In Part 3 of our blog articles series on Key Employment Law Topics in Video Games M&A (see part 1 here and part 2 here) we will conclude the series by focusing on the regulatory and employment law environment in Germany with respect to the use of external workforce. Misclassification risks are the most common employment law-related “red flags” in video game transactions. Therefore, it is of vital importance to understand the legal consequences of misclassification and the necessary measures which should be taken immediately after closing in order to mitigate risks.
Freelancers in Video Games industry
When having read part 2 of our blog series on crunch and the potential legal consequences you might have come up with the idea of using freelancers: Instead of exceeding standard working hours of your existing internal staff, why not increase manpower with external workforce for a limited time period to flexibly cover workload peaks, in particular at the end of a game development process? Freelancers do not enjoy termination protection; they also do not fall under the strict EU rules on working time. Besides, most software developers do not want to be employees anyways but work only on a freelance basis. Even though such personnel sourcing alternative might appear attractive from a business perspective at first glance, the benefits do usually not outweigh the legal risks of a potential misclassification.
1. What does misclassification of freelancers mean?
A misclassification occurs, if two parties intentionally or by mistake qualify their contractual relationship as service contract, but actually have entered into an employment contract. Such a misclassification can have severe consequences, in particular for the target which turns out to be the employer of the service provider/employee.
The reason, why misclassifications exist, is that the classification of a contractual relationship does not only depend on the intent of the contracting parties, but is also determined by law. The law intends to protect employees and thus grants employees certain rights to ensure such protection. Those rights shall not be circumvented by an employer forcing an individual into a “false” self-employment relationship, although such individual providing services is in fact personally dependent on his (only) “customer”, i.e. the employing company, similar to an employee. Freelancers (and their customers accordingly) are exempted from certain social security contributions such as the statutory pension scheme. Statutory pensions in Germany are financed by contributions of both employees and employers. The social security carriers have an interest that all employees and employers pay their contributions. The same goes for taxes: freelancers enjoy certain privileges when it comes to taxation. Only real freelancers shall benefit from these privileges. Therefore, the question whether the contract entered into between the parties is in fact an independent service contract or an employment contract, is not only of interest for the contracting parties, but also for the state and its taxpayers.
2. How are freelancers/employees classified?
The methodology of classifying employees/freelancers in Germany is similar to those in other countries. Whether the use of external staff results in a misclassification depends on the individual case. Unfortunately, it is often difficult to reliably assess the correct classification. According to case law, whether an occupation is carried out on an employed or self-employed/freelancer basis is decided within the framework of an overall assessment. The contractual arrangement and description of the activities in the contract is one important piece of classifying the contractual relationship, but not the decisive element. The decisive element is how the contractual relationship is actually implemented in practice.
Relevant criteria to assess the status of the freelancer
In order to evaluate the relationship in practice, courts have – over the last decades – developed certain criteria which are relevant for assessing the status. The following example criteria indicate the existence of an employment relationship:
- low complexity tasks;
- integration of freelancer into the business unit of the target
- close collaboration with employees of the business unit
- working together as team members of the employee;
- working on-site;
- using/working with operating resources of the target;
- remuneration per time and not per product;
- giving instructions to or receiving instructions from employees of the target;
- performing work which is usually done by the target’s employees;
- involvement in daily business tasks;
- freelancer is engaged because of capacity bottlenecks (such as seasonal demand, employees on sick or parental leave, interim position);
- work product of the freelancer cannot be distinguished from work product of the target and/or its employees.
Criteria in tech and video game business environment
Taking into account the above-mentioned criteria, the issues IT companies are facing when using IT freelancers become apparent. Many criteria which indicate an employment relationship actually do apply to IT freelancers because of the nature of the services they provide. IT freelancers such as software developers do not need capital-intensive work equipment except for their computer. Their profession is driven by communication and requires close collaboration with internal staff. If both freelancer and target apply agile work methods, such as Scrum, the collaborative and interactive nature of the work assignment becomes even more apparent; it then becomes difficult to distinguish the work product of the freelancer from the internal workforce’s work product. If – in addition – the target hires freelancers because of bottlenecks in development and higher workforce demands, only few arguments for qualifying the relationship as an independent service contract remain.
