The CIS sector is one that is used to change and HMRC scrutiny with the special rules for the deductions from those working in the construction…
It’s Monday morning and all is well and then the post arrives. There it is, that innocent letter from HMRC, warning of an impending Construction Industry Scheme (CIS) compliance review for a contractor client. Many readers will deal with those in the building industry, but for those who are unfamiliar with it a very brief summary may be in order.
The CIS provides that unless they are registered to receive gross payments, contractors must make a deduction of 20% or 30% from payments to subcontractors on account of the latter’s eventual tax liability. Some costs charged by the subcontractor can be subtracted when calculating the deduction and some types of work may be exempt from the scheme.
CIS is often an area where contractors may have been meaning to make some changes but one that often falls through the cracks. For example, are contractors within CIS sure that they are treating the costs of materials claimed by subcontractors correctly? Increasingly, allowable material deductions is an area HMRC is focusing on as part of its CIS compliance reviews.
What are CIS materials?
It might be obvious for some, but we are considering the costs of, for example, bricks, paving slabs, piping and fixings that a subcontractor may supply as part of a construction project. It also includes the cost of renting or hiring equipment or scaffolding.
What it does not cover, and where mistakes often happen, is the cost of using plant or equipment owned by the subcontractor, although consumables such as fuel used in running the plant or equipment can be claimed. The position differs if the subcontractor hires plant from a third party, as explained further below.
The legislation, FA 2004, s 61, specifies that the amount which can be excluded from CIS deductions is limited to the direct cost of materials used or to be used in carrying out the construction operations. What the subcontractor must not do is to try to profit by increasing these costs by adding a mark-up or passing on a notional charge for plant or equipment they already own.
Mistakes can easily arise when dealing with the cost of (and profit on) materials and the hire of plant and equipment. Cost of (and profit on) materials HMRC will want to test how the contractor checks that the amount they are excluding is not excessive. If a contractor pays a subcontractor they will almost certainly exclude the cost of any materials they provide from the amount liable to CIS deductions, but they must be able to prove that the cost is accurate. The best way to do this is to retain a copy of the subcontractor’s invoice. But simply accepting the subcontractor’s word, or applying a standard percentage is not sufficient – either will leave scope for HMRC to challenge the stated return.
- Contractors must have checks in place to prove that the exclusions from CIS deductions is correct.
- Plant and scaffolding hire can be treated as materials if hired by the subcontractor from a third party.
- HMRC clarified that the subcontractor must pay for materials to obtain a CIS materials deduction.
- If subcontractor costs are over-estimated, the contractor may be liable for the CIS tax shortfall, interest and penalties.
- Aside from the cost of materials, other risk areas for building contractors include failure to register under the CIS, or to submit monthly returns and the like.
When is CIS material?
If the subcontractor has uplifted the cost, for example they may be looking to make a profit on the amount they are charging for materials, the profit element does not qualify and will still be liable to CIS deductions. Ultimately, HMRC expects contractors to have robust systems in place to check the materials costs being paid. If HMRC were to carry out a compliance check and consider that the materials supplied have been overstated they will look to the contractor for the additional CIS tax that is considered to have been under deducted.
Plant or equipment hire
If a subcontractor has to hire plant or equipment from a third party to carry out the work, the cost of the hire and any consumable items such as fuel needed for its operation may be treated as materials when calculating any CIS deduction. It is important to note that this treatment only extends to plant and equipment hired by the subcontractor from a third party. If materials are claimed in relation to plant hire the contractor should, in every instance, be checking with the subcontractor whether they have hired the plant from a third party or whether they own the plant being provided. Whether plant is actually owned by the subcontractor for CIS purposes is not easily determined and specialist advice might be needed here.
Scaffolding is a major concern, but so might be site fencing or lighting. The issue is that a subcontractor cannot claim the cost of supplying equipment under CIS unless he actually incurs a cost in doing so. Therefore, as an example, a scaffolding company can only make a claim for materials if it hires in additional scaffolding. If it simply uses equipment it already owns then no deduction is allowed, and CIS is due against the full charge made for providing and installing the scaffolding. This can lead to a significant discrepancy on a return.
What will HMRC’s compliance check entail?
Many years ago, back in the days of SC60s and forms CIS5, CIS6, CIS23 and CIS24 (I know many readers will be too young to remember) I worked for HMRC as an employer compliance trainer in its CIS training team. One area we focused on was the cost of materials. We told the compliance officers that it was their job to ensure that claims for such costs were accurate or at least reasonable, and they needed to ensure that the contractor had a system for checking these. The first question from the trainees was ‘How can I be expected to know the cost of a brick?’ A trade price guide from a local DIY merchant may be a useful resource for advisers here.
If the contractor engages subcontractors who provide materials, they will almost certainly exclude the cost of those materials from the amount liable to CIS deductions. HMRC will want to test how the contractor checks that the amount excluded is not excessive. The department has legal precedent to support a very strict approach on this point. If the contractor cannot demonstrate that the amount accepted as the cost of materials is accurate, HMRC will seek to recover from the contractor any CIS it believes has been under deducted.
Under SI 2005/2045, reg 13(2) an HMRC officer can use their ‘best judgment’ when computing liabilities and corresponding deductions. HMRC’s standard approach has not changed over the years and it will review any subcontractor invoices and challenge those with materials (especially for the previously mentioned scaffolding and plant hire). The contractor must be able to show that they have an effective system in place to check the cost of materials claimed and this must be more than a simple agreement with the subcontractor. I would expect, as a minimum, that the contractor would be checking the cost against their own builders’ merchant price guide or using their quantity surveyor’s calculations.
