What’s emerging? ATO finalises tax/superannuation worker classification guidance as Parliament delays introducing Fair Work definition of “employee”

20 December 2023

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On 6 December 2023, the Australian Taxation Office (ATO) released Taxation Ruling - TR 2023/4 - Income tax: pay as you go withholding - who is an employee? (TR 2023/4), its finalised guidance on the ordinary meaning of “employee” for the purposes of pay-as-you-go withholding (PAYG) and Superannuation Guarantee (SG). The finalised ruling has been updated from its draft iteration to reflect the Full Federal Court decision in JMC Pty Ltd v Commissioner of Taxation [2023] FCAFC 76 (JMC), which had not been handed down at the time the draft was released.

Concurrently, the ATO has also released Practical Compliance Guideline - PCG 2023/2 - Classifying workers as employees or independent contractors - ATO compliance approach (PCG 2023/2), which provides an outline of the Commissioner of Taxation (the Commissioner)’s approach to compliance in this area, based on a series of process/governance risk factors. As with TR 2023/4, this represents the finalisation of the previously issued draft iteration.

In addition to highlighting the significance of the written contract when evaluating the nature of a relationship, TR 2023/4 describes the process through which the Commissioner intends to evaluate the terms of the contractual arrangement. Notably, it sets out a need to have regard to a broader recourse of events, circumstances and things external to the contract, for the purpose of identifying the rights and obligations of the parties, a process through which a determination can be made as to whether the written contract (if any) accurately and comprehensively reflects those rights and obligations.

The Commissioner also cautions against reliance on labels in the contract, and on an upfront assessment that is disproportionate to contractual performance. The latter is also reflected in criterion set out within PCG 2023/2, whereby a lower risk classification requires that the performance of the contractual arrangement has not significantly deviated from rights and obligations agreed to by the parties.

Separately, on 14 December 2023, although the Fair Work Legislation Amendment (Closing Loopholes) Act 2023 (the Act) was given royal assent, this did not include the originally proposed measures to introduce, for Fair Work purposes, a statutory definition of “employee”. This aspect of the original proposal will now need to be considered by Parliament in 2024.

Broadly, if passed, this definition requires that, in addition to reviewing the contractual terms between the parties, the “totality of the relationship” must be assessed including, but not limited to, how the contract is performed in practice. This proposed amendment is a response to the 2022 High Court decisions upon which TR 2023/4 and PCG 2023/2 are primarily based, with the objective being to reverse the impact of those High Court decisions for certain purposes.

Notwithstanding, and as referenced above, the definition is proposed to be introduced through the Fair Work Act 2009, and as such, prima facie, would not apply in a tax and/or superannuation context. That is, for tax and superannuation purposes, the common law principles will continue to apply, namely a contractual focus.

TR 2023/4 - Key changes and commentary

We understand the key changes between TR 2023/4 and its draft iteration have been driven by feedback received (as summarised in the accompanying compendium TR 2023/4EC) and to reflect principles emerging from the recent decision in the JMC case. We set out below our key observations.

Identifying the contract

The finalised ruling provides that the “first step” in determining the nature of a relationship is to identify the contract, which may be wholly written, wholly oral or a combination of written terms, oral terms, and/or terms implied by conduct. Importantly, the Commissioner considers that “events, circumstances and things external to the contract which are objective, known to the parties at the time of contracting” can be considered in identifying the purpose and terms of the contract.

The inclusion of the phrase “first step” emphasises that, in the Commissioner’s view, there is a fundamental requirement to more holistically assess whether a written contract is in fact comprehensive, prior to performing an assessment of the relationship. Whereas the High Court decisions generally proceeded on the footing that the written contracts were comprehensive, the Commissioner’s guidance cautions against assuming this to be the case, where a written agreement exists.

Totality of the relationship

The ATO received feedback that the draft ruling was not entirely reflective of the key principles emerging from the High Court decisions – in particular, some feedback suggested that the ATO’s reference to the “totality of the relationship” assessment was disproportionate to the contractual focus advocated in the decisions.

As noted in the accompanying compendium, the Commissioner reiterated that the majority judgment in the High Court decisions (particularly, CFMEU & Anor v Personnel Contracting Pty Ltd [2022] HCA 1) did not caution against applying a “totality of the relationship” assessment, but rather provided that this assessment should refer only to the legal (contractual) rights and obligations for both parties.

Control

While the finalised ruling continues to suggest a “holistic” approach (i.e. balancing factors in assessing the “totality of the relationship”), the Commissioner again indicates that the right to control is often a key indicator of employment.

To elaborate upon commentary that the right to control, as against actual control, is fundamental to the assessment, the following commentary was added in finalisation: “… with the increasing usage of skilled labour and consequential reduction in supervisory functions, the importance of control lies not so much in its actual exercise, although clearly that is relevant, as in the right of the employer to exercise it”.

As expanded upon in the compendium, the Commissioner noted that the concept of control should reflect modern working arrangements which often have increased flexibility, whereby certain work types will have increased or decreased importance placed on how, when or where work is done. As such, a stringent view that control will not exist if there is flexibility, for example, in where and when a worker performs work, is incorrect.

Hourly rate remuneration

Consistent with the draft ruling, the Commissioner reiterates his view that hourly rate remuneration is often consistent with an employment relationship.

In this regard, the JMC decision (albeit in obiter), provided that the hourly rate remuneration in that instance was not a “strong indicator”, even if “accepting that the payment as a whole was not payment for a result”; in fact, the commentary went even further providing that the Court “would incline to it favouring an independent contractor relationship” in that instance.

