How to avoid income tax penalties over staff misclassifications

When it comes to any business, it is important to first define the relationship between the business and the person giving a service. This helps avoid challenges when it comes to determining how to treat ‘payments for services’.

Generally and unfortunately, there are no clear guidelines under tax laws to determine business relationships, and in particular, what constitutes an independent-contractor relationship or an employee relationship.

For purposes of determining income tax, workers’ classification has always been a problem for most employers. Misclassification creates a high risk of non-compliance.

In simple words, an independent contractor is someone who provides ‘a contract for services’, and not ‘a contract of service’, which is often associated with employment. Some employers, either out of ignorance or to wilfully evade correct withholding obligations and statutory requirements, improperly classify employees as independent contractors.

It is critical that all businesses seek advice to properly understand and classify individuals providing services. It can appear to be very straightforward, but misclassifying individuals as independent contractors when they are employees — or vice versa — can lead to high exposure.

The penalties for misclassification include potential liabilities for failing to correctly withhold and account for employment taxes and other statutory deductions. Such a liability can go back years, and expose the company to regular revenue authority audits and inspections.

Right of control

In an attempt to unmask the relationship, most businesses have adopted the common law principle, which courts have also tried to base their judgements on. Interpretation is often based on ‘economic realities’ and/or ‘right of control’ — that is, the degree of control on the individual in the performance of his or her tasks; the mode of payment for services; who provides the tools of trade used by the worker to perform a service; and, how integrated is the worker in business operations.

In Kenya, there are two worker misclassification cases where the courts have ruled in favour of the Kenya Revenue Authority (KRA). The 2013 cases involved Everret Aviation and Kapa Oil Refineries. Typically, if the courts rule in favour of KRA, a 25 per cent penalty on the principal tax is assessed, and a further 2 per cent interest is charged from the dates the payment became due.

Reading the judgements in the two cases, one might think that until the day there will be a clear distinction between an independent contractor and an employee, it will forever remain elusive. But that is not the case.

In the UK, for example, tax authorities have developed an online Employment Status Indicator (ESI) tool that helps employers ascertain the status of an individual or group of workers via a series of questions about the working relationship. Though not conclusive, the tool gives businesses some guidance on their degree of exposure, and then flags areas where additional professional advice should be sought.

For Kenyan businesses, it is important to note that no single individual test on its own is likely to give an ideal and conclusive status of the relationship that exists.