Hiring the right people can make or break your business.

Many companies are seeking talents outside the US, but they are often not aware of legal consequences of cross-border work relationship.

I cover legal issues companies should consider when they hire an independent contractor from a foreign country.

 An online company hires freelancers from many different countries. One of those freelancers in Brazil became unhappy about compensation and asked for a raise tripling his current wage. The freelancer  made a public threat to blackmail the company if his demand for a raise is not met.

The company failed to successfully negotiate with him, and decided to sue him in a Brazilian court to protect their business.

It was extremely difficult for the company founders to find a local lawyer to stop the unethical behaviors of their independent contractor in a country that they had no knowledge or experience with its laws and cultures.  The founders had to search online and dig their contacts to get recommendations about a trustworthy lawyer who is experienced in a similar matter in a country they have never been to.

Adding to their troubles, they found only 1 out of 20 lawyers they found in Brazil spoke moderate English. The first lawyer they hired stopped working in the middle of the job due to family issues and didn’t return the initial payment even though he only worked 10% of what he was paid to do.

In the end, two co-founders ended up spending over $18,000 in legal fees and translations and more than 100 hours of their valuable time just to go to court in Brazil. The stress of dealing with the whole process while taking care of their regular business took its toll on founders and business itself.

The company’s attempt to reduce costs by hiring foreign independent contractors resulted in a costly legal nightmare.

Many companies hiring overseas contractors don’t realize that they are suddenly exposed to more legal liabilities under foreign laws. Learn how your company can reduce the risks associated with hiring a foreign independent contractor.

1. You can be penalized if your foreign independent contractor is actually an employee

Who is an independent contractor?

According to IRS definition, people who are in an independent trade, business or profession offering their services to the general public, are generally independent contractors. The payor for independent contractors has the right to control only the result of the work and not what will be done or how it will be done.

Independent contractors are subject to Self-Employment Tax. Companies hiring them don’t have to withhold income taxes or pay Social Security, Medicare, or Unemployment tax.

Who is an employee?

If the performance of your services is controlled by the payor, you are not an independent contractor.

The nature of the relationship between an employee and an employer is determined by the level of control and independence an employee has in their job. The important facts are whether expenses are reimbursed, who provides tools and supplies, and whether the work performed is a key aspect of the business.

If a US court or the IRS determines a person your company hired as an independent contractor is, in fact, an employee, you can face liabilities for not meeting the requirements of employment. You might have to pay that person’s unpaid Social Security and Medicare taxes, worker compensation premiums, unemployment tax, and unpaid benefits, as well as interest and penalties on those payments.

What is the cost of making a misclassification if the worker lives in the US?

In Fiscal Year 2015, the US Labor Department’s investigation of misclassification of employees as independent contractors recovered more than $246 million in back wages for more than 240,000 workers.

When the Labor Department or the IRS finds violations, they will investigate all of a company’s employees and contractors for a three-year period. For each violation during the period, the company may face penalties such as:

• $50 for a Form W-2 that was not filed;
• Penalties of 1.5% of the wages, plus 40% of Social Security and Medicare taxes (FICA) that were not withheld from the employee, and 100% of matching FICA taxes that were not paid by the employer. Daily accrued interest may also be added;
• Penalty under Section 6651 for failure-to-file Form 941 employment tax return is 5% of the tax amount per month, up to 25%;
• If the IRS suspects intentional misconduct or fraud, there could be additional fines;
• Some states impose separate fines and imprisonments. In California, the fine per violation can range from $5,000 to $25,000.

What is the cost of making a mistake if the worker lives outside of the US?

There could be more liability under local laws. For example, in EU countries, you might have to pay at least four weeks of vacation and holidays per year, in addition to unpaid wages and taxes. In France, a bogus self-employment status can bring an employer fines and up to three years of imprisonment. Argentina and Peru have similar penalties.

US companies hiring foreign contractors can often face significantly more risks and liabilities in foreign courts if the contractors are determined to be employees.

An employee is entitled to severance pay under the termination clause, while an independent contractor can be terminated without additional compensation. Therefore, an unhappy contractor might pursue severance pay award in a local court, claiming an employee status. He is likely to get the award with sympathetic local courts and labor agencies around the world.

