Employee vs contractor tests: Why employers need to differentiate

The question of what differentiates an employee from a contractor is one that has plagued many employers. Definitions have been picked over in court cases as lines were crossed, and it is wise for employers to be careful in how they classify those who work for them.

K3 Legal employment law specialist Cameron Fraser and K3 Consulting people specialist Karyn Gould break down what distinguishes an employee from a contractor. 

What is an employee?

An employee is a person engaged to do work for a reward (normally a wage or salary) and is entitled to all minimum employment rights under relevant employment laws. In New Zealand these include the Employment Relations Act 2000, Minimum Wage Act 1983 and the Holidays Act 2003. Basic rights include:

• Having a written employment agreement:
• Receiving the minimum wage, and all holiday and leave entitlements; and
• Receiving the KiwiSaver employer subsidy (some eligibility conditions apply, such as being an NZ citizen).

An employer must keep employee records such as employment agreements, remuneration, time worked, and holidays or leaves taken.

The duty of good faith also applies to all employment relationships, requiring the employer to be open and communicative with the employee and to consult with them on good faith regarding matters that may impact on their employment. This includes information-sharing obligations.

Employees are also able to bring personal grievances to challenge the decisions of their employer, such as a decision to terminate. In responding to a personal grievance, the employer generally has to prove that the action they have taken is one a fair and reasonable employer could have taken in the circumstances.

What is a contractor?

The person who is engaged on a Contract for Services is often referred to as a contractor, or an independent contractor, although there can be other labels. They can be a self-employed sole trader or may work under a registered company. Regardless, a contractor invoices the Principal (the hiring organisation) for their services; they pay their own tax and ACC levies. Contractors aren’t covered by most employment-related laws; this means they don’t get benefits like annual leave or sick leave, they can’t bring personal grievances, and general civil law determines most of their rights and responsibilities.

Why is important that businesses know the difference?

The signing of an Employment Agreement or a Contract for Services does not guarantee that a party is classified according to the signed documentation. The Employment Relations Authority (ERA) is empowered with the ability to determine if the “real nature” of the relationship is one of employment. A person who may have been labelled a contractor can therefore bring a claim in in which they say they are in reality an employee and are therefore entitled to all the benefits that this classification entails. This could include payment in arrears for leave entitlements, KiwiSaver payments, the requirement to be dealt with in good faith, the ability to bring a personal grievance and other standardised entitlements offered to similar employee roles in an organisation.

Fraser says that “it is worth taking the time to clearly assess the organisation’s needs and the specific nature of the work needing to be done, before engaging someone to carry out the work. This is so as not to expose the business to unforeseen later risk by not understanding the permitted parameters of Contractor arrangements and the potential consequences of getting it wrong. Problems tend to arise when a person who has been incorrectly classified as a contractor is terminated (often without any process), and then seeks advice on challenging their termination. By this stage the damage has almost always been done.”

As claims are often made in times of dispute, such as when an organisation decides to terminate a contract, there can be claims of unjustified dismissal, which could result in claims of compensation (such as for lost wages and/or hurt and humiliation) as well as potentially reinstatement to their previous role.

When is a contractor actually an employee?

This is a factual question that will depend on the specific circumstances of an individual role – it is not black and white, and no definitive lines can be drawn. However, there are tests that have been developed over the years through the courts which can assist in making the distinction.

An organisation must consider more than just how a person is paid to know if they are an employee or a contractor. If the person is acting as an employee, then even if they are being paid by invoice, an organisation may have legal obligations to them, as if the person was an employee.

There are four main tests that assist with determining if someone should be treated as an employee or a contractor:

• Intention test;
• Control vs independence test;
• Integration test; and
• Fundamental/economic reality test

An organisation needs to think about its situation and apply all the tests. No one test will give the correct answer. If the organisation is still unsure, it should seek specialist legal advice as if it gets the distinction wrong, there are financial risks for the organisation. These include but are not limited to potential payments for:

• unpaid PAYE tax; or
• ACC levies; or
• unpaid minimum wages; or
• holidays and leave entitlements.

