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The relationship between contractors and subcontractors in the construction industry changed earlier this year, as Sarah Laing explains.

Sarah Laing

Introduction

The Construction Industry Scheme (CIS) is a quasi PAYE system designed to counter tax evasion in the construction industry by imposing responsibility for making a deduction at source from payments made for labour services provided by self-employed building sub-contractors and companies unless those persons have received prior certification from HMRC. A major reform of the scheme took effect from 6 April 2007 - the legislation governing the reform is contained in the Finance Act 2004 and the regulations (SI 2005/2045).

The basics

Businesses operating in the construction industry are known as contractors and subcontractors and they may be companies, partnerships or self-employed individuals. A contractor will pay a subcontractor for construction operations. Subcontractors are those businesses that carry out building work for contractors.

Contractors include not just construction companies and building firms but also some government departments and local authorities, and many other businesses usually referred to in the industry as 'clients'. Private householders, and non-construction related businesses spending less than £1 million a year on construction work are NOT contractors and are not covered by the scheme.

The scheme applies to workers who for particular contracts are self-employed and are not employees subject to PAYE. For a contract to fall within the scheme, it must be one that is ‘not one of employment’. Employment status depends on general law.

Employment status

Under the new CIS, contractors must check or 'verify' new subcontractors with HMRC. Broadly, this means that HMRC will check the employment status of the subcontractor and ensure that he is properly registered for income tax and national insurance contributions purposes.

A worker’s employment status, that is whether they are employed or self-employed, is not a matter of choice. Whether someone is employed or self-employed depends upon the terms and conditions of the relevant engagement. The tax and NIC rules do, however, contain some special rules that apply to certain categories of worker in certain circumstances. A worker’s employment status will determine the charge to tax on income from that employment or self-employment. It will also determine the class of NICs, which are to be paid.

Construction payments

The term “contract payment” means any payment which is made under a construction contract made by a contractor to (FA 2004, s. 60):

(a) a sub-contractor,

(b) a person nominated by the sub-contractor or the contractor, or

(c) a person nominated by a person who is a sub-contractor under another such contract relating to all or any of the construction operations.

A payment made under a construction contract is not, however, a “contract payment” if the payment is treated as earnings from employment under ITEPA 2003, Part 2, Chapter 7 (Agency workers) (FA 2004, s. 60(3)). A payment is also not treated as a “contract payment” if the person to whom the payment is made or, in the case of a payment made to a nominee, each of the following persons:

• the nominee,
• the person who nominated him, and
• the person for whose labour (or, where that person is a company, for whose employees' or officers' labour) the payment is made,

is registered for gross payment when the payment is made (FA 2004, s. 60(4)).

Where a person is registered for gross payment as a partner in a firm, the above exemption applies only in relation to payments made under contracts under which the firm is a sub-contractor, or, where a person has nominated the firm to receive payments, the person who has nominated the firm is a sub-contractor (FA 2004, s. 60(5)).

Where a person is registered for gross payment otherwise than as a partner in a firm but he is, or becomes, a partner in a firm, the above exemption does not apply in relation to payments made under contracts under which the firm is a sub-contractor, or, where a person has nominated the firm to receive payments, the person who has nominated the firm is a sub-contractor (FA 2004, s. 60(6)).

Verification

Verification is the process HMRC use to make sure that subcontractors have the correct rate of deduction applied to their payments under the CIS. The contractor provides certain information about the subcontractor to HMRC. HMRC check that the subcontractor is registered with them and then tell the contractor what rate of deduction to apply, if any.

The contractor can then pay the subcontractor in one of the following ways:

• gross – i.e. without any deductions taken from the payment;
• net of a deduction at the standard rate (20 per cent);
• net of a deduction at the higher rate (30 per cent) because

- HMRC have no record of that subcontractor's registration, or
- HMRC are unable to verify the details for any other reason.

There is a general rule that a contractor does not have to verify a subcontractor if they last included that subcontractor on a return in the current or two previous tax years.

When HMRC verify a subcontractor, they will give the contractor a verification reference number. The verification reference number will be the same for each subcontractor that they have verified at the same time. If it is not possible to verify a subcontractor, HMRC will add one or two letters to the end of the number so that it is unique to that subcontractor.

Payments under deduction

Tax deductions must only be made from that part of the payment that does not represent the cost of materials incurred by the subcontractor. Any travelling expenses (including fuel costs) and subsistence paid to the subcontractor must be included in the gross amount of payment and the amount from which the deduction is made.

