The humble trowel – kryptonite to the average landlord’s financial wellbeing...
As I casually browsed HMRC’s manuals over the weekend (for lack of anything better to do) I stumbled on the following two-word entry in their Construction Industry Reform Manual, at CISR12080 “Property Developers and Property Investment Businesses”
To which my reply could only really be “I should blinking well think so”. Regular readers who are involved with CIS will be aware that HMRC’s stance on CIS is particularly predatory and its penalty regime ridiculously Draconian – and, in my lay opinion, utterly disproportionate. More on proportionality later.
Property Investors v Property Developers
Property investors, or landlords, let out property for an investment income. They are taxed as if running a business, however HMRC is emphatic that a property business is not a trade but a passive investment, and is therefore ineligible for enhanced trading losses, Entrepreneurs’ Relief, etc., etc.
Property developers, on the other hand, buy land and/or property, then subject the property to a process of ‘improvement’ – hopefully – with the intention of selling on at a profit. This comfortably comprises a trading activity.
HMRC knows this – it used to be in the manual at CISR12080. The difference between developing property for investment, as distinct from re-sale, is one which HMRC lost sight of in Terrace Hill (Berkeley) Ltd v HMRC  UKFTT 75 (TC) – a useful case for taxpayers, particularly in relation to one’s intentions with regard to property. Also worth a read just for the sheer novelty of watching HRMC try to argue that something actually is a trade.
What is CIS and Why Should I be Worried?
The Construction Industry Scheme (CIS) seeks to impose a quasi-PAYE or payroll regime on contractors who engage sub-contractors who are not directly employed, so that the contractor is obliged to withhold tax on behalf of its sub-contractors and pay it over to HMRC. Those sub-contractors are of course in business on their own account as far as the contractor is concerned, otherwise real PAYE would be applicable. (At this point it is probably worth noting, as an aside, that HMRC has a long-term grievance with what it perceives to be “False Self-Employment in the Construction Industry”, to which my reply would be “You say false self-employment, I say Castle Construction, and we really would like to call the whole thing off”). Fundamentally, HMRC’s justification for imposing CIS on the rest of us, is that there are far too many casual workers in the construction industry who simply wouldn’t pay their tax at all, unless it were taken from them in the first place.
While most people agree that property developers are caught by CIS, the matter is less clear-cut for property investors/landlords. That uncertainty has provided HMRC with ample opportunity to seek to impose very large penalties on some businesses which had not thought that CIS applied to them – penalties can accumulate to many thousands of pounds for failing to make monthly reports, regardless of whether or not any tax/payments should have been accounted for (although this is changing – see later).
Why the Uncertainty?
The scope of the legislation appears very broad. CIS applies to contractors, which the legislation (FA 2004 s 59) defines as including any person carrying on a business which includes construction operations; (or in fact potentially anyone carrying on a business at any time but see below). Construction operations basically include the alteration, repair, extension, demolition or dismantling of buildings or structures, whether permanent or not; installations in buildings, and even painting or decorating the interior or exterior of buildings. (See FA 2004 s 74 for the full definition and further conditions and exceptions). So, private homeowners are not caught by CIS if they pay someone to paint their house because the homeowners are not in business. But anyone else is fair game for CIS. Or, perhaps not.
Hold On a Moment!
The definition of “contractor” at FA 2004 s 59 also includes,
“a person carrying on a business at any time if his average annual expenditure on construction operations in [the previous three years] exceeds £1,000,000...”
Now, this begs a question: why is this sub-section needed, if any business which includes construction operations already be caught? In CIS parlance, this part applies to “non-mainstream”, or “deemed” contractors which are so large that their incidental expenditure on construction operations breaches the threshold. By implication, the activities of non-"mainstream construction businesses" do not automatically “include construction operations”, even if there is some construction work - otherwise they would already be within CIS by reason of the first part of the definition, i.e., simply having a business which included construction operations.
The inference to draw is that construction operations have to comprise a pretty fundamental component of your business model, in order for you to be caught by the first part, no matter how broad the definition might first appear, otherwise there would be no need for the follow-up definition for non-mainstream contractors, who are caught only if their construction spend is sufficiently substantial.
This, of course, would be sensible: CIS should not be devised to trip up unwary insurance companies, car dealerships, chemists, dress shops, etc., etc., that renovate, expand or re-locate – after all, what is the mischief that CIS is intended to prevent? Alas, the words “sensible”, “HMRC” and in particular “CIS” are only occasional bedfellows.