Don’t forget what happened to the company that had a conflict with a Brazilian freelancer. The sheer cost and effort of carrying on a lawsuit or dispute resolution in a foreign country can be a huge burden to a small company. It might cost you a lot just to find a trustworthy lawyer in a country you can’t even speak its language.

2. Learn how labor laws define ‘contractors’ and ’employees’ in the contractor’s country

In most countries (including the US), defining a worker as a contractor in a written agreement is not enough. Instead, countries look at the facts of the relationship to determine whether a worker is a contractor or an employee.

Even though countries have different standards for testing a work relationship, they tend to look similar. The goal of these standards is generally to examine how much control the company has over the individual it hires as an independent contractor.

In many countries, a contractor who works full-time, exclusively for one principal is a de facto employee. A long-term relationship also helps define an employment relationship. On the other hand, a contractor who provides his or her own office and supplies is more likely seen as an independent contractor.

Don’t assume that a worker who is a contractor in one country is also a contractor in another country. Each country follows their own laws to make the determination, and they are not always similar. One country might have unique criteria that don’t exist in other countries.

In some countries, a worker who signs non-compete or non-solicitation agreements is an employee, because these agreements are evidence of the employer’s control over the worker after termination.

If contracted workers do the same jobs that employees in the US do for the company, a foreign local government could find that this is an employer-employee relationship to protect their workers.

Make sure the worker you hired as an independent contractor is not an employee according to local laws, not just US laws. It is best to consult a local legal counsel to review how the work relationship can be interpreted by local laws, and what kinds of risks exist

3. Determine if your business has to report to the IRS or withhold tax on payments made to independent contractors.

If a business hires an independent contractor in the US, it is required to report payment over the annual total of $600 on Form 1099-MISC at the end of the year. To file 1099-MISC for US-based independent contractors, click this link and download the form.

For each contractor a company hires, a 1099-MISC should report the sum of all payments made during the year. A Form 1099 can be filed only on paper to the IRS, but there are services that will e-deliver copies to contractors and mail them to the IRS.

Until 2015, companies were required to send copies of this form to contractors by January 31 and to the IRS by March 31. However, the IRS announced on October 28, 2016 that employers should also file W-2’s (for employees) and Form 1099’s with the IRS by January 31, so that the IRS has plenty of time to spot errors.

Companies must also file a Form 1096 to summarize all 1099’s.

How to report payments made to non-US citizens living outside of US in general

Foreigners without US residency who made US source income should pay the same rates as US citizens, or 30%, depending on the type of income. A reduced rate or exemption can be applied if there is a tax treaty.

A US person or company paying a non-US citizen should examine facts whether the payment is US source income and report the amount to the IRS using Form 1042 and 1042-S, Foreign Persons’ US Source Income Subject to Withholding.

Should I report payments made to foreign independent contractors?

One of the conditions for a requirement to file Form 1042 and 1042-S is that a foreign person should have US source income.

The IRS provides guidance on how sources are determined for different types of income for foreign persons. Foreign independent contractors earn income by providing personal services. According to the IRS, the source of personal services income is determined by where services are performed. Therefore, even if a foreign person works for a US company, the income he or she receives is not US source income as long as service is performed outside of the US. As a result, a US company is not obligated to withhold or report taxes if the contractor does all his work outside of the US.

If a foreign contractor performs any part of his service in the US, certain conditions should be met to avoid tax obligations.

4. Which of the following cases applies to your ‘hiring independent contractor’ situation? Tax Implications for different ‘Employer – Independent Contractor’ cases for US companies

Case #1: A US company pays a foreign independent contractor living in another country

As the foreign contractor will perform all the services in his country, he does not have US sourced income, and the US company does not have to report to the IRS payments made to the contractor. If the company hires a Canadian contractor who lives in Canada, it does not have to withhold or report taxes to the IRS. The contractor only needs to pay Canadian tax on his income received from the company.