Whilst acknowledging this judgment, the finalised ruling provides that the Full Federal Court decision was unique to the facts of JMC, whereby other terms of the written contract were considered in favour of an independent contracting relationship. In our view, the Commissioner is cautioning taxpayers against adopting a strict rule of discounting hourly remuneration structures as not being potentially indicative of employment, given JMC commentary was in a factual context where numerous other indicia pointed against employment.

Ability to subcontract/delegate

The final ruling has also been updated to reflect the commentary in JMC decision concerning delegation. In that decision, it was found that a right to sub-contract/delegate, even where fettered (e.g. requiring prior written approval from the principal), “is still inconsistent with an employment relationship”. The judgment acknowledged that the assessment may be different if the right was “a sham or the right was without real content on its face or the right to subcontract was limited in scope, for example relating only to discrete tasks as opposed to the whole”.

The finalised ruling necessarily addresses the above JMC principles, however, the Commissioner’s commentary on this point seemingly seeks to further qualify any overt reliance on the concept of sub-contracting/delegation, stating that where the right to delegate is fettered, “the degree of inconsistency between it and the other terms of the contractual relationship between the parties will reveal the degree to which the fettered right to delegate, subcontract or assign tends against a finding of employment.”

Sham contract

As with the draft version, the finalised ruling provides that a contract’s validity can be challenged as a sham, where all parties to the agreement have no intention to create the purported legal relationship. However, in the finalised ruling, it has been clarified that this consideration will have regard to the contract law doctrine of “sham”, as against a reference to “sham arrangements” considered in the Fair Work Act 2009.

Key changes in risk profile for compliance

Whilst the format of the finalised PCG remains similar to the earlier draft, the criteria for falling within each risk zone has been updated. In summary:

for the very low and low risk zones, the Commissioner has now included a requirement to have a comprehensive written agreement governing the entire relationship between the parties;
for the very low risk zone, the Commissioner has added a new criterion, requiring that specific advice obtained on worker classification must also cover application of the extended meaning of “employee” under section 12 of the Superannuation Guarantee Administration Act 1992 (SGAA), with the outcome communicated to the worker;
for the medium zone, the Commissioner has removed the requirement to have obtained specific advice confirming the worker classification;
for the medium zone, the Commissioner has included a requirement that the performance of the arrangement has not significantly deviated from the contractual rights and obligations agreed to by the parties; and
for the medium zone, the Commissioner has included a requirement that the party relying on the guideline is meeting and appropriately reporting the correct tax and superannuation obligations that arise for their intended classification.

Based on the above, it is observed that the updated compliance guideline has, to some degree, narrowed the types of arrangements that will fall within the “very low” risk zone.

However, we consider it easier for employers to fall within the “medium” risk zone, given there is no longer a requirement for written advice. Notwithstanding, it is important to note that the implications of falling within the “medium” risk zone are limited relative to “very low” or “low” risk zones, in that the Commissioner will still apply compliance resource in both unpaid superannuation query and proactive case selection scenarios (however at lower priority relative to “high” risk zones).

What this means for employers?

Engaging workers through non-traditional (i.e. non-employment) channels and arrangements continue to be commonplace in many workforces, and worker protection remains a focus for both regulators and the Government.

The potential introduction of a Fair Work “employee” definition, emphasising a need for assessment of the practical effecting of the contractual relationship, will undoubtedly place heightened demands on organisations’ governance frameworks which will need to cater for the Fair Work assessment, the common law (contractual) assessment (relevant to tax/superannuation, among other things), and the extended provisions’ assessment (e.g. section 12 SGAA) for each employment tax.

In addition, the finalised ruling’s emphasis on the potential to review evidence outside the written contract (in order to establish the legal rights and obligations between the parties at contract formation) is, in our view, noteworthy. In the ruling’s compendium, it is provided that “(t)he Commissioner, not being party to the contract between the engaging entity and the worker, may need to gather the necessary evidence to establish whether the contractual agreement is written, verbal or a combination of the two”.

Organisations should therefore be careful of assuming a written contract to be comprehensive, whilst being aware of the likelihood that on review, the Commissioner may seek to test any such assertion by looking outside the contract, where relevant. Notwithstanding, the PCG’s criteria encourages organisations to have written contracts relating to independent contractor arrangements, provided the relationship aligns to the respective parties’ rights and obligations under the contract.

As such, in our view, it is recommended that organisations ensure comprehensive contracts are available as and when contracting relationships are required, whilst ensuring governance and processes are in place to enable contractual terms to be properly assessed prior to execution (including for accuracy and completeness of the parties’ rights and obligations). This governance should also allow for escalation and review, where the performance deviates (or is proposed to deviate) from the contract.

Further, those organisations seeking “very low” or “low” risk profiles can consider the attributes of existing governance relative to the criterion set out within the PCG. For example, if not already in place, organisations can consider formalised communications with the contractor, through engagement/procurement, on the resultant tax/superannuation outcomes of the arrangement. Of course, a need to obtain specific advice on worker classification and superannuation outcomes for the same kind of contractor arrangements, would be necessary for such a risk profile.

Some, or all, of any updated governance processes may be able to be automated, adding a further control aspect. For example, procurement protocols could be developed which automates centralised approval for non-use of template contractor agreements. Similarly, from a controls review perspective, exception-reporting could be developed through a technology-enabled, data-led approach to isolate potential risk areas (e.g. sole trader contractors paid the same amount for a period under sequential invoicing).

With the ruling and PCG now finalised, and the potential passage of new law which could include a Fair Work definition of “employee”, it is both timely and relevant for taxpayers to review their contractor governance frameworks to ensure best mitigation of compliance risk.