Germany: 170. Tax and Social Insurance Status of "Sham" and "Quasi-Dependent" Freelancers

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With effect from 1 January 1999, the new government of Social Democrats and Greens has enacted legislation which threatens to have considerable negative impact on certain self-employed individuals, especially those who work for a single principle client (Law for Correction of the Social Insurance System and the Protection of Employee Rights of 19 December 1998). Like the changes made in the field of low-paying jobs, the new rules have encountered stiff opposition from industry and the affected individuals.

In considering the new rules, it is important to bear in mind that Germany has no provisions equivalent to the "self-employment tax" in the United States and, with minor exceptions, does not require self-employed individuals to pay into any statutory pension plan.

The new rules will not apply to individuals covered by the social security system of a foreign country with which Germany has a social insurance treaty or to individuals who are subject to the social security jurisdiction of another EU member state by the terms of EU Ordinance 1408/71.

A provision in the laws governing the social insurance system (sec. 7 (4) SGB IV) has been changed to raise a rebuttable presumption that individuals nominally working on a freelance basis for a client are in fact the latter's dependent employees if any two of the following four tests are met:

• The individual does not have any dependent employees of his or her own who are subject to the public social insurance system. Members of the individual's extended family are disregarded for purposes of this test.
• The individual works "regularly and essentially" (regelmässig und im wesentlichen) for a single client. This requirement is met if five sixths of the individual's total income is earned from a single client. Companies belonging to the same corporate group are treated as a single client for purposes of this test.
• The work performed is of the sort typically performed by dependent employees.
• The individual does not offer his or her services on the general market as would an independent entrepreneur.

The above rules do not apply to commercial representatives (Handelsvertreter as defined in sec. 84 HGB) who organise their own activities independently for the most part and are able to fix their own working hours.

No change has been made in the underlying substantive legal distinction between a dependent employee and a freelancer. Instead, by raising a rebuttable presumption, the law shifts the burden of proof on this issue to the individual (and his or her clients) under the circumstances set forth above. While it is still possible in theory to rebut the presumption by presenting evidence of all relevant facts and circumstances, the expectation is that the presumption will be difficult to rebut in practice wherever it arises.

Persons nominally working as freelancers who are in fact dependent employees are commonly referred to as "sham freelancers" (Scheinselbständige).

The consequences of reclassification of a nominal freelancer as a dependent employee are highly disadvantageous for the person who, by reason of the reclassification, is regarded as the individual's employer for social insurance purposes. In situations in which the individual has worked for a single client, this client is the person who risks being treated as the individual's employer. If the nominal freelancer has worked for several clients, but nevertheless is reclassified as a dependent employee, he or she would appear to be the dependent employee of several employers at the same time. Hence, the negative consequences would be suffered by several employers.

Essentially, a client found in retrospect to have been the employer of an individual improperly treated as a freelancer is required to pay social insurance contributions on the individual's behalf not only in the future, but for the past as well. The obligation can extend backwards in time for several years and applies not only to the contributions which the employer would have owed had the relationship been treated properly from its inception, but also to the contributions owed by the employee, i.e. half of total contributions. Since total contributions currently exceed 40 % of an employee's wages, the back payments can be very substantial indeed.

Even if the employment relationship still continues, the employer's ability to pass half of this cost along to the employee is limited by law, generally to what can be deducted from the employee's salary in the three months following recognition of the misclassification. If the employment relationship has already terminated, the employer has no recourse whatsoever and can, in particular, not sue the employee for reimbursement of half of the social insurance arrearages paid by the employer.

Typically the employer bears virtually the full cost in such situations. The employee enjoys a windfall benefit at least with regard to the pension insurance payments made on his or her behalf, as these lead to accrual of pension insurance claims.

The distinction between dependent and independent employment is significant for tax purposes as well. A freelancer is generally required to remit VAT with regard to sums invoiced to his or her clients. Clients are generally entitled to an input tax credit for this VAT, if separately invoiced, which is almost invariably the case. If the individual is discovered to have been a dependent employee, the input tax credit is forfeited retroactively by the client, who is now seen as an employer. The individual remains obligated to remit to the tax authorities all VAT separately invoiced. The net result is that the employer loses the input tax credit and hence has additional cost in this amount, whereas the employee is probably no worse off than before.

