Construction accounting in the UK is more complex than most industries. Between the Construction Industry Scheme (CIS), the domestic reverse charge for VAT, long project timescales, retention payments and subcontractor management, there are several rules that apply only to this sector.
Getting these right is not optional. HMRC pays close attention to the construction industry, and the penalties for non-compliance are significant.
The Construction Industry Scheme (CIS)
The CIS is a tax deduction scheme that applies when a contractor pays a subcontractor for construction work. The contractor must deduct tax from the subcontractor’s payments and pass it to HMRC.
Who is a contractor?
You are a CIS contractor if you:
- Pay subcontractors for construction work, and
- Your average annual spend on construction operations in the previous 3 years exceeds £3 million, or
- You are a construction business yourself
Who is a subcontractor?
Any business or individual who carries out construction work for a contractor. This includes sole traders, partnerships and limited companies.
CIS deduction rates
| Subcontractor status | Deduction rate |
|---|---|
| Registered with HMRC (verified) | 20% |
| Registered for gross payment | 0% |
| Not registered | 30% |
Subcontractors can apply for gross payment status if they pass HMRC’s compliance, turnover and business tests. This avoids deductions entirely but requires a consistent record of tax compliance.
How CIS works in practice
- Verify the subcontractor with HMRC before making the first payment (online or by phone)
- Calculate the deduction – apply the rate to the labour element (materials are excluded from CIS deductions if separately itemised)
- Issue a payment statement to the subcontractor showing the gross amount, deductions and net payment
- File a monthly CIS return with HMRC by the 19th of each month
- Pay the deductions to HMRC by the 19th (postal) or 22nd (electronic) of each month
CIS and limited company subcontractors
Since April 2014, limited companies can have CIS deductions set off against their PAYE liability rather than their Corporation Tax. This avoids cash flow delays from waiting for a Corporation Tax refund.
Reverse charge VAT
Since March 2021, the domestic reverse charge applies to most supplies of construction services between VAT-registered businesses where CIS applies. This means the customer accounts for the VAT, not the supplier.
When does it apply?
The reverse charge applies when:
- The supply is of specified construction services (covered by CIS)
- Both parties are VAT-registered
- The customer is registered for CIS
- The supply is not to an end user or intermediary supplier connected to the end user
How it works
Instead of the supplier charging VAT on their invoice, they note that the reverse charge applies. The customer then accounts for both the output VAT and the input VAT on their VAT return.
Supplier’s invoice (for £10,000 of construction services):
| Line | Amount |
|---|---|
| Construction services | £10,000 |
| VAT (reverse charge – customer to account) | £0 |
| Total due | £10,000 |
Customer’s VAT return:
| Box | Amount |
|---|---|
| Box 1 (output VAT) | £2,000 |
| Box 4 (input VAT) | £2,000 |
| Box 6 (total sales) | — |
| Box 7 (total purchases) | £10,000 |
The net effect is nil for businesses with full VAT recovery, but both sides must be recorded correctly.
End users
The reverse charge does not apply if the customer is an end user – a business or individual that uses the construction services for their own purposes rather than making onward supplies of construction services. End users receive normal VAT invoices and pay VAT to the supplier as usual.
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Contract accounting
Construction projects often span months or years, creating challenges for revenue and profit recognition.
Stage of completion method
Under UK GAAP (FRS 102, Section 23), revenue on long-term contracts should be recognised by reference to the stage of completion of the contract at the balance sheet date. This means you recognise revenue as work progresses, rather than waiting until the project is complete.
The stage of completion can be measured by:
- Proportion of costs incurred to estimated total costs
- Physical completion (surveys, milestones)
- Labour hours as a proportion of total estimated hours
Example
A contractor wins a £500,000 project expected to cost £350,000. At year end, 60% of the work is complete:
| Item | Amount |
|---|---|
| Revenue recognised (60% x £500,000) | £300,000 |
| Costs recognised (60% x £350,000) | £210,000 |
| Profit recognised | £90,000 |
The remaining revenue and costs are recognised in future periods as the work continues.
Loss-making contracts
If a contract is expected to make a loss, you must recognise the entire expected loss immediately, not just the loss on work done to date. This is a key accounting principle that prevents understating liabilities.
Retention payments
Retentions are amounts held back by the client (typically 5% of the contract value) as security against defects. They are released in two stages:
- Half at practical completion (when the project is finished)
- Half at the end of the defects liability period (usually 12 months later)
Accounting for retentions
Retentions are included in revenue when the work is done, but shown as a separate debtor on the balance sheet until they are released:
| Date | Event | Accounting treatment |
|---|---|---|
| During project | Work completed, retention held | Revenue recognised, retention debtor recorded |
| Practical completion | First half released | Cash received, retention debtor reduced |
| End of defects period | Second half released | Cash received, retention debtor cleared |
Cash flow impact
Retentions can have a severe impact on cash flow. On a £500,000 project, £25,000 is held back for up to 18 months after the work is complete. If you have multiple projects, the total retention held can be substantial. Factor this into your cash flow forecasting.
Subcontractor management
Managing subcontractors involves both accounting and compliance:
- Verify CIS status before first payment
- Agree payment terms in writing
- Check insurance – public liability and professional indemnity
- Issue payment statements with every CIS payment
- Keep records of all verifications, payments and deductions for at least 3 years
Common construction accounting mistakes
- Failing to verify subcontractors – results in a 30% deduction rate instead of 20%
- Not applying the reverse charge correctly – charging VAT when you should not, or vice versa
- Recognising revenue too early – booking profit before work is sufficiently complete
- Ignoring retention cash flow – not planning for the cash held back by clients
- Late CIS returns – monthly returns must be filed by the 19th; late filing attracts a £100 penalty per month
- Not separating materials on CIS invoices – CIS deductions apply to labour only if materials are clearly itemised
- Under-reporting as a contractor – failing to register as a CIS contractor when you should
Getting your systems right
Construction accounting is too complex for spreadsheets. You need accounting software that handles:
- CIS deductions and returns – calculating deductions and filing monthly returns
- Reverse charge VAT – applying the correct treatment automatically
- Project-based accounting – tracking costs and revenue by project
- Retention tracking – monitoring what is held, when it is due and chasing releases
- Subcontractor management – storing verification details and generating payment statements
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