 

Action Required

• No need to withhold or report payments made

Case #2: A US company pays a foreign independent contractor, who lives in the US and has a visa that allows her to work in the US

The visa status itself does not determine whether a foreign contractor should pay tax on compensation. It is the place where service is performed that determines the source of the income.

If the foreign national lives in the US and performs the service in the US, the company must withhold tax at the rate of 30% before compensation is made to the contractor.

However, there are two exceptions to this rule. If the contractor is a resident of a country that has a tax treaty that allows withholding exemption, such as Canada or Mexico, the withholding amount can be reduced or eliminated. The contractor should claim this exemption by submitting Form 8233 to the hiring company.

The second exception is when a contractor stays in the US for a long time and becomes a resident by meeting a substantial presence test without a residence visa. The formula to determine substantial presence is complicated because days in different years weigh differently. But if the contractor stays more than 31 days during the current year and more than 120 days in any preceding years, he is at risk to be taxed as a US resident. If the international contractor is considered a US resident, his compensation will be withheld at the same rate as US residents, instead of 30% for non-residents.

 

Actions Required

• Withhold tax before compensation is made to a foreign contractor
• File Forms 1042, 1042-S and 1042-T (summary of 1042-S) by March, 15th of the year following the year subject to filing.
• Request a contractor to submit Form 8233 to claim exemption

Case #3: A US company pays a foreign independent contractor who is currently in the US without a visa that allows him to work for US companies

Hiring a foreigner without a proper work permit can subject the company to various fines and penalties by US Immigration and Customs Enforcement. However, Canadian and Mexican citizens can work temporarily, without a visa for providing professional services.

Setting aside the work permit issue, a foreign contractor working in the US should pay tax on his US sourced income. If his country has a tax treaty with the US, he will be able to claim exemptions by filing Form 8233.

 

Actions Required

• Resolve a work permit issue to avoid fines and penalties
• Withhold tax before compensation is made to a foreign contractor
• File Forms 1042, 1042-S and 1042-T (summary of 1042-S) by March, 15th of the year following the year subject to filing.
• Request a contractor to submit Form 8233 to claim exemption

Case #4: A US company pays an independent contractor who is a US citizen living in another country

A US citizen is subject to the same tax rules wherever he lives. Even if the service is performed outside of the US, and the contractor spends sufficient time to become a tax resident of another country, he will be a US citizen in the eyes of the IRS. Therefore, the company should issue a Form 1099 as it would to any US resident contractors.

 

Actions Required

• No need to withhold tax before payments.
• File Forms 1099 and 1096 by January 31st of the year following the year subject to filing.

 

Case #5: A US company pays an independent contractor who is a US citizen living in the US

The company will issue a Form 1099 for payments made to a contractor.

 

Actions Required

• No need to withhold tax before payments.
• File Forms 1099 and 1096 by January 31st of the year following the year subject to filing.

Case #6: A US company pays a US LLC, which is owned by a foreign national living in another country

Many companies may assume they can issue a Form 1099 to a US LLC. However, the IRS will not regard a US LLC as a separate entity for federal tax purposes if it has a single owner.

The same rule applies when the owner of the LLC is a non-resident foreign national. The payment is made to a foreign contractor, not a US LLC in the eyes of the IRS. Therefore, the employer should consider withholding based on where the service was performed, and whether tax treaty exemptions can be applied.

 

Actions Required

• Determine if tax should be withheld
• If no withholding is required
• no need to withhold or report payments
• If withholding is required
• Withhold tax before compensation is made to a foreign contractor
• File Forms 1042, 1042-S and 1042-T (summary of 1042-S) by March, 15th of the year following the year subject to filing.
• Request a contractor to submit Form 8233 to claim exemption

Keep in mind that the above case studies assume the foreign worker is an independent contractor. If facts suggest a foreign worker is actually an employee, and you are paying foreign employees instead of contractors, different rules apply.

5. Have foreign contractors complete IRS Form W-8BEN

When a US company hires independent contractors who are US residents, it should have contractors complete Form W-9.

The equivalent form for overseas contractors is W-8BEN. Even though companies do not have to report foreign contractor payments to the IRS, they should have foreign contractors complete Form W-8BEN (for individuals) or W-8BEN-E (for entities).

