U.S. Tax Desk Newsletter - December 2021

The Croatian tax administration has recently initiated action to identify hidden employment cases among the increasing population of sole entrepreneurs.

 The Croatian tax administration has sent questionnaires to sole entrepreneurs operating in a low tax regime. The questionnaire asks them to explain their business model and their relationship with their main clients (dependence, control, working hours, equipment, the fee arrangement, etc.).

 The focus of the Croatian tax administration is on domestic arrangements. However, similar actions may be expected for cross-border arrangements, especially in case the deemed employer is based in the EU (given that the Croatian tax administration should have legal grounds to collect at least social security contributions from an EU-based employer).   

What is hidden employment?

Last year Croatia introduced new provisions to the personal income tax rules defining typical employment characteristics. The purpose of this was to provide a clear legal basis to identify cases of using tax benefits contrary to the main goals of such rules.

 Characteristics of employment are determined based on the fulfillment of three criteria:

• Behavioral control - facts that show whether the deemed employer has the right to direct and control the deemed employee's work, through instructions, training, or other means,
• Financial control - facts that show whether the deemed employer has the right to direct or control financial and business aspects of the deemed employee's work,
• Parties' relations - facts that show the type of relationship between the parties.

With this respect, if the tax administration determines that a particular engagement has sufficient employment characteristics, the procedure for calculating taxes and contributions prescribed for employment will be carried out, regardless of how the work is contracted, irrespective of the residency of the payee, etc.

 If the tax administration determined a case of hidden employment, the likely scenario would be that they would charge the sole entrepreneur with taxes and social security contributions due if the fees they have received under such arrangement would be considered as salary (employment income). Suppose the tax administration would not collect such amounts from the sole entrepreneur directly; in that case, the tax administration will likely use available legal options to collect such payments from the deemed employer.

 See below for an overview of the difference in the tax burden in sole entrepreneurs and employment cases.

Companies should review their arrangements with sole entrepreneurs based in Croatia to determine whether such arrangements have qualifications of hidden employment (in substance or appearance) and take appropriate action to minimize the risk for their contractors.