Sham Contracting: When Practical Shortcuts May Become a Legal Risk
This next article in my Practical Workplace Guidance for Employers series follows earlier articles about employee, contractor and labour hire arrangements and choosing the right engagement model and focuses on why getting that decision wrong can have legal consequences.
‘Sham contracting’ under the Fair Work Act 2009 is a risk for businesses deliberately doing the wrong thing, but it can also affect contractor arrangements used as a practical shortcut where the model cannot be genuinely justified.
In practice, I often see businesses looking for short-term resourcing solutions while they are growing, managing a downturn, waiting for funding certainty or trying to work within headcount limits. The pressures are commercially understandable. The issue is whether the model chosen actually reflects the work being done. In that sense, some contractor arrangements can start to look more like ongoing casual or employee arrangements, particularly where the work continues, the person becomes integrated into the team, and the business needs day-to-day control.
What the law is concerned with
In simple terms, sham contracting can arise where a worker is told or represented to be an independent contractor when they are an employee in the eyes of the law. The key point for employers is that the law is concerned with substance, not just labels.
A contractor agreement is relevant, but it is not the end of the question. The business also needs to consider whether the arrangement actually operates like independent contracting in practice.
Fair Work guidance explains that sham contracting may arise unless the business can prove it reasonably believed the worker was a contractor. It also identifies specific prohibitions, including knowingly making false statements to persuade an employee to become a contractor, or dismissing or threatening to dismiss an employee to engage them as a contractor to do the same or mostly the same work.
Why this can become expensive
Sham contracting risk can expose a business to the very obligations it was trying to avoid, including employee entitlements, superannuation, tax, workers compensation, notice, redundancy and termination-related claims.
There are also penalties under the Fair Work Act for breaching sham contracting provisions.
The practical cost can also be significant, as these can take management time, attract regulator attention, create legal costs and leave the business with less clarity about performance, exit arrangements, confidential information, work product and client relationships.
Where businesses can get caught
The risk often sits in the gap between the reason for the arrangement and the reality of the work.
- A contractor is engaged because of a hiring freeze, but the person is filling an ongoing role.
- A contractor is used because payroll and employment administration feel difficult, but the business still wants regular hours, close supervision and control over how the work is done.
- A contractor starts with a defined project, but the engagement keeps being extended and the person becomes part of the ordinary team.
- A contractor invoices for services, but has little independence, commercial risk or ability to work for others.
- A business calls the arrangement consulting, but manages the person through the same reporting lines, systems and performance expectations as employees.
The reasonable belief issue
The key question is whether the business has a reasonable basis for treating the person as a contractor. The business must be able to explain, in practical terms, why the contractor model was appropriate. Questions to consider include:
- What are we buying — a role or an independent service?
- Why is this not an employee role?
- What independence does the contractor have?
- What control does the business need?
- What makes this arrangement different from employment?
If the answers are “it was easier,” “we wanted flexibility” or “we did not have headcount approval,” that may not be enough.
Managing the risk
For HR teams, recruitment teams and SMEs, the best time to manage sham contracting risk is before the arrangement starts, or before it is extended again. The following contractor review steps can help.
- Document the reason for the model
Record why contracting is appropriate, not just why it is convenient. - Define the service or outcome
Be clear about what the contractor is being engaged to deliver. - Check the level of control
If the business needs fixed hours, close supervision, internal reporting and ordinary performance management, employment may be the better model. - Check the day-to-day reality
Make sure the contract reflects what is actually happening, not the preferred label. - Review long-term or changing arrangements
If the work has become ongoing, integrated or similar to employee work, review whether the model still fits. - Get advice where the answer is unclear
Grey areas are common. The earlier the arrangement is checked, the easier it is to manage the risk.
These steps help test if the arrangement can withstand scrutiny if it is later challenged.
Final thought
Independent contracting is not the problem, using it for the wrong reason is. If the model cannot be genuinely justified, it is worth reviewing before the risk becomes expensive.