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Overview
Employees are often misclassified as independent contractors.
Misclassification can sometimes be an innocent mistake by all
parties involved, or a conscious decision made by an employer to
avoid certain responsibilities and costs as legislated by the
Personal Income Tax Act or other regulatory bodies. In either case,
the penalty for making the wrong distinction can result in serious
tax exposures to organizations.
In accordance with Section 108 of the Personal Income Tax Act,
‘Employment’ includes any appointment or office, whether
public or otherwise, for which remuneration is payable for tax
purposes. A person in paid employment should be distinguished from
another who is self-employed, as an independent contractor.
This article highlights the difference between an employee and
an independent contractor, the factors to be considered as a guide
for companies in classifying an individual as an employee and
independent contractor and how the difference impacts tax
obligations.
Distinction between Employee and Independent Contractor
An employee is a person who works for the employer on a regular
basis, in return for a remuneration called ‘salary’. The
terms and conditions of the employment are described under a
contract known as a ‘contract of employment’. An employee
gives up elements of control and independence and is eligible for
certain benefits and works within the constraint of a
workplace.
An independent contractor on the other hand, is a self-employed
person, that is, a consultant, lawyer, accountant, engineer or any
other person who provides services to other organizations for a
fee. Common law principles further define independent contractor
status by a method of payment. If a person is on an employer’s
payroll and receives a steady pay, clearly the person is an
employee and not an independent contractor.
An independent contractor is free from any control or influence
of the company as he can apply his discretion concerning the manner
and method of completing the task and whatever the outcome of the
task, the independent contractor is responsible for it.
How to determine whether a person is an employee or an
independent contractor
- Contract of Service- Employment
Agreement
Under the Nigerian laws, the relationship between an employer and
an employee could be likened to that of a master and servant
relationship, hence a contract of service is created at the
inception of this relationship. This is so because the employer is
directly in control of the work-related activities of the employee.
Such as the time of work, the tools and equipment used for the
work, when and where the work should be done and the way the work
must be done. - Contract for Service- Service/Independent Contractor
Agreement
This is an agreement between an independent contractor and a
client to carry out a specific project or assignment for a fee. In
this case, the independent contractor who is considered an expert
in the service he is contracted for is in direct control of how
work is done and provides the requisite work tools for the
job.
Major differences between an Employee and an Independent
Contractor
It can sometimes be difficult to correctly identify the
differences between an employee and an independent
contractor. Hence, having a classification process that puts
policies to serve as a guide in determining the tax treatment of
the income received for services rendered is required, such as:
- Direct control of their work & provision of work
tools and equipment
Independent contractors control their work, the manner and time
their work is done, and the tools and equipment used to do their
work. Unlike employees, independent contractors are not subject to
control by their clients and their work is done with little or no
supervision.
Also, they usually provide their own work tools and equipment,
while employees use the work tools and equipment provided by their
employers. Also, unlike independent contractors, employees may be
required to work from offices provided by employers. - Usually operate their own businesses and openly market
their services
Independent contractors usually operate as sole proprietors,
partners and companies; while employees operate only as individuals
It is not uncommon for independent contractors to have a business
name and work for multiple clients.
They also openly market their services because they are in direct
control of their business. Conversely, many employees are not
allowed to work for other employers as they are limited by a
Non-compete Agreement or other provisions that may limit or prevent
them from engaging in other paid employment. - Experts in their Industries
While employees receive some sort of training for their jobs,
independent contracts bring their specialized expertise to their
work. Consequently, independent contractors may not require any
special training to do their work. - Responsible for their own taxes and generally control
their payment
While employers withhold and remit taxes on behalf of their
employees, independent contractors on the other hand file their
personal income tax returns annually and directly remit their taxes
to the government.
Unlike the employees who receive a specified salary at a
particular period, independent contractors are generally
compensated for services provided directly be service
beneficiaries. They may have a standard billing rate for their
service which is usually paid after an invoice has been issued to
the client. - Employees usually work for an indefinite period of
time
Unlike independent contractors, employees usually work for an
indefinite period of time. While independent contractors are
usually engaged for a specific project for a shorter period of
time. - Independent Contractors may Subcontract or Delegate
Their Work
Generally, independent contractors may contract sub-contractors to
do their work since they have control of how their work is done.
Employees, on the other hand, are required to do their work
themselves except in cases where a supervisor or head of the
department may be allowed to delegate work to members of their team
who are also employees of the employer.
Tax Implication
While the independent contractor is sometimes subject to
Withholding Tax (WHT) on his income, the employee is taxed under
the Pay As You Earn (PAYE) system.
This practical distinction is muddled somewhat by section 3(3)
(d) of the PITA which defines employment as including “any
service rendered by any person in return for any gains or
profits.” The definition does cover independent contractors,
but in practice, they are never taxed as an employee. They claim
deductible expenses, capital allowances and loss relief, where
applicable, before declaring a chargeable profit. In contrast,
employees are only entitled to some tax-free personal allowances
and reimbursement.
The analysis above indicates that the word ’employment’;
as used in the context of Nigeria tax law has less expansive
meaning than the ordinary meaning of the word. For example, a
person may ’employ’ himself in the profession of law, but
he is not necessarily an employee of his clients for tax purposes.
Accountants who act as auditors for several companies practice a
profession and cannot be treated as employees of the companies. But
an accountant who is appointed to be a company’s internal
auditor holds an office under it. He is an employee of the company.
Thus, an employment exists where a person holds an office or
receives wages or salaries from an employer for duties performed.
As stated earlier, this is often described as a “contract of
service.”
In a case where an employee works for more than one employer, it
may not be expedient to charge each of his wages as a separate
employment income. Rather, his engagement may be services of
contracts performed as part of a profession or vocation. The income
from all sources could then be aggregated and taxed as the profits
or gains of a business or profession.
Therefore, under the PITA, persons who hold office or
appointments for remuneration or render services in return for any
gains or profits are persons in employment. However, gains or
profits from professions are distinguished from employment…
“The dividing line between a profession and an employment
could be narrow one and may not be easy to determine”.
Conclusion
It is critical that business owners correctly determine whether
the individuals providing services are employees or independent
contractors.
Classifying a worker as an employee or an independent contractor
has a significant effect on the tax treatment of the payments made
for the services rendered. Thus, organizations need to pay close
attention to workers’ classification issues to ensure
compliance with the Nigerian tax provisions.
Employers should also think carefully about entering independent
contractor relationships that is for long-term or indefinitely.
They should consult a competent Tax Professional to periodically
conduct audits of all positions and review the requirements for an
employee versus an independent contractor to avoid unanticipated
consequences and penalties.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.