3. Using intermediaries to mitigate risks?
Some companies are trying to mitigate these risks by not engaging freelancers directly, but via agencies. Such a contractual setup does not mitigate the risk, if the freelancers are not employed by the agency as employees, but are engaged by the agency as self-employed subcontractors. Reason is that such a self-employed subcontractor will then nevertheless be regarded as employee of the agency, if the above-mentioned criteria apply, i.e. the subcontractor is integrated in the business of the target. One might think that this is not the problem of the target, but instead of the agency. However, this is not correct: the integration of the subcontractor into the business of the target will in most cases be considered as unlawful labor lease with the result that the target is deemed to be the employer of the subcontractor.
4. Consequences of misclassification
If the freelancer is reclassified to be an employee of the target, the target /employer will likely neither have paid social security contributions nor withheld income tax in relation to the freelancer, who in fact was an employee. If the freelancer’s services were subject to VAT, the target has likely also deducted input tax. If it turns out that the services were actually services performed by an employee, the target has to reimburse the input tax to the tax authority. The target can – to the extent possible – take recourse against the freelancer. The same applies to income tax. The target, if considered to be an employer, is also liable to withhold and pay to the tax authorities the income tax to be paid by the employee on the remuneration received from the employer. Again, the employer can take recourse against the employee.
However, in most cases the employer cannot take recourse against the employee with respect to social security contributions and this applies to both, the employee’s and the employer’s portion of the social security contribution. The social security contributions amount to roughly 40% of the salary amount (20% for the employee’s portion and 20% for the employer’s portion). In case of intentional misclassification, the basis for calculating the social contributions usually doubles because the agreed salary is deemed to be a net amount by operation of law. Furthermore, the employer has to pay 1% of the monthly social security contributions as late payment fine per month. It is not uncommon that the late payment fines put affected companies at risk of insolvency.
The following example should illustrate the severe consequences:
- An intentionally misclassified freelancer was hired for a full calendar year and received EUR 19,608.00 in total. This amounts to EUR 1,634.00 gross per month.
- Since this would be a case of intentional misclassification this amount will be considered as net payment which needs to be grossed up adding applicable income tax. A monthly net amount of EUR 1,634.00 results in a gross extrapolated amount of EUR 3,703.77 per month based on tax class VI.
- This amount will be the basis for calculating the social security contributions which are approx. 40% of the gross amount, i.e. about EUR 1,481.51 per month or EUR 17,778.12 for the whole calendar year. If the relevant person had been hired as employee instead of as freelancer from the beginning for a salary of EUR 1,634.00 gross per month, the company’s payment obligation for social security would have been limited to the employer’s portion, i.e. of EUR 326.80 (= EUR 3,921.60 per year).
- This is not the end: The social security contribution amount of EUR 1,481.51 will be subject to a late payment fine of 1% per month, i.e. EUR 14.82 for each month per salary. This adds up from month to month (EUR 14.82 x 12 + EUR 14.82 x 11 + EUR 14.82 x 10 etc.), so that after one year there is already a late payment surcharge of about EUR 1,155.00.
- In the end, the company will in addition to the originally agreed amount of EUR 19,608.00 have to pay social security contributions in the amount of EUR 17,778.12 as well as late payment penalties of EUR 1,155.00. In total this is almost five times as high as the payments the company would have had to pay if the company had hired the freelancer as employee and processed the payments correctly. In addition to the social security payments, the company is liable for income tax not paid by the freelancer and the company may have to back pay erroneous input tax deduction if the services were in fact not subject to VAT.
Furthermore, since the freelancer is deemed to be an employee of the target, the freelancer might enjoy statutory termination protection and could claim minimum statutory vacation which is one monthly salary per year in Germany.
In addition to the financial risks, intentional misclassification is a criminal offence in Germany. The threshold for intent is quite low as so-called “conditional intent” suffices. Such conditional intent is fulfilled if the employer could have realized the possibility of a misclassification risk, but has nonetheless entered into the contractual relationship on a freelance basis. The authorities are very strict in this respect, because social security laws provide for a so-called status assessment procedure. Prior to engaging a freelancer the target has to possibility to ask the competent authority to assess the status of the freelancer. Therefore, courts argue that the target could have verified the status before entering into the contractual relationship. If the target has not used this possibility and has not implemented a compliance system which is equally robust as the status assessment procedure, the authorities are likely to argue that the target and its representatives acted with conditional intent.
5. How to deal with misclassification risks in an M&A setting?
Due diligence to focus on freelancer agreements and integration of freelancer
Given that the classification of freelancers as employees mainly depends more on the factual circumstances and less on the type of agreements in place, the legal due diligence regarding the use of freelancers can only be limited. In light of the time and cost constraints in an M&A transaction, a reasonable due diligence should focus on the thorough review of the freelancer agreements and in addition request information on how such freelancers are integrated into the business of the target.