These forms are used to establish status as a foreign person or entity. The paying company is entitled to rely on the claims made on these forms to determine tax reporting and withholding obligations.

The company can be subject to various federal and state penalties for not withholding tax before payment is made to a contractor. These penalties can have especially serious consequences, because you can be personally liable.

Therefore, make sure to get the W-8BEN completed by the foreign contractor. If the information on the form is different from facts, and the worker does not qualify as a foreign contractor, the company is not liable for failing to meet tax requirements.

Form W-8BEN and W-8BEN-E are valid from the date they are signed until the last day of the third calendar year, and should be updated beyond the three-year period.

Click here to download Form W-8BEN.

6. Learn the nuances of local tax laws related to independent contractors

We discussed earlier how different countries’ labor laws can use different criteria to distinguish contractors from employees.

This applies to tax laws, as well. How tax laws treat payments to contractors can be different from one country to another.

Tax agencies in most countries do not require hiring companies to report payments made to contractors. If the company is not a resident of a country and has no permanent establishment in the country where a foreign contractor is a resident, there will be no need to report or withhold taxes.

However, keep in mind that permanent establishment can be easily triggered by signing a contract in a country, or having a regular place of business, even for a short time. Local tax agencies may easily find grounds to impose taxes on foreign companies.

A small number of countries have enacted laws to protect independent contractors and require companies to provide benefits or payroll withholdings. For example, France has designations called portage salarial and auto-entrepreneur for self-employed freelancers who are autonomous, but each of their principals may have to make payroll withholdings and contributions similar to those of a regular employer.

In Spain, an economically dependent contractor who has one client from whom he devotes more than 75% of his full-time effort is entitled to benefits, such as 18 days annual paid time off and severance pay.

In Romania, starting in 2017, companies hiring individual contractors should pay the same payroll taxes as they would hired employees. One way to avoid this is to hire contractors who have a service provider status, for which they must apply.

In order to avoid these liabilities and penalties under local laws, it is important to talk to a professional who is familiar with the foreign country’s tax treatment of independent contractors before hiring.

Additionally, it is a good idea to specify the contractor’s duty to comply with local tax requirements in a contractor agreement, and request a proof of tax compliance.

7. The benefits and risks of hiring a domestic or foreign independent contractor

Companies that hire independent contractors, whether locally or globally, are often motivated by financial reasons. Hiring independent contractors is a lot less expensive than hiring employees with less costs of employee benefits, office space and equipment.

And, companies get even more discounts when they hire from other countries with better exchange rates and lower costs of labor. Money saved from hiring can be invested back into growing the business.

Here are other benefits of hiring an independent contractor.

• You have greater staffing flexibility. It is easier to hire contractors for specific tasks or projects and let go of them when the job is finished or it isn’t a good match. You don’t have to face expense and potential legal trouble of firing employees.
• You can increase productivity. Contractors often bring specific skills to the company to accomplish specific goals and don’t need to be trained before being fully productive like full-time employees.
• You have less exposure to lawsuits. Employees have many rights under laws and can easily make legal claims against employers. For example, they have rights to minimum wage and overtime compensation, protection against discrimination and they can sue employers for wrongful termination. On the other hand, the relationship with a contractor is viewed more as one between businesses and does not have the same rights as employees. A well drafted contract can prevent most of issues with an independent contractor.

As we have discussed earlier, hiring an independent contractor can carry certain risks that don’t exist in employment relationships. The biggest risk is the government scrutiny. The IRS and Department of Labor are fully aware that companies hire contractors to save taxes, and have been aggressive in pursuing companies that issue many 1099’s.

Other risks you should consider when hiring an independent contractor are:

• You have less control over how work is done. Unlike employees, you cannot closely supervise how independent contractors work and cannot ask them to report specifics other than the work product. If you have too much control, you risk turning contractors into employees.
• You might have lack of consistency. Most of contractors are hired on project-basis or for short-terms and you can experience high turnovers for tasks that might benefit from long-term engagement.

