Contracts for Work and Services can be used to a limited extent to reduce wages. In most cases, however, these are sham service contracts—which must be clearly distinguished from regular service contracts—that enable outright wage dumping. Therefore, it makes little sense to ban service contracts outright. It makes more sense to do so in the core business operations of companies.
This is especially true when specialized expertise is required for this core area and legal regulations must be followed—for example, in the meat industry. In such cases, expertise can still be outsourced on a temporary basis as part of the core business. If, however, core tasks are permanently outsourced, the contracting company loses its basis for existence.
Just as the market is flexible, so is the labor market. Even if this adaptation sometimes involves companies resorting to illegal practices such as bogus service contracts, this does not mean that existing service contracts become invalid. Bogus service contracts must be punished as illegal instruments through the means of the rule of law.
What is a sham contract for services?
A sham contract for work exists when a contract is formally concluded as a contract for work or a service contract, but in practice exhibits the actual characteristics of an employment relationship: The contractor is bound by the client’s instructions, integrated into the client’s operational organization, and works with the client’s equipment—even though the contract states otherwise.
The goal of bogus service contracts is almost always to avoid the costs associated with regular employment: social security contributions, payroll taxes, the minimum wage, and labor law protections. In many cases, this constitutes a form of bogus self-employment—the person in question formally acts as a self-employed entrepreneur but is, in fact, an employee.
Characteristics of a Sham Contract for Services
- The contractor is bound by instructions and receives them directly from the client
- He is integrated into the client's operational processes and work schedule
- He uses the client's equipment, tools, or facilities
- There is no clearly defined, distinct body of work or deliverable
- The financial risk lies not with the contractor but with the client
What about contracts for work and undeclared work?
Illegal employment is in Section 1, Paragraph 2 of the Act on Combating Undeclared Work and Illegal Employment defined. According to this definition, undeclared work occurs when someone performs a service or carries out work—or has such work performed—and meets the following criteria:
- An employer, a business owner, or a self-employed person subject to social security contributions fails to fulfill the social security obligations under the contract—namely, registration, payment of contributions, and record-keeping requirements.
- A taxpayer fails to fulfill the tax obligation under the contract.
- A person is receiving social benefits but is not complying with the notification requirements under the contractual relationship.
- The service provider has failed to comply with the requirement to report self-employment or has not obtained the required itinerant trade license.
- A service provider is operating a business that requires a license without being registered in the trade registry.
Services provided as part of neighborhood assistance are clearly not considered undeclared work, as long as they are performed without the intention of making a sustained profit. Even a small payment for such services does not constitute undeclared work.
Most violations involve failure to comply with reporting requirements and benefit fraud: Those involved work for pay while simultaneously receiving social benefits. For employers, undeclared work usually involves failing to register employees with unemployment, health, long-term care, and pension insurance—in order to avoid paying both social security contributions and payroll taxes.
In addition to the damage caused to social security systems and the loss of tax revenue, undeclared work undermines fair competition. Companies that save on labor costs in this way gain an illegal advantage over honest competitors.
Contracts for Work and Unreported Work
The role of service contracts in the context of undeclared work is to require the contractor to pay social security contributions and taxes—while the client is not subject to any reporting obligations. Contractors, for their part, have an interest in not reporting their work in order to avoid paying social security contributions, income taxes, and other costs. This applies to companies operating under service contracts as well as to self-employed individuals. For the latter, there is an additional incentive to continue receiving social benefits by posing as job seekers.
How can we combat illegal employment?
Authorities report that “bogus self-employment” is the most common method used for undeclared work: individuals who are, in fact, employees present themselves as self-employed entrepreneurs, with their tasks being assigned to them through a contract for services.
The Act Against Illegal Employment and Social Benefit Fraud, which took effect on July 18, 2019, gave tax authorities greater authority to combat undeclared work. Among other things, the powers of customs authorities and their staffing levels were expanded. Data sharing between the relevant agencies is also set to be improved.
Reasons for Undeclared Work
Undeclared work has seen a surge due to several factors. Rising labor costs resulting from high collective bargaining agreements and the minimum wage have led to an increase in undeclared work within certain industries. Added to this is the economic cycle: When the economy is booming, the extent of undeclared work decreases accordingly. When the economy slows down, companies save money by relying on undeclared work.
