Sham contracting occurs when a business treats a worker as an independent contractor when they are, in substance, an employee. It's illegal under the Fair Work Act 2009, and the penalties are severe: up to $93,900 per contravention for individuals and $469,500 for companies.
The key test is the nature of the working relationship, not what the contract says. The ATO and Fair Work look at factors including: Does the worker control how, when, and where the work is done? Do they provide their own tools and equipment? Can they subcontract or delegate? Do they work for multiple clients? Do they bear financial risk (e.g., quoting for profit/loss)?
If a worker looks, acts, and is managed like an employee — set hours, provided tools, one client, paid hourly, directed in how to do the work — then they are likely an employee regardless of what the contract says. Calling them a contractor doesn't change the legal reality.
The consequences of getting this wrong extend beyond penalties. You may owe back-payment of all leave entitlements (annual leave, personal leave, long service leave), superannuation guarantee with interest and penalties, PAYG withholding, and workers' compensation premiums. In construction and trades, sham contracting is an enforcement priority for the ATO and Fair Work Ombudsman.