The Risks of Engaging Foreign Independent Contractors

Employment Law

The Risks of Engaging Foreign Independent Contractors

May 3, 2021 | Employment Law

In today’s global economy, it has become increasingly common for companies based in the United States to engage workers who live in other countries to provide services as independent contractors. This practice has become even more prevalent during the COVID-19 pandemic with the broad expansion of virtual work.

Companies can save money hiring independent contractors because they do not have to provide benefits, office space, or equipment to contractors or pay taxes on compensation paid to contractors. Companies can often save even more money engaging contractors from other countries due to lower labor costs.

Furthermore, a U.S. company does not even have to issue a 1099 to a foreign contractor providing services abroad. Internal Revenue Service (IRS) Publication 515 states, “Compensation paid to a nonresident alien … for services performed outside the United States is not considered wages and is not subject to withholding.” [ 1 ]

However, there are also significant risks to hiring foreign independent contractors that should be carefully considered before doing so. In a prior post , I discussed various factors a U.S. company should consider when engaging foreign independent contractors to work abroad. This post addresses the potential negative consequences of this practice, which can be considerable.

Contractor Regulations in Worker’s Country

Many countries have specific regulations that apply to independent contractors and impose penalties for not following the regulations.

For example, in the Philippines, Department of Labor and Employment (DOLE) Order No. 174 imposes specific requirements and restrictions on contractor relationships (e.g., written contractor agreement required, contractor must register with government) and hefty consequences for violations (e.g., violation of contract requirements renders the company the direct employer of its purported contractor). [2]

A U.S. company that engages foreign independent contractors must become familiar with the independent contractor requirements in every country where it engages contractors and may have to retain legal counsel in each country to ensure compliance with local laws.

Improper Classification

U.S. companies that hire foreign contractors to work abroad may face scrutiny and penalties from foreign governments for improperly classifying a worker as an independent contractor rather than an employee.

Broadly speaking, an independent contractor relationship normally exists if the worker can work for other companies, the relationship is short-term, the worker has control over how/when the work is performed, the worker assumes some business risk, and the worker pays his own taxes. However, each country has its own laws and regulations to determine whether a worker is an employee or an independent contractor, and these laws and regulations can vary widely.

In the U.S., a company that misclassifies a worker as an independent contractor may face liability in the form of back tax withholding (including Social Security and Medicare), overtime (for non-exempt workers), benefits, interest, and penalties.

In foreign countries with more employee-friendly laws, an employer might also have to pay back vacation/holiday pay, mandatory benefits, severance/notice pay, government fines, and other country-specific penalties, which can be quite expensive. The following are several examples of the potential consequences of improper classification of foreign workers:

  • In France, improperly classifying a worker as an independent contractor can result in fines and up to three years of imprisonment. [3 ]
  • In the Philippines, a company that misclassifies a worker as an independent contractor may be liable for not providing certain employee protections under Philippine law, such as “rest days,” “13 th month pay,” and various types of leave. [4]
  • In Mexico, a company that misclassifies a worker as an independent contractor may have to pay the worker backpay for mandatory fringe benefits (e.g., year-end bonus equal to at least 15 days of wages, vacation premium of 25% of salary payable during vacation period, and paid holidays), share 10% of its profits with the worker, and pay a fine in the amount of 250 to 5,000 times the minimum wage. [5]

Thus, a U.S. company that engages foreign independent contractors risks having to defend its classification of the worker in foreign courts or before foreign administrative agencies, which would likely require hiring foreign legal counsel and incurring significant legal fees and costs, and may ultimately have to pay significant penalties for improper classifications.

Taxes

Although U.S. companies that engage foreign independent contractors have no tax reporting or withholding obligations to the IRS, they may have tax obligations to the countries where the contractors live and work.

When a U.S. company engages an independent contractor to provide services in another country, the contractor’s activities in that country could result in the company being deemed to have permanently established a corporate presence in the country, which could implicate burdensome corporate and tax obligations.

Many countries have enacted legislation to address the tax ramifications of misclassifying workers as independent contractors. For example, the United Kingdom has adopted “anti-avoidance” tax rules that require companies to pay taxes on compensation paid to contractors who perform the same type of work as regular employees of the company. [6] In Romania, companies must pay the same payroll taxes for employees and independent contractors. [7]

Therefore, a U.S. company that engages foreign independent contractors to avoid paying employment taxes may ultimately find itself paying taxes and penalties in the country where the contractor works.

Conclusion

Although there can be benefits to U.S. companies engaging foreign contractors to work abroad, there are also significant risks that should be considered and weighed against the benefits. A U.S. company that engages foreign independent contractors to work abroad to save money can easily find itself losing money on legal fees, back pay/benefits, unpaid taxes, and penalties.

If you have questions about the potential risks of engaging foreign contractors, please contact Maureen Carr at mcarr@beankinney.com or 703-526-5597.

[1] https://www.irs.gov/pub/irs-pdf/p515.pdf

[2] https://www.dole.gov.ph/news/department-order-no-174-17-rules-implementing-articles-106-to-109-of-the-labor-code-as-amended/ .

[3] https://jiahkimlaw.com/business/ultimate-guide-hiring-foreign-independent-contractor/

[4] https://jiahkimlaw.com/business/philippines-independent-contractors/

[5] https://www.letsdeel.com/blog/how-to-set-up-as-independent-contractor-in-mexico#:~:text=Under%20Mexican%20legislation%2C%20independent%20contractors,how%20the%20services%20are%20rendered ; https://knowledge.leglobal.org/eic/country/mexico/legal-framework-differentiating-employees-independent-contractors-11/

[6] https://www.rossmartin.co.uk/employers/essential-know-how/4146-off-payroll-working-at-a-glance#:~:text=The%20Off%2Dpayroll%20working%20tax,worker%20are%20subject%20to%20PAYE

[7] https://jiahkimlaw.com/business/ultimate-guide-hiring-foreign-independent-contractor/

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