Multi-Layered Disguised Contracting in Japan: Risks under the Worker Dispatching Act for U.S. Companies

Outsourcing and contracting are common business strategies globally, allowing companies to focus on core competencies and manage resources efficiently. In Japan, while legitimate contracting (請負 - ukeoi) and business process outsourcing (業務委託 - gyōmu itaku) are widely used, businesses must navigate these arrangements carefully to avoid falling into "disguised contracting" (偽装請負 - gisō ukeoi). The risks are amplified in "multi-layered disguised contracting" (多重偽装請負 - tajū gisō ukeoi) structures, where chains of contractors can obscure the true nature of work relationships. For U.S. companies operating in Japan, or those whose Japanese subsidiaries engage in such practices, understanding the potential liabilities, particularly under Article 40-6 of the Worker Dispatching Act (労働者派遣法 - Rōdōsha Hakkenhō), is crucial. An Osaka High Court decision on April 20, Reiwa 5 (2023), offers recent judicial perspective on these complex scenarios.

The Legal Trichotomy: Contracting, Dispatch, and Worker Supply in Japan

To appreciate the risks, it's essential to understand how Japanese law distinguishes between different forms of labor provision:

1. Legitimate Contracting (Ukeoi / Gyōmu Itaku):
   In a true contracting arrangement, a client company (the orderer) entrusts a specific scope of work to a contractor. The contractor is responsible for completing that work using its own employees, whom it directly manages, supervises, and instructs. The contractor bears business risk and maintains operational independence. The client company can provide specifications and quality requirements for the deliverables but should not exercise direct, detailed command and control over how the contractor's employees perform their day-to-day tasks.
2. Regulated Worker Dispatch (Rōdōsha Haken):
   Worker dispatch involves an employee of a dispatching agency working under the direct instruction and supervision of a client company at the client's premises. This is a legal and regulated form of labor, governed by the Worker Dispatching Act. The WDA imposes strict requirements, including:
   • Licensing for dispatch agencies.
   • Limitations on the duration for which dispatched workers can be assigned to certain roles or workplaces.
   • Rules aimed at ensuring equal pay for equal work between dispatched workers and the client's regular employees.
   • Obligations on both the dispatch agency (as the employer) and the client company (as the de facto supervisor).
3. Prohibited Worker Supply (Rōdōsha Kyōkyū Jigyō):
   Worker supply, defined as supplying workers to another person to have them work under the direction and command of that other person based on a supply contract, is generally prohibited under Article 44 of the Employment Security Act (職業安定法 - Shokugyō Anteihō). Licensed worker dispatch is the primary exception to this prohibition. Arrangements that are, in substance, worker supply but do not meet the WDA's requirements for legal dispatch are illegal.

The Perils of Disguised Contracting (Gisō Ukeoi)

Disguised contracting occurs when a contractual relationship is labeled as a contract for work or services, but in reality, the client company directly supervises and instructs the "contractor's" employees in much the same way it would its own employees or legally dispatched workers. This circumvents the regulations and protections mandated by the Worker Dispatching Act.

Key Indicators of Disguised Contracting:
The Ministry of Health, Labour and Welfare (MHLW) has issued guidelines (notably, Public Notice No. 37 of 1986, commonly known as "告示37号" - Kokuji Sanjūnana-gō) to help distinguish legitimate contracting from disguised dispatch. Factors indicating that an arrangement might be disguised dispatch include:

• Direct Instructions and Command: The client company, rather than the nominal employer (contractor), gives detailed instructions to the workers on how to perform their tasks, allocates work, and manages their work pace.
• Management of Working Hours and Discipline: The client company effectively controls the workers' attendance, working hours, breaks, overtime, and disciplinary matters.
• Lack of Contractor Independence: The "contractor" lacks genuine business independence. For example, they may not provide their own tools or equipment, lack specialized expertise or planning capabilities for the contracted work, or do not bear entrepreneurial risk. The work might be integrated into the client's own operational structure, with workers treated similarly to the client's direct employees.
• Personnel Decisions: The client company has significant influence over the selection, evaluation, or deployment of the "contractor's" workers.