In the case of foreign independent contractors, a chance of US government scrutiny might be lower, because a company doesn’t have to issue a 1099 to foreign independent contractors, and no tax is due from the foreign contractors. However, companies should be aware that now they are dealing with foreign labor and tax laws. Companies hiring foreign contractors can  experience difficulty in controlling quality of work because of language differences and lack of face-to-face communication.  

8.Prepare an iron clad contractor agreement that meets legal requirements of all countries involved

Having a solid written agreement is crucial when you hire a foreign contractor. Language barriers and cultural differences can often create miscommunication that can be avoided by putting agreed terms in writing. Your agreement should also take local labor and tax laws into consideration, so it is not invalidated by mistake in the future.

To prevent costly and time-consuming disputes in foreign countries, the agreement should clearly state the scope of services and compensation. It should also indicate the contractor’s independence and the hiring company’s lack of control regarding how the contractor performs the work.

Additionally, a typical contractor agreement contains:

• Confidentiality and/or non-disclosure clauses protect the company’s information from disclosure or misuse by contractors;
• Indemnity clauses protect the company from being liable for any violation or infringement by a contractor;
• Intellectual Property Transfer clauses transfer copyrights from a contractor to the company. In the US, independent contractors own the rights to the work done for the principal, unless it is transferred in writing. In some countries, certain intellectual property rights stay with creators and cannot be transferred, even in writing. International independent contractor agreements should reflect local laws related to intellectual property ownership;
• Notice clause—Too often, contractor agreements mirror at-will employment agreements, where either party can walk away at any time, without reason nor notice. It could result in interruptions in business if the company relies on contractors for important tasks. Include a clause that requires a written notice in advance by either party terminating an agreement;
• Dispute resolution clauses are about resolving disputes when they arise. When multiple countries are involved in the work relationship, selecting governing laws and a forum in advance can save a great deal of time and resources in future litigations. Parties can also choose to have alternative dispute resolutions, such as mediation or arbitration, instead of lengthy litigations. Make sure to determine if the contractor’s country of origin requires the use of local laws and courts in work agreements.

It is important to understand that a contractor agreement between parties in different countries should meet the requirements of laws of all involved countries. What is true in one country is not always true in another country. Seek out the help of a local counsel, and have him collaborate with your counsel in your home country.

A well-drafted contract can save you a lot of money and trouble in the future, especially in cross-border matters. In the Brazilian freelancer case we discussed in the introduction, the Brazilian court considered the terms of the contract between the business owner and the worker as the most important factor. 

9. An employer’s guide to avoid turning independent contractors into employees

Even though the way a contract defines the work relationship is an important piece of evidence, most courts around the world look beyond the terms of the contract to determine the actual relationship.

Therefore, it is important that the facts support the principal-contractor relationship, showing that a contractor is autonomous, without the principal controlling how and when the work is done. Each country has different criteria to make a determination, but here are some ideas to support a contractor status.

• Avoid an exclusive relationship. Allow a contractor to have multiple clients other than your company;
• DO NOT have a work schedule set by your company;
• DO NOT have a training system or supervision;
• DO NOT require reporting on tasks or metrics;
• Let contractors provide their own supplies and tools;
• DO NOT provide any employment type benefits (pension plan, insurance and vacation pay) outside of agreed payments;
• DO NOT provide reimbursement for incurred costs;
• DO NOT hire a contractor to perform a key aspect of your business.

Many companies believe they don’t have any risks because their contracts specify a principal-contractor relationship and the terms of the relationship clearly. Unfortunately, a written contract is not a cure-all for issues arising out of the unique work relationship. Judges around the world will give more weight to facts over a written contract.

10. How to pay international independent contractors

One of the common challenges we have seen US companies face when they hire international independent contractors is sending money to foreign countries. Fees are higher and the process can involve more steps.

Even though PayPal is available in 202 countries as of December 2016, you cannot use it in some countries with many talented workers. International wire transfer is often the only option. Wiring money internationally is not a very cost-effective method of payment, because both the sending and receiving banks charge high fees. Banks also have different exchange rates, and a receiving contractor can lose money in the exchange rate.

