Construction Industry Scheme – not just for "mainstream" contractors

HM Revenue & Customs (HMRC) are increasingly focusing on compliance by businesses with the Construction Industry Scheme (CIS). The CIS legislation is likely to be familiar territory for organisations which operate as "mainstream" contractors and sub-contractors in the construction industry.  However, the broad scope of the CIS legislation frequently results in many "non-mainstream" construction businesses being drawn, often unwittingly, within the scope of the CIS legislation and even for those who know they are subject to the regime there are subtleties and nuances which can be overlooked. The consequences of non-compliance can be severe.

This briefing contains:

• a brief overview of the CIS regime;

• a summary of the types of payments and businesses which can fall within the regime; and
• analysis as to why this matters. 

Overview

The UK Government has for many years been concerned that if payments relating to construction operations are made to sub-contractors in cash, such payments may not be declared by sub-contractors to HMRC and income tax may not be paid in respect of such amounts.  In order to prevent a loss of revenue for the Exchequer, the first version of the CIS was introduced in 1972 requiring the deduction of tax at source from certain payments relating to certain construction operations.

The framework for the current form of the CIS is set out in Chapter 3 of Part 3 of the Finance Act 2004 and the Income Tax (Construction Industry Scheme) Regulations 2005 (SI 2005/2045) (as amended) (the CIS Regulations). HMRC recently consulted on possible changes to the CIS, particularly in the context of fraudulent abuse of the current CIS regime, in a consultation document entitled "Fraud on provision of labour in construction sector: consultation on VAT and other policy options".

The scope of the CIS is very broad both in terms of the types of persons and entities which are subject to the CIS and the types of payments caught.

Broadly, the CIS applies to "contract payments" made under a construction contract by a "contractor" to a "sub-contractor" in the course of "construction operations".

The safest approach is to assume that the CIS will apply to all payments made to all sub-contractors (everyone from a multinational construction firm to an individual odd job) in the course of construction operations, unless it is clear that a specific exemption applies.

In HMRC's view, any contract awarded by a contractor that places a duty on another party to execute, or arrange for the execution of construction operations, or supply labour for such operations, represents a contract relating to construction operations.  This applies even if the construction element only forms part of the overall contract.

The fact that all payments under "mixed" contracts, being contracts in respect of both construction and non-construction operations, in HMRC's view at least, fall within the scope of the CIS can create significant issues and CIS deductions from "mixed" contracts are frequently missed in practice (e.g. agreements relating to land and works or design and build). 

The application of the CIS is not restricted to UK companies and provided the construction operations take place in the UK, the CIS can apply to any companies, partnerships and sole-traders, irrespective of where they are established or are resident for tax purposes. 

Contract payments

If the CIS applies, the contractor is required to verify the CIS status of each of its sub-contractors and withhold amounts in respect of tax from each "contract payment" made to those sub-contractors.  Unless the sub-contractor is registered for "gross payment", the amount to be withheld is either 20 per cent, or 30 per cent, depending on the registration status of the sub-contractor.  No withholding is required at all if the sub-contractor is registered with HMRC for "gross payment".

The first step in calculating the amount of a contract payment is to take the amount of the payments made by the contractor to the sub-contractor and deduct any value added tax which was payable in respect of such payments.  The direct cost of "materials" can then be deducted from the resulting amount. HMRC guidance provides that "materials" means consumable stores (equipment which is now unusable), fuel (except fuel for travelling), plant hire and the cost of manufacture or prefabrication of materials.  Contractors should therefore ask sub-contractors for evidence in connection with the direct cost of the materials and retain such evidence in case HMRC commence a CIS compliance check (as to which, please see below). 

If this information is unavailable or is not provided, the contractor must make a fair estimate of the actual cost of the materials.  If the deduction for the cost of materials appears to be excessive, HMRC may seek to recover any under deduction from the contractor and it is therefore important that the contractor is comfortable that any information provided by a sub-contractor seems reasonable. 

"Mainstream" and "deemed" contractors

The CIS does not only apply to companies whose principal activity is construction (mainstream contractors), but also applies to "deemed contractors".  Broadly a "deemed contractor" is a non-mainstream contractor which incurs, on average, £1,000,000 (exclusive of VAT) of expenditure on construction operations per annum over the preceding three year period.  Many organisations (e.g. institutional landlords or pension fund investors) may therefore be "deemed contractors" even though they would not ordinarily be considered to be contractors as that term is generally understood in the construction industry.

Sub-contractors

A "sub-contractor" is a person who is under a duty to a contractor or deemed contractor to carry out construction operations by providing his own labour or the labour of others, or the person is answerable to the contractor for the carrying out of construction operations by others.  It is possible for a person to act both as a contractor and sub-contractor simultaneously and this is easily overlooked in practice as two separate registrations with HMRC are required.  Again, the broad definition of sub-contractor means that many entities will fulfil this definition even though their principal business activities are not construction activities – e.g. a tenant which agrees to carry out works to the shell and core of a building in consideration for payment from a landlord which is a "mainstream" or deemed contractor.