An employer may also be at risk of receiving penalties from Inland Revenue and/or the ERA (that could be both costly and harm your reputation). This risk can also be the result of an investigation from a Labour Inspector. An organisation may also be declined approval to bring in future workers from overseas.

The ERA or Employment Court will consider (non-exhaustively) the written and oral terms of the contract between the parties, and also how the relationship operates in practice.

The Intention Test

What the parties intended the relationship to be is relevant, but it doesn’t on its own determine the true nature of their relationship. This is often discerned from the wording of any agreement between the parties.

The fact that the intention of the parties is not determinative and is simply one factor that would be weighed by the ERA/Court in determining the true nature of the relationship was recently affirmed by the Employment Court in Barry v C I Builders Ltd [2021] NZEmpC 82, where Chief Judge Inglis went on to observe:

“Work might be offered and accepted on a stated basis, but if the reality of the relationship in practice does not marry up, party intention will not operate to convert the relationship into something it is not (at [17]).”

In that case, evidence was given by Maurice Davis, the General Secretary of the Amalgamated Workers Union, which is the largest construction industry union in New Zealand (with approximately 8,000 members). He said it was increasingly common for construction businesses, particularly smaller ones, to engage less skilled and specialised workers on an hourly basis, ostensibly as contractors. Davis said this had the effect of shielding such businesses from the liabilities and obligations associated with employing staff.

The Court in the Barry case went on to find that Barry was in fact an employee, and warned that the independent contractor model was not an alternative which enabled hirers to assess the suitability of a worker for employment.

Fraser observes that in his experience, this practice is not unique to the construction sector but takes place to some degree in almost all industries. He says that “businesses should be alert to the way in which persons they have engaged on contractor agreements are working for them. The nature of the relationship can change over time, and regular reviews of contractor relationships (bearing in mind all four tests) are essential to good practice and limiting potential risks of future claims.”

Control vs Independence Test

The greater the control exercised over the worker’s work content, hours, and methods, the more likely it is that a person is an employee. A worker with greater freedom to choose who to work for, where to work, when to work, the tools used and so on, is more likely to be a contractor.

The Court in the Barry case placed importance on the degree of control exercised by the company over Barry. It found that while he was a relatively experienced construction worker, he was nonetheless closely supervised and directed. In practical terms, he was told what to do, where and when, and had little flexibility. He was expected to turn up each day and work a full day, and to advise the site manager if he wanted to leave early or take a day off.

The Court found this was a factor that weighed in favour of finding the real nature of his relationship was one of employment.

In Leota v Parcel Express Limited [2020] NZEmpC 61, the Employment Court found that Leota, a courier driver who had been engaged on an independent contractor agreement, was in fact an employee, placing particular reliance on the high degree of control placed over Leota’s work. This indicated that an industry practice of engaging contractors was not determinative.

Integration Test

This test looks at whether the work performed by the person is fundamental to the employer’s business (and whether they are “part and parcel” of the organisation). Usually, the work performed by a contractor is only a supplementary part of the business.

A person is more likely to be considered to be an employee of the organisation if the work is:

• the type that is commonly done by employees; or
• continuous (not a one-off project).

And where the contractor:

• generally provides their own tools and specialist equipment; or
• is less likely to be integrated into the team e.g., not included in general organisation events or communications; or
• paid based on results.

Fundamental/Economic Reality Test

This test involves looking at the total situation of the work relationship to determine its economic reality. A contractor is expected to be a person in business on their own account, therefore:

• A contractor often advertises their services
• A contractor usually issues invoices setting out their fees or charges in order to get paid
• A contractor is able to profit from their work. For example, they can often decide how much to charge for their services, and how many jobs to take on.
• A contractor may work for multiple principals at the same time
• A contractor can often get someone else to do the work instead of them, either by subcontracting the work, or employing their own employees.
• A contractor carries financial risk. For example, they may not profit from a job if their costs exceed budget. They may also give guarantees to cover breaches of their responsibilities. They may carry their own insurance to help protect against these risks.