The contractor must provide a written statement to every subcontractor from whom a deduction has been made within 14 days of the end of each tax month.

Monthly returns

Each month, contractors must send HMRC a complete return of all payments made to all subcontractors within the CIS in the preceding tax month (FA 2004, s. 70). This is regardless of whether the subcontractors were paid gross or net of either the standard or higher deduction. Monthly returns must reach HMRC within 14 days of the end of the tax month they are for. Returns may be made electronically or by post (SI 2005/2045, Reg. 7).

There are no annual returns within the Construction Industry Scheme.

HMRC will impose a penalty of £100 where a contractor fails to submit a monthly return on time.  If the contractor should have returned information about more than 50 subcontractors, the penalty will be a further £100 for each additional 50 subcontractors or part thereof. The penalty will be repeated for every month the return is outstanding. If a contractor submits a monthly return that is incomplete or incorrect, HMRC may charge penalties where they believe the error or omission has been caused by negligence or intent on the part of the contractor. If a contractor fails to produce records relating to payments made under the CIS when asked to do so, HMRC may charge penalties up to £3,000 (FA 2004, s. 72).

Subcontractors

A subcontractor is any business which has agreed to carry out construction operations for another business or body which is a contractor or deemed contractor – whether by doing the operations itself, or by having them done by its own subcontractors or employees, or in any other way. Subcontractors include concerns normally known as main contractors, where they are engaged by a client who is a contractor, for example, a local authority.

Some businesses may act solely as contractors or as subcontractors but many act as both. This means that they both pay businesses below them and are paid by businesses above them in a chain. So for some of their transactions they will have to follow the rules for contractors and for others the rules for subcontractors.

Labour-only subcontractors

The term ‘labour only subcontractor’ includes arrangements where the subcontractor may be required to supply his own tools. A subcontractor may also be required to supply materials connected with the contract the cost of which will be deducted prior to the calculation of the deduction on account of tax made from payments to subcontractors.

Agencies as subcontractors

Where a worker is supplied to a contractor by or through an agency and the worker carries out construction operations under the terms of a contract they have with the agency, the agency supplying the worker will be a subcontractor as far as the contractor is concerned. The contractor must always apply the scheme when making payment to the agency.

Where a worker is merely introduced to the contractor by an agency and subsequently carries out construction operations under the terms of a contract they have with the contractor, the agency is not a subcontractor in this case.

Special rules apply to agency workers who normally treat the worker as an employee for tax and NIC purposes. The business paying the worker should normally deduct tax under PAYE and account for Class 1 NICs. Very exceptionally, the special rules for agency workers do not apply and any payments for construction work will fall within the scheme. The agency will then be a contractor and will need to fulfil its obligations in that role.

Registration

New subcontractors need to register with HMRC if they do not want deductions at the higher rate made from their payments. HMRC will only authorise a contractor to make gross payments to a subcontractor where the following conditions are satisfied.

The business test

To satisfy this condition, the subcontractor must provide evidence that he is carrying on a business in the United Kingdom which:

(a) consists of or includes the carrying out of construction operations or the furnishing or arranging for the furnishing of labour in carrying out construction operations, and

(b) is, to a substantial extent, carried on by means of an account with a bank.

The turnover test

The applicant must satisfy HMRC that in the year following the making of the application:

• as an individual, his net business turnover from construction work (that is, after the cost of any materials used to earn that income) is £30,000 a year or more (SI2005.2045, Reg. 28), or
• as a partnership or company, the net business turnover from construction work (that is, after deducting the cost of any materials) is £30,000 a year or more multiplied by the number of partners or directors.

In the case of 'close companies' (broadly, companies controlled by five or fewer individuals), the figure will be multiplied by the number of individuals who are directors and/or shareholders. For a husband and wife team, for instance, it would be £60,000.

An alternative test for partnerships and companies is that the business has an annual net turnover from construction work (after deducting the cost of materials) of £200,000 or more (SI2005.2045, Reg. 28).

The compliance test

The subcontractor must have kept all his tax affairs up-to-date during the “qualifying period” (the period of 12 months ending with the date of the application in question). This means he must have paid all tax liabilities, including any PAYE and subcontractor deductions, and submitted all tax returns on time. HMRC will not accept an application from a subcontractor who brings his tax affairs up-to-date just prior to submitting that application.

The above article first appeared in Tax Adviser (November 2007), and is reproduced with the kind permission of the publisher CCH (http://www.cch.co.uk/).