Registration

Contractors must register for the CIS before making any contract payments to sub-contractors. Sub-contractors must register before they start work in the construction industry.  The optimal position is generally for a sub-contractor to apply to HMRC and to obtain "gross payment status" such that no CIS deductions are required to be made in respect of contract payments paid to that sub-contractor.  Even if gross payment status is not granted, the incentive for a sub-contractor to nevertheless register with HMRC is that the contractor must then deduct tax at 20 per cent, rather than 30 per cent if the sub-contractor is not registered with HMRC at all. There can, however, be issues in practice where sub-contractors are unwilling to register under the CIS on the basis that they do not have appropriate policies, procedures or personnel in place to ensure CIS compliance and registration may be a cumbersome and time-consuming process for tenants who may only act as a sub-contractor vis-à-vis their landlord for a very short period of time. 

Potential timing issues may arise where, for example, a new property-owning vehicle will carry on a property rental business but first needs to improve the property by incurring significant capital expenditure in the first three years of its ownership.  The CIS legislation does not state explicitly when such a "deemed contractor" should register under the CIS, although HMRC guidance suggests that it must register when the construction contract is entered into pursuant to which the entity will incur in excess of £1,000,000 (exclusive of VAT) of capital expenditure on average per annum over a three-year period. 

Exemptions 

A number of exemptions apply but the two most commonly encountered in practice are those found in Regulation 20 and Regulation 22 of the CIS Regulations.

Regulation 20 provides that the payment of a reverse premium (e.g. a cash lump sum paid by a landlord to a tenant as an inducement to enter into a lease) is not a contract payment. Such payments may often be referred to as "capital contributions", and analysis will be required to ascertain if such a payment comprises a reverse premium for CIS purposes. 

Regulation 22 broadly has the effect that payments made by a deemed contractor in respect of property used for its business fall outside the CIS, e.g. a payment made by a supermarket tenant to a third party sub-contractor in respect of the construction of a new supermarket.

However, Regulation 22 does not apply if the property is held as an investment by the deemed contractor, e.g. a payment by the owner of a shopping centre which is held by the owner as an investment to a third party sub-contractor to build an extension to the centre. 

Non-compliance 

Penalties, interest and tax-geared penalties can arise for a failure to appropriately operate the CIS in terms of ensuring appropriate registration, deductions and payments to HMRC as well as for a failure to appropriately verify the CIS status of sub-contractors and to report contract payments through a contractor's CIS returns.

Furthermore, we are aware that HMRC are carrying out compliance checks when inaccuracies are identified by HMRC in relation to an organisation's CIS policies, procedures and compliance.  The number of CIS-related cases heard before the Tax Tribunals demonstrates that HMRC are prepared to litigate cases in relation to CIS non-compliance. 

Why this matters

Both "mainstream" and "deemed" contractors and sub-contractors should be aware of the CIS regime to avoid penalties, interest and wasted management time in rectifying errors and in responding to compliance checks if HMRC discover inaccuracies. 

The CIS also presents a significant cash flow risk for sub-contractors, as a sub-contractor may receive 20 per cent or 30 per cent less than it anticipated in respect of payments made to it in connection with the construction operations. Such cash flow issues could potentially result in the insolvency of the sub-contractor if it becomes unable to pay its debts as they fall due as a result of CIS withholding.

Contracts should be drafted carefully to ensure that the contractor has the ability to request information from the sub-contractor to enable it to verify the sub-contractor's CIS status prior to making any payments, to determine whether any deductions need to be made under the CIS legislation and to make any such deductions if required. It is not good enough just to have the contractual protections in place, however, as the on-boarding and finance teams need to be involved and alive to the status of the sub-contractors throughout the life of the contract. 

More fundamentally from a commercial perspective, consideration should be given as to whether contracts should be split into those in respect of which construction services are provided and those where no such services are provided to avoid all payments under a "mixed" contract being brought within the scope of the CIS regime. 

It is also important to consider the impact on the timing of a project or transaction should there be unexpected delays due to CIS registrations being required, which is particularly relevant in the context of contract payments made by landlords to tenants which fall within the scope of the CIS. 

From 15 September 2016 many contractors and sub-contractors are now obliged to publish online a tax strategy which is freely available to the public and any material failure to comply with the CIS regime could result in breaches of a published tax strategy.

Both contractors and sub-contractors should ensure appropriate policies and procedures are in place to prevent any minor non-compliance with the CIS legislation from putting the contractor or sub-contractor in breach of the terms of any finance provided by third-party lenders. 

Finally, when the forthcoming new Corporate Criminal Offence of the Failure to Prevent the Facilitation of Tax Evasion is introduced, which is expected to be later in 2017, it will be even more important for organisations to ensure that they can demonstrate that they have appropriate CIS policies and procedures in place.