benefits and even short them on access to government programs. Workers who aren’t paying into Employment Insurance and Canada Pension Plan on a regular basis may be denied benefits when out of work, or smaller payments when they retire. Workers who lack worker’s compensation coverage may find themselves without wage assistance after an accident at work.
Misclassification also creates a host of legal issues that affect both the employer and employee, going back to date of hire. While contractors are exempt from most employment laws, the treatment of employees is highly regulated in most countries. During an investigation, authorities will look at hours of work, overtime and vacation pay, and liabilities and insurance. Misclassification due to ignorance or inexperience isn’t an excuse in the eyes of any tax or labour agency.
“Contractors” who are deemed to be employees will be on the hook for missed payroll taxes. They may also be denied past business expenses and ordered to pay back those claims. Even if they’re deemed an independent contractor, they may enjoy elevated attention from the CRA for years to come.
Worker Misclassification in Canada
In Canada, worker misclassification can be investigated by several different bodies including the Labour Board, Canada Revenue Agency, worker’s compensation boards, and provincial and federal courts. Similarly, there are many reasons why your working arrangement might come under scrutiny. Accidents in the workplace, workers taking long-term leaves, audits, and direct worker complaints can all trigger an investigation.
Worker’s Compensation implications
Worker’s Compensation Boards are responsible for investigating workplace accidents and injuries, setting premiums for employer insurance, and providing lost wage compensation to workers who have been injured. In Canada, employers must register every employee with their provincial workers compensation board and pay premiums on their behalf. If you are discovered to have misclassified your workers, you will be responsible for outstanding premiums plus interest and fines.
Tax Implications
Canada Revenue Agency is responsible for collecting and distributing taxes, as well as investigating tax fraud. Employers who are found to have misclassified employees may be responsible for paying all unpaid employer and employee payroll taxes, including CPP, EI and provincial health taxes.
Even the CRA finding that your worker is a contractor after all doesn’t quite settle things. They may be deemed a personal service business and be required to remit at an elevated tax rate. They’ll also lose many of the benefits of being incorporated.
Legal implications
Employment law in Canada has provincial and federal dimensions. Federal employment law governs employees of the federal government and those in federally regulated industries such as banks or transportation. Provincial law governs most other workers. Due to the rise in worker misclassification, courts regularly look at cases of wrongful dismissal, unpaid wages and benefits, and more.
Because of the rise in worker misclassification, the CRA and other agencies are paying close attention to companies that rely on contractors. A PEO or Employer of Record provider can help you mitigate misclassification risk by helping you hire workers the right way, and by hiring your international workers on your behalf.
How to Mitigate or Avoid Misclassification Risk
Misclassification can cause serious problems for your business and for your employees. Luckily there are ways to mitigate your risks, such as implementing sound hiring policies and working with HR experts like a PEO or EOR.
Ensure Contracts are Compliant and Professionally Drafted
It is vital that all your contracts, no matter the worker type, be locally compliant and professionally drafted. Reusing contracts that were drafted for a different worker type, in a different jurisdiction, or long ago, can leave your business exposed. Work with local employment lawyers and human resources professionals to ensure that you have a full set of compliant employment agreements and experts on hand to advise on you on worker classification.
Develop Compliant Hiring Processes and Policies
Employment law is more than what goes into a contract. It also governs the hiring and firing process and day to day treatment of your employees – and it changes, regularly. Developing consistent and compliant hiring processes and policies is one of the best ways to mitigate your risks. These practices should be developed by an in house, local HR team or by a local EOR that has a native understanding of employment law and the challenges of the local market.
Work with a PEO or Employer of Record
Professional Employer Organizations and Employers of Record mitigate your risks and streamline your hiring processes. They take on drafting contracts, onboarding new hires, managing benefits and perks, and processing payroll. They ensure that your whole workforce, employee or contractor, is handled with due care and compliance.
PEOs that offer Employer of Record service, like Canadian Payroll Services, take that a step further by hiring contractors and employees on your behalf. We help you hire in Canada without having to open a local subsidiary or build up a local support staff.
Our certified HR Managers and Payroll Practitioners handle every aspect of compliance for you, including keeping on top of frequent changes in employment legislation.
Want to learn more about how Canadian Payroll Services can help? Contact us today!
Frequently Asked Questions
What is employee misclassification?
Employee misclassification is the incorrect classification of a worker in order to a) reap tax benefits for either the company or the worker, b) deny a worker employee benefits, or c) deny a worker overtime pay. Misclassification occurs when workers are hired as contractors but treated as employees, or workers are hired as managers but treated as employees.
What is independent contractor misclassification?
Independent contractor misclassification is similar to what would be called 1099 misclassification in the United States. It occurs when a worker is classified as a contractor but treated like an employee, in order to deny them benefits or for the company to evade employer taxes. Independent contractor misclassification can also be initiated by employees who wish to avoid mandatory payroll taxes and gain access to business tax deductions.
What are the penalties for employee misclassification?
Employee misclassification can only be determined by relevant regulatory agencies and can lead to audits, fines and being ordered to pay back taxes. Companies that are found to have misclassified their employees may experience long-term scrutiny from the Canada Revenue Agency and provincial Worker’s Compensation boards.