Due to the fluidity of the factors, the relationship is not static. It might start out as a principal-contractor relationship, and then morph into an employment relationship if, for example, the principal/employer starts exercising a great deal more control over the contractor/employee’s activities.

The economic reality test was also considered in detail in the Leota case, with the Employment Court rejecting the claims by Parcel Express that Leota was free to grow his own business as an independent courier driver. Instead, it found that (at [66]):

“the reality is that Mr Leota had very limited opportunities to increase his remuneration, given the way in which the relationship operated, the continuous nature of the work, and hours, he undertook for Parcel Express, and the regulatory restrictions he was subject to in terms of driving hour limitations.”

It went on to find that the totality of the evidence strongly suggested Leota had no business of his own, as he was solely in the business of Parcel Express. This was important to its finding that he was in fact an employee.

Engaging employees or contractors via third-party providers

Some businesses may wish to limit their liability regarding the nature of if their workers are employees or contractors by engaging them through a third party, such a recruitment agency or other labour-hire organisation.

Employers should be aware of the Employment Relations (Triangular Employment) Amendment Act 2019, which came into force on 28 June 2020.

The Amendment defines a “controlling party” in essence as being the party that the employee performs the work for, and one that has control or direction over the employee in a similar way to that of an employer. It allows for remedies where the controlling third party caused or contributed to personal grievance.

Therefore, it is possible that an employee hired via a third-party arrangement could contest the nature of their engagement (being employee vs. contractor) and the controlling party may be required to participate in defending the nature of that agreement.

The ERA will be able to divide responsibility for remedies between the controlling party and the party who engages them, reflecting the degree to which each contributed to the personal grievance.

That being said, it is still possible for a worker engaged through a third party (such as a labour-hire company) to bring an action claiming they are in reality an employee of the end-user/”host”  business. This occurred in Prasad v LSG Sky Chefs New Zealand [2017] NZEmpC 150, where the Employment Court found that personnel engaged by LSG through a labour-hire company (Solutions) were, in reality, employees of LSG. The Court confirmed that determining the real nature of the relationship was an intensely factual exercise involving consideration of the tests discussed above, and that a labour-hire agreement does not represent an “impenetrable shield.”

The Employment Court recently confirmed in Head v Chief Executive of the Inland Revenue Department [2021] ERNZ 183 that the recent law change regarding triangular employment does not prevent a worker from bringing this type of claim against the end-user/host (at [96]). The ERA/Court is still able to determine on the facts what the real nature of the relationship is.

Other considerations

There are limited statutory exclusions to this general ability of a worker to bring a claim they are an employee (as opposed to a contractor), such as real estate agents, sharemilkers, or some film-production workers. The applicability of these exclusions will depend on the circumstances of the particular engagement.

It is also possible that a new class of “vulnerable” or “dependent” contractors may be recognised in future legislation, which would be afforded further protection without being classified as employees. Legislation has not yet been announced or introduced to Parliament, although public submissions have been received and a Working Group engaged to provide feedback. Businesses should pay close attention to developments in this area.

Assessment and review

It is recommended that all organisations carefully assess their obligations and requirements before making offers of either contracts of service (employment) or contracts for services (independent contractors), and that they also implement regular reviews of all persons engaged as contractors to ensure the nature of the engagement accurately reflects the reality of the work being done. The organisation can then make decisions to either clarify or amend practices, or negotiate new terms according to what is appropriate.

To assist with this exercise, businesses may find it helpful to refer to the following analysis of common questions referred to by the Court in the Leota case in considering this issue:

This article was provided by K3 Legal