The contractor must be able to show that they have an effective system in place.
HMRC CIS compliance checks can be expected to enquire into the cost of materials and to include a sample check of this as standard. The extent of any check will depend on the Revenue’s initial findings and the evidence the contractor can provide, verbal and written, to demonstrate that the cost of materials are reasonable. At the very least, the best evidence is a copy of the subcontractor’s invoice. The time has long passed when HMRC would accept the subcontractor’s word or apply a standard percentage.
For example: Smith, Bloggs and HMRC Smith & Co are contacted by a prospective client, Bloggs of Bloggs Builders Ltd, for help with a CIS review by HMRC. After agreeing to act and undertaking the normal formalities, it is found that HMRC is following its normal approach and has asked the contractor for all their invoices where materials had been deducted over the past six months. This was an onerous and time-consuming process and some invoices included the supply of scaffolding and plant hire.
During the initial conversation with the contractor, Smith asks Bloggs whether the company would be able to demonstrate and evidence to HMRC that the cost of materials had been reviewed before payment.
Bloggs is surprised that this was required and believed that trade experience would be enough to show that they knew roughly what the cost of material should be. Further, the company employed a quantity surveyor who should be reviewing the costs for a project. Here, the risk is the lack of evidence of checks being made and simple agreements, often verbal, were not going to be sufficient to satisfy HMRC. Fortunately, with some work and time spent on their part, Bloggs was able to show that their surveyor did undertake periodic (although not regular) checks and they were able to obtain evidence from a subcontractor that scaffolding had been hired. Together with some research from the builders merchant, HMRC was satisfied that the costs could be justified.
Here there was limited evidence, but some detailed checks were able to show that the costs were reasonable, just not well-documented. Without evidence, a sample check by HMRC could have resulted in a substantial additional CIS liability as well as interest and penalties. Instead, the costs here were those incurred by Smith and Bloggs in undertaking a retrospective review, which could have been avoided by the maintenance of ongoing clear records.
The cost of materials has always been a risky area, but it has recently received more attention following the First-tier Tribunal case Elmpine Developments Ltd (TC 7830) – where such costs were under review following HMRC’s disallowance – and consultations. In the spring Budget 2020, the government announced a consultation to tackle CIS abuse. Tackling Construction Industry Scheme Abuse (was published on 19 March 2020 setting out proposals. Following meetings with those working in the sector and their representatives, a summary of responses was published in HMRC’s November 2020 policy paper, Changes to tackle Construction Industry Scheme abuse (tinyurl.com/y5dx5tyf) and the plan is to introduce measures from 6 April 2021; this includes some relating to the cost of materials.
The proposed measures remove doubt and confirm that it is only when the subcontractor directly purchases materials to fulfil their own contract with their contractor that they will be entitled to a reduction for materials costs from the gross contract payment before the CIS deduction is calculated. This will also stop several claims within the supply chain for the same materials, where previously there have been instances of multiple subcontracts claiming for the same materials.
Costs of non-compliance
At its simplest, getting it wrong will cost the contractor money.
As well as being liable for the CIS under-deduction there is the potential for interest and penalties. Although the contractor may be able to obtain an offset against their CIS under-deduction if the subcontractor has declared the income and accounted for the tax due, this does not cover interest and penalties. It is also worth remembering that any penalty will be calculated on the full amount of the under-deduction and not the amount after the set-off.
Contractors also need to remember that some subcontractors may not have made a return of the income, which means that any additional CIS due on those amounts may still fall on the contractor. This can be significant if the cost of materials is a large element of the amount charged by the subcontractor, such as with supply and fit arrangements.
Further, compliance failures identified during HMRC compliance reviews can result in the removal of gross payment status. This can have serious financial repercussions.
How does the contractor get it right?
The contractor needs to have a robust system and processes in place to check that the cost of materials is reasonable and genuine.
This could include:
- reviewing invoices which include the cost of materials;
- documenting the process and recording who is responsible for each area of reviewing and checking, especially if the costs are agreed by a quantity surveyor;
- maintaining a record to show when costs were checked and whether they were approved or rejected;
- keeping an explanation of how the cost of the materials was allowed, either as a note on the invoice or as part of a recorded process of invoice checks;
- detailing the checks made on cost of plant and equipment provided to confirm that they are not owned by the subcontractor; and
- notifying subcontractors that the cost of materials will be reviewed and to warn them that invoices may be called for as evidence.
I have focused on the cost of materials in this article, but there are other known risk areas for contractors which include failures to:
- register under CIS;
- undertake CIS checks on subcontractors;
- submit monthly returns;
- identify what is a construction operation;
- review mixed contracts;
- correctly treat payments for accommodation, travel and subsistence; and
- check the employment status of workers.
The construction industry scheme has many pitfalls for the unwary contractor, subcontractor and their advisers. If a contractor is making a mistake for one subcontractor it is likely that they are making the same error for many and this magnifies the potential under-declared liability as well as the potential interest and penalties. An efficient system of checks and reviews should prove a strong foundation against any future HMRC investigation.
For more information on CIS and how we may be able to help you please contact us.
This article was originally published in Taxation Magazine in February 2021.