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Peculiarities of labor relations in the field of IT. Risks of work with FOP (individual entrepreneurs) and requalification of civil law contracts into employment contracts

30/ 01/ 2017
  Author: Nataliia Mysnyk  - Attorney at Law, Senior Associate of the Litigation practice at GOLAW Peculiarities of documenting labor relations in IT companies There is an unspoken rule on the IT market: the more successful is a business, the more frequent are tax audits. The main claims on the part of inspectors are: • understatement personal income tax obligations by IT companies and • understatement of payroll subject to unifies social tax (UST). It should be admitted that such claims are not unfounded. Indeed, in order to optimize taxation IT companies often use shadow remuneration for their employees. Usually it looks as follows. Personnel of a company is registered as Individual Entrepreneurs (FOP) and single tax payers of Group 3. Then such FOR being single tax payer enters into a civil law contract with the company (though in fact acting as an employee). Upon receipt of remuneration, FOPs declare it and pay their taxes at the rate for FOPs (for Group 3 it is 5%, net of VAT), thus, reducing the tax burden of their employer. Of course, this scheme is convenient for business. Tax authorities, however, do not recognize such transactions considering them fictitious, and charge additional tax liabilities to the company for payment of personal income tax and UST. The basis for an unscheduled tax audit in such cases shall be p. 78.1.13 of the Tax Code of Ukraine (TCU), according to which an audit may be conducted if any information is received on wage tax evasion, including cases of a failure to enter into employment contracts with hired employees. In addition to audits, such operations shall also entail penalties for violation of labour laws. Thus, for instance, according to Article 265 of the Labour Code of Ukraine: for the actual admission of an employee to work without execution of an employment contract and payment of salary (fee) without assessment of taxes and levies a company may be charged a fine of 30 minimum wages, which currently equals to UAH 96,000. The body authorized to charge such fine is the State Employment Service of Ukraine. At the same time, the legislation does not specifies how exactly auditing bodies can establish the fact of existence of employment relations, and what evidence can they use in support of their conclusions. Therefore, generally, all disputes concerning the audit results end up in courts. Civil law contracts vs employment contracts When hearing labor disputes, courts primarily establish key differences between civil law and employment contracts. According to civil law contracts, FOP shall be free to act, be personally liable and be result-oriented. A contractor shall not be obliged to abide by codes of conduct, shall plan his/her time and arrange his/her work at his/her sole discretion. FOP, however, is deprived of any social protection. In the case of employment contracts it is the opposite: basic conditions are to abide by the code of conduct, perform job duties without reference to results and with low liability level. Differences in terms of working conditions According to the court, the main feature that distinguishes employment contracts from civil law contracts, is that labor law regulates the process of work, its organization, and in civil law contracts the process of work is outside the regulation and the aim of such a contract is to obtain some tangible result. For example, in its judgment dated April 15, 2015 the High Specialized Court of Ukraine for Civil and Criminal Cases did not declare the existence of employment relations, as it did not establish the fact of employment of the plaintiff to the specific position; clarification of the plaintiffs rights and obligations, informing against receipt of working conditions, benefits and compensations. The Supreme Court of Ukraine, in its judgment dated April 12, 2011, to the contrary, established the existence of labour relations, as in this case the customer arranged works: provided briefing, ordered access badges and issued salary cards. The State Tax Administration of Ukraine expressed its vision of the problem of differences between an employment contract and a civil law contract. Thus, in Letter No. 1558 / П / 17-0715 dated 29.03.2007 STA of Ukraine came to the following conclusions: “According to a service agreement, not the working process is paid for, but the specific result thereof, which is identified upon completion of work and documented in certificate of works completed (services rendered). At the same time, if a period and time of work performance is specified in the contract, as well as the daily provision of services, instead of a on-time service, then such contract shall have signs of an employment contract”. In order to enable companies using labour of FOPs to avoid tax risks, terms and conditions of civil law contracts must be clearly formulated: providing for independent business activity, mobilization of resources, non-continuity, application of penalties, clear identification of results of the works completed, etc. Differences in terms of the contract forms In addition to different terms and conditions, employment contracts and civil law contracts have also different forms. According to the Labour Code of Ukraine, no employee may be admitted to work without employment contract executed by the owner’s Order and notification sent to tax authorities. That is, for proper documenting of labor relations an order on employment must be issued and tax authorities must be notified of this fact. As regards civil law contracts, the legislation provides for them mandatory written form. Thus, Article 208 of the Civil Code of Ukraine specifies that all transactions between an individual and a legal entity must be executed in writing. The absence of a written contract on the part of a FOP shall entail the risk of recognition of the fact of employment relations. For example, in the judgment of Sumy District Administrative Court dated August 03, 2016 in Case No. 818/706/16 the court found: “Pursuant to p. 2 of part 1 of Article 208 of the Civil Code of Ukraine, transactions between an individual and a legal entity should be executed in writing. There was no written agreement between the parties. Therefore, as the civil law relations were documented, and the person was in fact allowed to work, the court considers justified the conclusions of the defendant on existence of labour relations between the parties”. Difference in terms of remuneration Another difference between labor and civil law relations is the procedure of financing them. Under an employment contract, payment is made systematically, usually twice a month (an advance payment and salary). In case of civil law relations, services are paid upon completion (in a lump sum). Therefore, if a civil law contract provides for strict schedule of payments, it is highly probable that such contracts will be declared employment contracts. Thus, for instance, Kyiv Administrative Court of Appeal, in its decision in Case No. 826/11822/15 stated that: during the investigation into the contents of civil law contracts, the inspectors came to the conclusions that such contracts meet the criteria of labor relations. Under such contracts, employees have been paid monthly remuneration in the form of an advance payment and salary simultaneously with the other staff employees of the company (the remuneration is deducted according to the delivery and acceptance certificate prepared once a month. At the same time, no advance payments by contractors are prescribed by civil law contracts). How to avoid risks In order to avoid risks of requalification of civil law contracts as employment contracts, companies should follow some simple recommendations: - to execute civil law contracts with FOPs in writing; - to take into account the fact that FOP’s activities must satisfy the conditions of a civil law contract; - to provide for a paragraph in the contract, according to which FOP shall be personally liable for performance of works and shall receive compensation depending on results thereof; - to avoid description of any social protection in the contract, either vacation, or sick pay or compensation of travel costs. It’s not an easy task to prove the existence of civil law relations with employees of IT companies. Subject to accurate preparation of documents, however, is quite real.