If an arrangement exhibits these characteristics, labor authorities and courts may reclassify it as de facto worker dispatch, regardless of the contract's label.

Multi-Layered Disguised Contracting: Compounding the Risks

Multi-layered disguised contracting involves a chain of contractual relationships. For example:

• Company A (Ultimate Client) contracts with Company B (Primary Contractor) for a project.
• Company B then subcontracts part or all of this work to Company C (Secondary Contractor).
• The worker (X) is formally employed by Company C but performs their duties at Company A's premises, taking direct operational instructions from managers at Company A and/or Company B.

This structure can make it even more challenging to identify the true lines of command and employment responsibility. It often involves a violation of the Employment Security Act's prohibition on worker supply by the intermediary contractors (B and C, if they are merely channeling labor without genuine contracting functions or dispatch licenses). For the worker, such arrangements can lead to precarious employment, lower wages due to multiple layers of fees, and difficulty in asserting their rights.

The "Direct Employment Offer Obligation" (Deemed Offer Rule) – WDA Article 40-6

To address illegal dispatch situations and protect workers, Article 40-6 of the Worker Dispatching Act introduced a powerful remedy: the "direct employment offer obligation," often referred to as the "deemed offer rule" (労働契約申込みみなし制度 - rōdō keiyaku mōshikomi minashi seido).

Under this provision, if a client company receives dispatched workers in violation of certain critical sections of the WDA, the client company is deemed to have offered a direct employment contract to the dispatched worker. The terms of this deemed offer are generally the same as the working conditions under which the worker was dispatched. The worker can then choose to accept this deemed offer, thereby establishing a direct employment relationship with the client company.

Key Triggers for Article 40-6 include:

• Receiving workers from an unlicensed dispatch agency (Article 40-6(1)(i)).
• Receiving workers in prohibited types of work (e.g., port transport, construction, certain professional services unless specific exemptions apply) (Article 40-6(1)(i), referencing WDA Article 4).
• Exceeding statutory time limits for dispatch to a specific post or by an individual worker (Article 40-6(1)(ii)-(iv)).
• Receiving worker dispatch services disguised as a contract for work or other non-dispatch arrangement, with the intent to evade labor laws (Article 40-6(1)(v)). This is the provision most pertinent to disguised contracting scenarios.

The "intent to evade" (免脱目的 - mentatsu mokuteki) element in Article 40-6(1)(v) has been a focal point of legal interpretation and litigation.

The Osaka High Court Decision of April 20, Reiwa 5 (2023)

The decision of the Osaka High Court on April 20, Reiwa 5 (2023) (Rōdō Shimbunsha Shūkan Rōdō Hōrei Jōhō (Rōshun) No. 2040, p. 57) dealt with a multi-layered disguised contracting arrangement.

Simplified Factual Scenario:
A worker (X) was employed by Company Y3 (a secondary contractor). Y3 had a service contract with Company Y2 (a primary contractor), which was a wholly-owned subsidiary of Company Y1. Y2, in turn, had a service contract with Y1 (the ultimate client). Worker X performed architectural design work at Y1's premises and received daily operational instructions primarily from Y1's employees, and also to some extent from Y2's employees. X argued this was a disguised dispatch and sought a declaration of an employment relationship with Y1 (and alternatively Y2) based on WDA Article 40-6.