Seller should be requested to provide copies of the freelancer agreements. Additionally, Purchaser should ask Seller specific questions regarding the scope of the work performed by the freelancer and the integration of the freelancer into the target’s day to day business.
Misclassification risks are typically addressed in the representations and warranties section and the tax indemnity and specific indemnities clauses of the share purchase agreement.
Specific Representations and Warranties
- Specific representations and warranties regarding freelancers should be requested if the due diligence revealed that the target uses freelancers, contractors or consultants. However, since freelancers, contractors or consultants are very frequently used in the software and video game sector it is recommended to request such representations and warranties even if no information and documents were provided by the sellers in the due diligence. A specific purchaser-friendly warranty may be worded as follows:
- “All freelancers, contractors and/or consultants (“Freelancers“) that were previously or are currently performing services for the business of the Target Company (i) are and have been rightly classified as freelancers under applicable laws; (ii) would not reasonably be expected to be reclassified by any governmental authorities as employees of the Target Company, (iii) are not entitled to any rights from the Target Company under applicable employment laws; and (iv) have received all their rights and benefits to which they are and were entitled according to any applicable law or contract with the Target Company and are owed nothing from the Target Company other than routine payments made in the ordinary course of business.“
Tax Indemnity / Specific Indemnity
To the extent M&A market practice in the relevant jurisdiction includes a tax indemnities in the share purchase agreement, such tax indemnity should cover income tax, back pay of input tax deductions and social security payment obligations. In addition, the tax indemnity should cover penalties, fines, fees and interests that become due as a result of unpaid income tax and social security contributions.
- To the extent M&A market practice in the relevant jurisdiction includes a tax indemnities in the share purchase agreement, such tax indemnity should cover income tax, back pay of input tax deductions and social security payment obligations. In addition, the tax indemnity should cover penalties, fines, fees and interests that become due as a result of unpaid income tax and social security contributions.
- Such tax indemnity would then cover the monetary risks of the target and/or the buyer to a large extent. However, target may have additional costs and losses as a consequence of the freelancers being deemed employees. Such losses and costs include in particular the expenses which occur in connection with the ongoing salary to be paid to the freelancer and the termination of the deemed employment of the freelancer (e.g. severance payments, court and legal advisor fees). The risks for such losses and costs would need to be addressed in a specific indemnity e.g. as follows:
- “Seller shall indemnify and hold harmless the Purchaser, and upon Purchaser’s election the Target Company, fully on demand in respect of an amount equal to all Losses actually incurred, suffered or sustained by any member of the Purchaser group and/or Target Company, or asserted against any of them, relating to, resulting from or arising out of any use of freelancers, contractors and/or consultants prior to the Closing Date if such freelancers, contractors and/or consultants have been misclassified and should have been treated as employees pursuant to applicable employment and social security contribution laws by the Target Company.“
In light of the difficulties to assess the employment law status of the freelancers used at the target in course of the due diligence, buyer should review and assess immediately after closing whether the criteria listed above are fulfilled.
This assessment requires inter alia the following:
- interviews with the relevant persons dealing with the freelancer on questions relating to
- the project the freelancer was assigned to,
- the general staffing of the project (internal and external resources),
- the scope of freelancer’s duties and how the services were delivered, in particular with respect to working modalities (e.g. agile working/Scrum) and milestones,
- reviewing work products such as documentation, project time line and milestones, email exchange,
- assessment of technical implementation of freelancer contact into the target’s day to day business such as telephone number, email address, access to IT environment.
If risks of a misclassification become apparent, buyer must address these risks as quickly as possible. The required actions depend on the level of the risk of a misclassification. Such actions include for example:
- Proper termination of contract with the freelancer or entering into an employment contract with the freelancer,
- contact public authorities, such as social security authorities, tax authorities and – depending on the case – prosecution authority,
- if necessary, payment of social security contributions and amendment of tax filings for the past,
- implement a robust compliance system in order to effectively avoid misclassification in the future, which includes inter alia
- implementation of proper assessment measures (either internally or by using the social security’s status assessment procedure) before engaging with external workforce,
- revise freelancer contract templates,
- training of employees on how to collaborate with external workforce,
- monitor compliant use of external workforce,
- conduct audits on regular basis to avoid gradual operational integration of external workforce.