The direct link to the economy also stems from the worker’s interests. When the economy is generally strong, it is easier for workers to find a regular job, which they generally prefer to working off the books. If, on the other hand, it is difficult to find a regular job, undeclared work is seen as the lesser of two evils.
Added to this are changes in taxes and fees, as well as a general decline in tax compliance. The risk of getting caught also plays a significant role: the more labor costs rise, the greater the incentive to work off the books. The higher the risk of being penalized, the lower the incentive to take that risk.
Consequences of Illegal Employment
Undeclared work poses a number of risks for everyone involved:
- For the client: There is no legal certainty, for example, regarding the right to receive services or the rectification of defects. The client must place blind trust in the contractor.
- For the Contractor: There is no legal protection regarding the right to compensation. Furthermore, there is a complete lack of social security coverage: Undeclared work does not accrue pension benefits, and there are no entitlements under unemployment insurance when the employment relationship ends.
- For the national economy: Distortion of competition, loss of social security contributions and tax revenue, and the undermining of statutory minimum standards.
- Under criminal law: Fines of up to several hundred thousand euros; in cases of serious repeat offenses, criminal penalties for both the client and the contractor.
Conclusion
Contracts for services are increasingly being used for purposes other than those originally intended. While the majority of such contracts continue to serve the purpose of hiring skilled workers for their knowledge and skills, there is a growing number of cases in which they are used to reduce labor costs.
In order to engage in outright wage dumping—and thereby circumvent statutory minimum wages—there is an increasing reliance on bogus service contracts and even undeclared work. In this context, the employee’s skills and knowledge play only a minor role. Instead, the focus is on cutting labor costs and insurance premiums.
Policymakers have responded by tightening the laws. In addition, government agencies are being given more authority and staff. Illegal employment harms the economy above all by distorting competition and resulting in a loss of social security contributions and tax revenue.
At the same time, undeclared work deprives those affected of their legal protections. Ultimately, it is the undeclared worker who is left in a significantly worse position—he has no entitlement to benefits from the pension and social security systems.
Additional information: Contract for Work and Materials – Legal Aspects
Frequently Asked Questions About Sham Contracts and Illegal Employment
A genuine contract for services obligates the contractor to achieve a specific, definable result—the contractor is not subject to the client’s instructions and bears the financial risk themselves. A sham contract for services merely pretends to grant this independence: In practice, the contractor is subject to the client’s instructions, integrated into the client’s business operations, and uses the client’s equipment. The goal is to circumvent social security obligations, income tax, and labor law protections.
According to Section 1(2) of the SchwarzArbG, undeclared work occurs when, in connection with the provision of services or the performance of work, social security reporting and contribution obligations are not fulfilled, tax obligations arising from the contract are ignored, social benefits are received despite being employed, the obligation to register as self-employed is not fulfilled, or a trade requiring a license is operated without being entered in the trade register.
For the client: Back payments of all social security contributions (employee and employer shares), income tax, fines amounting to several hundred thousand euros, and the risk of criminal prosecution. For the contractor: No social security coverage, no pension benefits, no entitlement to unemployment benefits, and no legal protection regarding the right to compensation.
Authorities—in particular Customs (Financial Control of Illegal Employment) and pension insurance agencies—examine the actual nature of employment relationships: Who issues the instructions? Who provides the equipment? What is the time commitment? If the actual circumstances differ from the contract terms, it is likely a sham contract for services. Since 2019, the Law Against Illegal Employment has granted authorities expanded powers and improved data sharing.
Fictitious contracts for work are illegal instruments that must be punished through the legal system—they do not invalidate the contract-for-work instrument itself. Genuine contracts for services fulfill an important economic function: they enable companies to flexibly procure specialized expertise. A ban on all contracts for services would destroy legitimate business models without solving the problem of abuse.
During economic downturns, cost pressures on companies increase, which heightens the incentive to save on social security contributions and payroll taxes by resorting to undeclared work. At the same time, workers find it harder to secure regular jobs and are more likely to accept informal employment. The combination of greater hardship on both sides and the perception that detection is less likely fuels the rise in illegal employment.