The High Court's Key Findings:

1. Application of WDA Article 40-6 to the Ultimate Client (Y1):
   The court held that Article 40-6 did not directly apply to Y1. Its reasoning was that, for Article 40-6 to apply, Y1 must be "receiving worker dispatch services." Under the WDA's definition (Article 2(i)), "worker dispatch" involves an employer (dispatch agency) having its own employed workers work under the direction of a client. In this multi-layered setup, Y1 was not receiving workers directly employed by Y2 (the entity it contracted with for the service) or Y3. Y2 was not X's employer; Y3 was. The court also denied analogous application of Article 40-6 to Y1, citing legislative history which suggests a distinction between the regulatory scope of the WDA (for dispatch) and the Employment Security Act (for worker supply). This is a significant finding, potentially limiting the reach of Article 40-6 to the direct client in a recognized or de facto dispatch layer, rather than the ultimate beneficiary in a longer chain.
2. Application of WDA Article 40-6 to the Primary Contractor (Y2):
   The court found that Article 40-6 could, in principle, apply to Y2. The logic here is that Y2 was receiving services from Y3 that involved Y3's employee (X) working under Y2's (and Y1's) direction. In substance, Y2 was acting as a client company receiving dispatch-like services from Y3. If this relationship between Y2 (as client) and Y3 (as de facto dispatcher of its employee X) was a disguised dispatch intended to evade the law, Y2 could face the deemed employment offer obligation towards X.
3. The Crucial Element: "Intent to Evade Laws" (Mentatsu Mokuteki) for Both Y1 and Y2:
   Despite finding Article 40-6 potentially applicable to Y2 (and hypothetically to Y1 if the structural argument were overcome), the High Court concluded that neither Y1 nor Y2 possessed the requisite "intent to evade" the WDA or other labor laws.
   The court stated that the mere objective existence of a disguised contracting situation (i.e., Y1 or Y2 giving direct instructions to X) was not, by itself, sufficient to automatically infer an intent to evade. The court considered factors such as:This finding underscores that proving "intent to evade" can be a substantial hurdle for workers seeking to invoke Article 40-6(1)(v).
   • The "subtlety" in distinguishing legitimate client instructions within a service contract from direct operational command that characterizes dispatch.
   • The fact that both Y1 and Y2 had taken steps to investigate and rectify the situation after being alerted to potential issues by the labor authorities during an inspection.

Analyzing "Intent to Evade": A Complex Evidentiary Challenge

The "intent to evade" criterion is subjective and often the most difficult part of an Article 40-6(1)(v) claim. How is it established?

• MHLW Interpretation: MHLW guidelines suggest that intent is not presumed merely from the existence of a disguised dispatch state. However, it can be recognized based on a comprehensive assessment of facts, such as when a client is clearly aware that the arrangement is, in substance, worker dispatch and continues it to avoid WDA obligations.
• Objective Circumstances: While direct proof of subjective intent (e.g., internal company memos explicitly stating an intention to bypass the WDA) is rare, courts can infer intent from objective circumstances. These might include:
  • The client's extensive and detailed involvement in the daily work, attendance management, and even personnel evaluations of the "contractor's" employees.
  • A complete lack of operational independence on the part of the contractor (e.g., no separate business substance, merely supplying personnel).
  • The duration and explicitness of the disguised arrangement.
  • Previous warnings or guidance from labor authorities regarding similar arrangements.
• Case Law Variation: There has been some variation in how strictly courts interpret this. Some earlier prominent cases, like the Tōri case (Osaka High Court, November 30, 2017, although primarily about direct employment under general contract law, its principles on recognizing de facto employment are relevant), suggested that a prolonged and clear state of disguised dispatch could strongly indicate circumvention. The Osaka High Court in the April 2023 decision, however, appears to have set a higher bar for inferring intent, emphasizing the companies' cooperative response to administrative guidance. This suggests that a company's conduct after being made aware of potential issues can influence the assessment of its prior intent.