The best way to send money to overseas independent contractors is still PayPal. The payment receiver fees are 2.9% + $0.30 in the US and 3.9% + exchange fee for payments made internationally. Some companies prefer PayPal because it allows payment through a corporate credit card.

PayPal also has a more advanced business solution called PayPal MassPay, which has to be setup separately. Once setup, payments can be made to multiple payees by uploading a file with all of their information simultaneously. The fee is paid by the sender. MassPay has even lower fees than regular PayPal. To send money to a receiver in the US, it only costs a maximum of $1, while it costs a maximum of $20 for an international receiver.

TransferMate is another good service. It doesn’t charge a sender for initiating an international wire transfer. The service is currently available in the US, Canada and a handful of European countries. Some other well-known payment service providers are Payoneer, Skrill, BrainTree, Alipay and Xoom. If both parties are familiar with Bitcoin, it can be a fast and easy payment solution, as well.

11. Other things to consider when you hire a foreign independent contractor

We discussed the legal intricacies of hiring a foreign independent contractor. To sum up, meet the definition of a contractor, both in the US and the country of the contractor; examine the facts to see if there is any US tax withholding and reporting liability; confirm the contractor is tax compliant in his or her country.

Most of all, a solid contractor agreement that takes both legal systems into account will serve companies well.

What are some other things a company should be aware when they hire contractors internationally?

• Keep good records of payments made to foreign contractors in order to record business deductions. Often, the only record will be your well-kept internal bookkeeping, because there is no Form 1099 filed;
• Where candidates are located matters—even if you find great talent, the location and time difference could make working together less efficient;
• Communication is often more challenging with cultural and language differences;
• Learning about local laws and cultures will pay off greatly for any company hiring a foreign worker. Don’t assume things are the same as in the US;
• Have a recruiting procedure to find qualified workers. It could be difficult to fact-check foreign resumes. Have references thoroughly checked. Consider having a video interview;
• In the same way, have a procedure to monitor work done by a contractor. A remote work relationship can be seen as more casual by some workers. Upwork has time-tracking features. There are other tools to monitor remote workers, such as Hubstaff.

12. BONUS: When your foreign contractor starts to look like an employee

Your business might be more concerned about the status of contractors when it expects to have certain control over them, or if the relationship becomes full-time or long-lasting.

When the business is ready to hire workers as employees, it should be aware of different tax withholding and reporting rules in the US and the country of an employee’s residence.

Generally, if a foreign employee provides a service entirely outside of the US, there is no withholding requirement. However, if a foreign employee works in the US, his income tax should be withheld at the same graduated tax rate as US residents, including Social Security and Medicare tax. The tax withholding can be exempt if the employee’s country has a tax treaty with the US, and he claims the exemption through the form 8233.

One issue a US company should be aware of is that it could be inadvertently subject to a foreign country’s income tax by creating permanent establishment in that country. Permanent Establishment means that the business has stable and ongoing business activities resulting in locally created income. In many countries, having employees, especially ones who are involved in sales activities, can be interpreted as a sufficient ground to create permanent establishment. Each country defines permanent establishment differently, with some countries more strict than others. Therefore, it is important to consult local tax specialists before hiring employees in a foreign country.

One way to avoid permanent establishment would be to hire contractors who are incorporated in their local country. A business-to-business contract is more readily interpreted as a contractor relationship in many countries.

A business can also hire individuals as leased employees through a temporary agency, or a partner business in the country of origin, who hires them as employees. Then your business can have a contract with a local company offering the services of a contractor.

Conclusion

Working with foreign independent contractors provides many advantages for growing businesses. By paying attention to the above issues before hiring, a business will be able to prevent costly legal troubles in the future. It is always a good idea to have payment and other work-related records in writing. If a business expects an extended relationship with a contractor, it needs to take further steps to consult local lawyers regarding labor laws, or hire the worker as an employee.

Navigating a cross-border contractor relationship or employment can be overwhelming for small businesses. Schedule a time to talk with us to identify the best ways your business can prevent risks and maximize growth.

We want to hear from you.

Do you have any legal question about hiring a foreign independent contractor that I didn’t cover in this guide? Email at info@jiahkimlaw.com or Call 646-389-5065.
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