Author: Nataliia Mysnyk  – Attorney at Law, Senior Associate of the Litigation practice at GOLAW

Peculiarities of documenting labor relations in IT companies

There is an unspoken rule on the IT market: the more successful is a business, the more frequent are tax audits.

The main claims on the part of inspectors are:

• understatement personal income tax obligations by IT companies and
• understatement of payroll subject to unifies social tax (UST).

It should be admitted that such claims are not unfounded.

Indeed, in order to optimize taxation IT companies often use shadow remuneration for their employees.

Usually it looks as follows.

Personnel of a company is registered as Individual Entrepreneurs (FOP) and single tax payers of Group 3. Then such FOR being single tax payer enters into a civil law contract with the company (though in fact acting as an employee). Upon receipt of remuneration, FOPs declare it and pay their taxes at the rate for FOPs (for Group 3 it is 5%, net of VAT), thus, reducing the tax burden of their employer.

Of course, this scheme is convenient for business. Tax authorities, however, do not recognize such transactions considering them fictitious, and charge additional tax liabilities to the company for payment of personal income tax and UST.

The basis for an unscheduled tax audit in such cases shall be p. 78.1.13 of the Tax Code of Ukraine (TCU), according to which an audit may be conducted if any information is received on wage tax evasion, including cases of a failure to enter into employment contracts with hired employees.

In addition to audits, such operations shall also entail penalties for violation of labour laws. Thus, for instance, according to Article 265 of the Labour Code of Ukraine: for the actual admission of an employee to work without execution of an employment contract and payment of salary (fee) without assessment of taxes and levies a company may be charged a fine of 30 minimum wages, which currently equals to UAH 96,000. The body authorized to charge such fine is the State Employment Service of Ukraine.

At the same time, the legislation does not specifies how exactly auditing bodies can establish the fact of existence of employment relations, and what evidence can they use in support of their conclusions. Therefore, generally, all disputes concerning the audit results end up in courts.

Civil law contracts vs employment contracts

When hearing labor disputes, courts primarily establish key differences between civil law and employment contracts.

