Misclassifying workers as independent contractors instead of employees can expose employers to serious risks, both from a labour law and tax perspective. The Labour Relations Act 66 of 1995 as amended (“LRA”) and other relevant labour laws provide essential protections to employees that independent contractors do not enjoy. Additionally, tax responsibilities shift significantly when someone is deemed an employee, as employers have obligations to the South African Revenue Service (“SARS”) in this context.

Critical Differences Between Employees and Independent Contractors

Under the LRA, distinguishing between an employee and an independent contractor requires an understanding of section 213, which defines an employee as anyone who works for another person or assists in conducting the business and receives remuneration in exchange for their work. 

Independent contractors, on the other hand, are self-employed and offer services under a contract for services, typically not receiving employment benefits.

The Protection of Employees

The LRA, along with the Basic Conditions of Employment Act 75 of 1997 as amended (“BCEA”), offers comprehensive protection only to employees. When an employer misclassifies an employee as an independent contractor, they may inadvertently deny that worker the rights and benefits provided under these laws. More importantly, an independent contractor may be recognised as an employee under the LRA and will have potential claims against his or her employer.

Who is an Employee?

South African courts and the Commission for Conciliation, Mediation and Arbitration (“CCMA”) apply several tests to determine whether a worker is an employee or an independent contractor. Section 200A of the LRA provides for a presumption of employment if any of the following conditions are met: 

• The employer exercises control over the worker's work and hours. 
• The worker forms part of the employer's organisation. 
• The worker provides personal services to the employer. 
• The worker is economically dependent on the employer. 
• The employer provides the tools of trade.

These criteria ensure that courts focus on the substance of the relationship rather than the title given to it by the employer. If the working relationship appears to meet these criteria, the courts or the CCMA may determine that the individual is, in fact, an employee, regardless of what the contract states.

Consequences of Misclassification Under the LRA

Once a worker is classified as an employee, the employer may face several potential consequences, including: 

Unfair dismissal claims: Employees enjoy the right to not be unfairly dismissed under Section 185 of the LRA. A misclassified employee could bring a claim for unfair dismissal, even though the employer believed them to be a contractor. 

Unfair labour practice claims: An employee could claim compensation for unfair labour practices related to promotions, demotions, or disciplinary actions that were not available to them as a contractor. 

Retrospective compensation: If it is found that a worker was misclassified, the employer could be ordered to pay retrospective compensation, including back pay for benefits such as leave entitlements, severance pay, and overtime.

These claims can create both financial strain and reputational damage for businesses, mainly if a significant portion of the workforce is found to have been misclassified.

The Impact of Misclassification from a Tax Perfective 

The classification of workers as either employees or independent contractors also has significant tax implications, governed primarily by the Income Tax Act 58 of 1962 as amended. In the past, employers and workers often tried to avoid the obligations associated with formal employment relationships, such as employees’ tax (PAYE), by setting up private companies, close corporations, or trusts through which they provided services. Employers would then classify individuals as independent contractors rather than employees, as this would grant the employee tax benefits.

However, the South African Revenue Service (SARS) has introduced stringent anti-avoidance measures to combat these practices. The Fourth Schedule of the Income Tax Act defines the concepts of "personal service providers" and "labour brokers," both of which are regarded as employees for tax purposes under paragraph 1 of the Schedule. Consequently, the remuneration paid to such entities is subject to PAYE withholding unless specific exemptions apply.

Employers who misclassify workers face significant tax liabilities. If SARS determines that a worker or entity was incorrectly classified as an independent contractor rather than an employee, the employer may be required to pay all outstanding PAYE, along with penalties and interest. This risk is exacerbated when dealing with personal service providers and labour brokers, who still need to obtain the necessary certificate of exemption from SARS. In the absence of this exemption, these entities must be treated as employees for tax purposes.

Best Practices for Employers to Avoid Misclassification

Conduct a Comprehensive Review of Contracts: Employers should ensure that all contracts with workers accurately reflect the nature of the relationship. Independent contractors should have contracts for services, not contracts of service (which are typically for employees).

Apply the "Substance Over Form" Principle: The courts and SARS will look at the actual relationship between the parties, not just the written contract. Employers should ensure that the day-to-day working relationship aligns with the terms of the contract. If workers are subject to control, have fixed hours, and rely on the employer for their income, they may be employees.

Seek Legal and Tax Advice: If there is uncertainty about a worker's classification, employers should seek legal or tax advice. Ensure that the definition of employee in the LRA and the Income Tax Act are met.

Conclusion

Distinguishing between employees and independent contractors is a complex but crucial exercise for every Employer. The implications of this distinction are far-reaching, impacting the rights and protections available to workers and the legal obligations of the employer. It requires a thorough analysis of the working relationship, contractual terms, and applicable legal standards, including presumptions of employment and guidance from both a labour relations perspective as well as a tax perspective. Employers must be cautious when structuring their relationships with workers to ensure compliance with labour legislation, while workers should be aware of their rights in determining their true status. Contact an expert at SchoemanLaw Inc for assistance today!

Written by Nicolene Schoeman-Louw, Specialist: Commercial Law and Contract Drafting, SchoemanLaw Inc