Employees vs contractors: Understanding the differences for SMEs

• A new definition of an employee comes into effect on August 26, changing the definitions of employee and contractor. 
• The change could have a broad impact on the entitlements businesses owes its workforce. 

However, understanding the distinction between the two is crucial to running a business lawfully. A worker’s status determines their entitlements – from whether they’re owed superannuation to whether they can claim compensation. 

We speak with three experts about how to distinguish between an employee and a contractor, what small to medium-sized enterprises (SMEs) should consider when deciding who to hire and the risks of getting it wrong. 

What is the difference between an employer and a contractor at law? 

“Broadly, contractors provide services to principals,” says Tim McDonald, Principal, McCabes Lawyers, and Lawyer Monthly’s Employment and Industrial Lawyer of the Year for the past four years. 

“They run their own business outside the enterprise of the principal, and have control over how, when and where the work is performed.   

“Employees, on the other hand, perform a service […] they work under the direct control of the employer.” 

Tim McDonald, Principal, McCabes Lawyers 

To determine the difference, it is necessary to apply the new definition of the employer-employee (as opposed to principal-contractor) relationship in the Fair Work Act. This will come into effect on 26 August 2024. 

The new section 15AA(1) provides that whether an employer-employee relationship exists turns on “ascertaining the real substance, practical reality and true nature of the relationship between the individual and the person,” says McDonald. 

This requires a consideration of many factors, including not only the contract, but also how the work is performed. 

The new definition will likely override that given by the High Court in 2022 in Construction, Forestry, Maritime, Mining and Energy Union and Another v Personnel Contracting. It stated that, where there’s an effective written contract, its terms are the primary determiner.  

“Moving forward, [the] analysis […] will likely return to the multifactorial approach, [which was the approach applied by the High Court before 2022],” says McDonald. 

“[It] was set out in […] Jiang Shen Cai trading as French Accent v Michael Anthony Do Rozario and is likely to be re-enlivened. 

“The ultimate question is whether, viewed as a practical matter, the worker could be said to be conducting a business of his or her own, of which the work in question forms part of that.” 

This question is answered by an objective analysis, based on a variety of factors.  

The first is the contract.  

“The terms and terminology of the contract are always important,” says McDonald. 

“However, the parties cannot alter the true nature of their relationship by putting a different label on it. 

“In particular, an express term that the worker is an independent contractor cannot take effect […] if it contradicts the effect of […] the contract as a whole. 

“Similarly, [the parties’] subsequent conduct may demonstrate that the relationship has a character contrary to the terms of the contract.” 

It is also necessary to consider the “indicia” identified by the High Court in Stevens v Brodribb Sawmilling and other cases. McDonald provides the following list: 

• Whether the putative employer exercises, or has the right to exercise, control over the manner in which the work is performed, place of work, hours of work and the like.  
• Whether the worker performs work for others or has the entitlement to do so. 
• Whether the worker has a separate place of work and/or advertises his or her services to the world at large. 
• Whether the worker provides and maintains significant tools or equipment.   
• Whether the work can be delegated or subcontracted. 
• Whether the putative employer has the right to suspend or dismiss the person engaged. 
• Whether the putative employer presents the worker to the world at large as an emanation of the business. 
• Whether income tax is deducted from remuneration paid to the worker. 
• Whether the worker is remunerated by periodic wage or salary or by reference to completion of tasks. 
• Whether the worker is provided with paid holidays or sick leave. 
• Whether the work involves a profession, trade or distinct calling on the part of the person engaged. 
• Whether the worker creates goodwill or saleable assets in the course of working. 
• Whether the worker spends a significant portion of his remuneration on business expenses. 

Why does the distinction matter? 

Whether a worker is an employee or contractor determines their entitlements. 

“An employment relationship has attached many minimum standards and employment-related entitlements, including limitations on when and how work can be performed, and things like accrued leave and other benefits, including protection from unfair dismissal,” says McDonald. 

Marianna Agostino, director, Conscious Wealth Creation 

In return for honouring these entitlements, the SME enjoys the benefit of an employee’s loyalty. 

“Many business owners shy away from employing staff,” says Marianna Agostino, director, Conscious Wealth Creation, an accounting practice. 

“However, where a business requires a dedicated person who [will] remain loyal, an employee is more suited.”   

In contrast, where the worker is a contractor, an SME owes fewer obligations.   

“A contractor arrangement, that is not a sham arrangement, avoids many of these obligations, with the contractor being responsible for many of those employment related matters,” says McDonald. 

For SMEs, hiring contractors can be attractive for many reasons.   

“[One] benefit is that you’re not committed to keep a contractor on for any particular amount of time – other than what’s in the contract,” says Agostino. 

“You’re able to increase and decrease your workforce in line with demands.” 

Tony Dimitriadis, director, AD Partners 

However, contracting might be the only way to ensure certain tasks are completed. 

“Sometimes contracting is necessary, where you require specialist skills that cannot easily be obtained by recruiting an employee,” says Tony Dimitriadis, director, AD Partners, tax accountants and business growth specialists. 

Grey areas: where the laws governing employees and contractors overlap 

Although the law recognises the distinction between employees and contractors, recent laws have increased contractors’ rights. 

“For example, minimum superannuation contributions may be payable, […] if the work performed is primarily for the contractor’s labour,” says McDonald.   

“This can be avoidable if the contractor is a company rather than a sole trader.”   

In addition, SMEs might be liable for payroll tax on payments to contractors unless an exemption applies. 

Some contractors are viewed as employees for the purposes of workers compensation. 

“For example, in New South Wales, Schedule 1 to the Workplace Injury Management and Workers Compensation Act 1998 (NSW) provides a list of persons deemed to be workers,” says Dimitriadis. 

“This includes a contractor who performs work exceeding $10 in value (not being work incidental to a trade or business regularly carried on by the contractor in the contractor’s own name, or under a business or firm name) and who neither sublets the contract nor employs any workers.” 

What precautions should SMEs take? 

SMEs can take several precautions to ensure they meet their obligations. The trick is to apply them before engaging a worker. 

“It is vitally important that the contract appropriately governs the relationship, from the outset,” says McDonald. 

Agostino adds, “Engaging workers with your business in line with the actual work that they will perform is pivotal.” 

Also important is determining how any grey areas will affect arrangements. 

“[These] need to be navigated with specificity in the contractor relationship and contemplated when negotiating the contract,” says McDonald. 

What happens if SMEs get it wrong? 

“Generally, the employment relationship is more heavily regulated than a contractor relationship,” says Dimitriadis. 

“So, if you incorrectly classify an individual as a contractor, you will find you are at risk of breaching the law.”   

SMEs could become back paying under a modern award, as well as superannuation and payroll tax – all of which might attract penalties. 

They might discover that workers have more rights than they expected. 

“Many employees have access to an unfair dismissal regime, and to other remedies where their employer acts to the detriment of the employee,” says Dimitriadis. 

“For example, under the Fair Work Act, an employer must not take adverse action against an employee because the employee makes a complaint about safety matters affecting the employee’s employment.” 

Whatever the arrangement, for SMEs, understanding and applying the law can be challenging. 

“It is definitely not black or white, and navigating the different shades of grey can be problematic,” says Dimitriadis. 

“We highly recommend you seek professional advice before engaging contractors in your business.”