While there is no legal prohibition on seeking to recover the VAT amount from the employee, the legal grounds of such an action are unclear. No claim for unjust enrichment would appear to lie as long as the employee has paid the VAT invoiced to the tax authorities, because in this case there is no net enrichment of the employee. In any event, recourse against the employee is often impossible as a practical matter.

A case is currently pending before the European Court of Justice posing the issue of whether forfeiture of the input tax credit in this and other situations is compatible with EU law.

Besides the negative VAT consequences, the client/employer may also be liable for failure to withhold income tax (wage tax) from the sums paid to the sham freelance employee. This liability is relevant whenever the employee has not paid the income tax owing on such amounts. Once again, the employer's exposure is potentially considerable.

It is not clear whether the rebuttable presumption raised for social insurance law purposes also applies for tax purposes. Since distinct bodies of law involved, this would not appear to be the case. The tax risk as a practical matter remains high, however, since reclassification for social insurance purposes seems likely to prompt close scrutiny for tax purposes as well.

It is not clear whether the tax and social insurance authorities will exchange information with each other in this regard.

It is not clear whether the rebuttable presumption raised under the new law first applies to periods from 1999 onwards or to prior years as well. Since the change is procedural in nature, not substantive, the reversal of the burden of proof may well apply to years prior to 1999.

Before assigning work to small freelancers, especially those who have no dependent employees of their own and are likely to fulfil two or more of the tests set forth above, clients should consider their chances of rebutting a presumption of a sham freelance arrangement. Even if these appear good, it is important to document the factors indicative of a genuine freelance arrangement from the start. For instance, information on the extent to which a freelancer works for other clients and is visible on the general market should be gathered prior to issuance of a contract. Non-competition clauses should probably not be included in contracts with small freelancers.

A procedure also exists whereby freelancers who have doubts as to their status may request a ruling from the appropriate social insurance authorities. Clients may wish to consider requiring certain of their freelancers to obtain such a ruling.

A reasonable chance appears to exist that changes will be made in the social insurance legislation in response to the considerable political protest. Certain industries, e.g. the software programming industry, have argued that the effects of the law in its present form will be devastating for their businesses. The government has indicated willingness to correct its legislation if undesired consequences become evident.

It is still too soon, however, to speculate as to what revisions might be made.

The term "quasi-dependent freelancer" must be distinguished from that of "sham freelancer". "Quasi-dependent freelancer" (arbeitnehmerähnlicher Selbständiger) refers to individuals working in an independent (self-employed) capacity who meet both of the following tests:

• They have no dependent employees of their own who are subject to the public social insurance system, except for family members; and
• They work regularly and essentially for a single client.

It should be noted that individuals who meet the above two tests will also be presumed to be dependent employees under the rules set forth in sec. 1 above. Hence, the classification as "quasi-dependent freelancer" can only occur in cases in which the presumption has been rebutted, since otherwise the basic requirement of working in an independent capacity would not be met.

The consequences of classification as a quasi-dependent freelancer differ greatly from those of classification as a sham freelancer. Quasi-dependent freelancers are required to pay into the statutory pension insurance system at the standard rate, currently 19.5 % of annual income up to an income ceiling which is adjusted each year (currently DM 102,000 / DM 86,400 per year in the old and new German states respectively).

The clients of quasi-dependent freelancers are not treated as employers. They have no withholding obligations. The pension insurance contributions are owed solely by the freelancer.

The new law contains opt-out provisions for freelancers who were in business prior to 1 January 1999. Freelancers 50 years of age and older on 2 January 1999 may opt out of the new rules unconditionally.

Freelancers under this age are permitted to opt out provided they had contractual pension insurance (such as whole life insurance) with a public or private insurance carrier on 10 December 1998. If such insurance is not equivalent to public pension insurance, additional insurance must be taken out by 30 June 1999. Equivalence is determined in part with respect to the cost of this contractual pension insurance, which must be at least equal to the payments which would be required under the public pension insurance system.

The election to opt out must be exercised in both cases by 30 June 1999 by application to the public pension insurance authorities.

The statutory changes discussed in this article are regarded by some as stopgap measures constituting a poor substitute for the lack of a statutory self-employment tax or compulsory membership of all self-employed individuals in the general public pension insurance system. However, there is no apparent willingness to take such a radical step at this time.

The new legislation is harshly criticised and may be revised in certain respects in the foreseeable future. It may also be challenged on constitutional grounds.

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