HMRC Changes its Mind - #1
Up until a couple of years ago, CISR12080 used to say that property investors were different to property developers, were not considered to be carrying on a business which included construction operations, and were therefore not automatically within CIS. This was reaffirmed as recently as August 2011 in HMRC’s “News for Construction Industry Scheme – Mainstream and Deemed Contractors”, which said,
“Note: Property investors will only be brought into CIS where their expenditure on construction operations exceeds £1 million per annum.”
So up until fairly recently, HMRC seemed to accept that there was no substantive construction operation element to a property investor's business and it was largely subject to the same rules as any other, non-constructing business.
Unfortunately, CISR12080 was subsequently changed in 2012, to say,
“Where a business that is ordinarily a property investor, undertakes activities attributed to those of ‘property development’, they will be considered a mainstream contractor [caught for CIS] during the period of that development.”
In other words, regardless of the intention to develop with no direct profit motive, HMRC wanted to deem landlords as mainstream contractors on a temporary basis. I knew this to be an approach adopted by HRMC’s officers ‘on the ground’ and had several interesting discussions with them on this new tack, from around 2010 onwards.
Needless to say, they failed satisfactorily to address why the legislation required a de minimis average annual spend of £1,000,000 before non-mainstream contractors could be deemed to be caught, if all it actually took was an Inspector waving his or her magic pen and saying “Izzy, wizzy, you are now a mainstream contractor and fall within the scope of CIS reporting requirements”. (Or more accurately, “Izzy, wizzy, you were a mainstream contractor during the period when you built the investment property at X, and I now find you liable to tens of thousands of pounds in penalties for failing to file the monthly returns I now determine you should have made”).
There were numerous routes to challenge the horrendous penalties which then ensued. In my experience, they invariably collapsed to nil or a token amount, which it was not cost-effective to challenge/reduce further. However, I know of one tax barrister who was bent on taking a pro bone case for the remainder to the Tribunal and I have every expectation he will prove successful – or perhaps HMRC will drop the case because they stand to lose far more than they might gain.
HMRC Changes its Mind - #2: What Now for Property Investors?
Or course I do not know the mind of HMRC. Who could? However, I suggest that HMRC faces a dilemma: it has to explain why, so far as the legislation is concerned, property investors are a ‘special case’. If a property investor’s business (or indeed any business) 'includes construction operations' then it is automatically caught by the CIS legislation. But it seems clear that those construction operations have to comprise a significant part of the taxpayer's business model - something which HMRC, up until quite recently, appeared to accept.
I should admit there is an argument that it is implicit in a landlord’s business model that there will be renovations, repairs, decorating, etc., unless the tenant is responsible for everything; and that may be the attraction for HMRC. But In that case, practicaly every landlord would be caught by CIS – a scenario which HMRC does not want and could not possibly manage. In fact, if any amount of repairs or re-decorating sets off CIS, then pretty much every butcher, baker or candlestick maker would also be caught.
But HMRC has never said this: instead, HMRC decided around 2012 that from then on, property investors who undertake a development project – even for letting and capital appreciation – have entered a new world where, largely unlike any other non-construction business that might undertake such a project, they acquire temporary mainstream contractor status. To my reading, the legislation simply does not support this approach.
It is, then, entirely understandable to me that the guidance should be up for review – and, hopefully, a re-instatement of HMRC’s previous position, that property investors need to be spending an average >£1,000,000 per year on construction operation payments before having to worry about CIS.
On the plus side, it seems that HMRC intends to abolish penalties for nil returns – long the scourge for non-mainstream, deemed contractors who only temporarily engaged in construction operations. This new approach applies from April 2015, based on HMRC’s Response Following Consultations on Improving the Operation of CIS in December 2014. HMRC said at page 12,
“A number of comments were received about the change to the nil return obligation. The consultation discussed HMRC’s proposal to replace the statutory obligation to file a nil return with a voluntary nil notification. This was mainly welcomed by respondents as removing unnecessary and disproportionate penalties where no subcontractors have been paid.”
Hmm, there’s that word again. Helpful of HMRC to acknowledge that CIS penalties are disproportionate; perhaps HMRC meant that penalties were disproportionate only when no sub-contractors had been paid. But I think they have the right of it, wittingly or no, as the sentence is actually cast.