Risks for U.S. Companies Utilizing Multi-Layered Contracting Structures in Japan

The Osaka High Court's 2023 decision, while specific to its facts, offers several takeaways for U.S. companies:

1. Ultimate Client (Top of the Chain): The decision suggests that Article 40-6 of the WDA may not directly apply to the ultimate client in a multi-layered structure if that client is not receiving workers employed by its direct contractor. This could offer some insulation from the "deemed employment offer" rule for the very top company in a long chain. However:
   • This is one High Court decision, and future jurisprudence could evolve.
   • Other legal risks persist, such as liability under the Employment Security Act for engaging in or benefiting from illegal worker supply, or potential tort liability.
   • Reputational damage from being associated with exploitative labor practices is always a concern.
2. Japanese Subsidiaries as Intermediary Contractors: If a U.S. company's Japanese subsidiary acts as a primary contractor (like Y2 in the case), and it subcontracts work while allowing its own client (or itself) to directly command the subcontractor's employees, that subsidiary faces a direct risk of Article 40-6 applying to it. The key will be whether "intent to evade" can be established against the subsidiary.
3. Violation of Employment Security Act: Regardless of WDA Article 40-6, multi-layered arrangements where intermediaries are merely channeling labor without genuine contracting functions or dispatch licenses almost invariably violate Article 44 of the Employment Security Act (prohibition of worker supply). This can lead to criminal penalties for the entities involved in the illegal supply and administrative sanctions.
4. The "Intent" Factor is Key but Unpredictable: The Osaka High Court's approach to "intent to evade" suggests that a cooperative attitude towards labor authorities and prompt corrective action might mitigate findings of such intent. However, this is a fact-dependent assessment and relying on being able to disprove intent after the fact is a risky strategy.

Mitigating Risks: Best Practices for Engaging Contractors in Japan

To minimize the risks associated with disguised and multi-layered contracting in Japan, companies should adopt robust compliance practices:

1. Thorough Due Diligence on Contractors: Before engaging any contractor or subcontractor, verify their legitimacy, operational independence, and, if dispatch services are genuinely intended, their WDA license. Avoid entities that appear to be mere shell companies for labor provision.
2. Clear and Detailed Contracts: Contracts should precisely define the scope of work to be performed by the contractor, deliverables, quality standards, and timelines. Crucially, the contract should affirm the contractor's responsibility for managing its own employees, including work allocation, instruction, and labor management.
3. Strict Observance of Command Structures: Train client-side managers and employees to scrupulously avoid giving direct, daily operational instructions or performance management to the employees of contractors or subcontractors. All communications regarding work tasks should ideally flow through designated supervisory personnel of the contractor.
4. Maintain Separation: Ensure a clear distinction in practice between the client's employees and the contractor's employees regarding work allocation, supervision, working hours management, evaluation, and disciplinary processes.
5. Regular Audits and Reviews: Periodically audit and review existing contracting and subcontracting arrangements to ensure they are being performed legitimately and have not evolved into de facto dispatch relationships.
6. Seek Expert Legal Advice: Given the complexity of Japanese labor laws, particularly the WDA and the Employment Security Act, consult with experienced Japanese labor law attorneys when structuring any significant outsourcing, contracting, or multi-layered service arrangements. They can help draft compliant contracts and advise on operational best practices.

Conclusion

Multi-layered disguised contracting presents significant legal and reputational risks for all parties involved in Japan. While Article 40-6 of the Worker Dispatching Act provides a potent "deemed direct employment offer" remedy for workers caught in illegal dispatch situations, its application in complex, multi-tiered structures, especially concerning the liability of the ultimate client and the critical element of "intent to evade laws," is still being shaped by court decisions like the Osaka High Court ruling of April 20, 2023. This ruling suggests that the direct application of Article 40-6 to the ultimate client in a multi-layered chain may be limited by the WDA's specific definition of "worker dispatch," and that establishing "intent to evade" requires more than just the objective existence of a disguised arrangement.

For U.S. companies and their Japanese subsidiaries, the key takeaway is the paramount importance of proactive compliance. This includes rigorous due diligence, clearly defined contractual relationships that reflect genuine contracting principles, strict adherence to proper command channels, and regular reviews of ongoing arrangements. Circumventing Japanese labor regulations, whether intentionally or inadvertently through poorly structured contracting chains, can lead to severe legal consequences, including potential criminal penalties for illegal worker supply and the unexpected creation of direct employment obligations.