According to civil law contracts, FOP shall be free to act, be personally liable and be result-oriented. A contractor shall not be obliged to abide by codes of conduct, shall plan his/her time and arrange his/her work at his/her sole discretion. FOP, however, is deprived of any social protection.

In the case of employment contracts it is the opposite: basic conditions are to abide by the code of conduct, perform job duties without reference to results and with low liability level.

Differences in terms of working conditions

According to the court, the main feature that distinguishes employment contracts from civil law contracts, is that labor law regulates the process of work, its organization, and in civil law contracts the process of work is outside the regulation and the aim of such a contract is to obtain some tangible result.

For example, in its judgment dated April 15, 2015 the High Specialized Court of Ukraine for Civil and Criminal Cases did not declare the existence of employment relations, as it did not establish the fact of employment of the plaintiff to the specific position; clarification of the plaintiff’s rights and obligations, informing against receipt of working conditions, benefits and compensations.

The Supreme Court of Ukraine, in its judgment dated April 12, 2011, to the contrary, established the existence of labour relations, as in this case the customer arranged works: provided briefing, ordered access badges and issued salary cards.

The State Tax Administration of Ukraine expressed its vision of the problem of differences between an employment contract and a civil law contract. Thus, in Letter No. 1558 / П / 17-0715 dated 29.03.2007 STA of Ukraine came to the following conclusions: “According to a service agreement, not the working process is paid for, but the specific result thereof, which is identified upon completion of work and documented in certificate of works completed (services rendered). At the same time, if a period and time of work performance is specified in the contract, as well as the daily provision of services, instead of a on-time service, then such contract shall have signs of an employment contract”.

In order to enable companies using labour of FOPs to avoid tax risks, terms and conditions of civil law contracts must be clearly formulated: providing for independent business activity, mobilization of resources, non-continuity, application of penalties, clear identification of results of the works completed, etc.

Differences in terms of the contract forms

In addition to different terms and conditions, employment contracts and civil law contracts have also different forms.

According to the Labour Code of Ukraine, no employee may be admitted to work without employment contract executed by the owner’s Order and notification sent to tax authorities. That is, for proper documenting of labor relations an order on employment must be issued and tax authorities must be notified of this fact.

As regards civil law contracts, the legislation provides for them mandatory written form. Thus, Article 208 of the Civil Code of Ukraine specifies that all transactions between an individual and a legal entity must be executed in writing.

The absence of a written contract on the part of a FOP shall entail the risk of recognition of the fact of employment relations.

For example, in the judgment of Sumy District Administrative Court dated August 03, 2016 in Case No. 818/706/16 the court found: “Pursuant to p. 2 of part 1 of Article 208 of the Civil Code of Ukraine, transactions between an individual and a legal entity should be executed in writing. There was no written agreement between the parties. Therefore, as the civil law relations were documented, and the person was in fact allowed to work, the court considers justified the conclusions of the defendant on existence of labour relations between the parties”.

Difference in terms of remuneration

Another difference between labor and civil law relations is the procedure of financing them.

Under an employment contract, payment is made systematically, usually twice a month (an advance payment and salary). In case of civil law relations, services are paid upon completion (in a lump sum).

Therefore, if a civil law contract provides for strict schedule of payments, it is highly probable that such contracts will be declared employment contracts.

Thus, for instance, Kyiv Administrative Court of Appeal, in its decision in Case No. 826/11822/15 stated that: during the investigation into the contents of civil law contracts, the inspectors came to the conclusions that such contracts meet the criteria of labor relations. Under such contracts, employees have been paid monthly remuneration in the form of an advance payment and salary simultaneously with the other staff employees of the company (the remuneration is deducted according to the delivery and acceptance certificate prepared once a month. At the same time, no advance payments by contractors are prescribed by civil law contracts).

How to avoid risks

In order to avoid risks of requalification of civil law contracts as employment contracts, companies should follow some simple recommendations:

– to execute civil law contracts with FOPs in writing;
– to take into account the fact that FOP’s activities must satisfy the conditions of a civil law contract;
– to provide for a paragraph in the contract, according to which FOP shall be personally liable for performance of works and shall receive compensation depending on results thereof;
– to avoid description of any social protection in the contract, either vacation, or sick pay or compensation of travel costs.

It’s not an easy task to prove the existence of civil law relations with employees of IT companies. Subject to accurate preparation of documents, however, is quite real.

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