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Property Tax Portal by James Bailey

James Bailey explains why many ‘buy to sell’ entrepreneurs may well be contractors within HMRC’s Construction Industry Scheme.‘Buy to let’ has grown hugely in the last few years, with more and more people becoming landlords.

For some, the next step is ‘buy to sell’. Instead of looking for long term rental income, they opt for a quicker profit, either by building a new property on a greenfield site, or by buying a dilapidated property and refurbishing it. As soon as possible, the property is sold on at a profit.

Most people are aware of one important tax distinction between these two activities – ‘Buy to let’ is an investment activity and when a property is eventually sold, the result will be a capital gain. ‘Buy to sell’ is a trading activity, and the profit from it will be charged to income tax.

There is another distinction that I suspect many ‘buy to sell’ entrepreneurs are not aware of, but it is one that could cost them serious money if they get it wrong.

If you are a ‘property developer’, then you are almost certainly a ‘contractor’ for the purposes of HM Revenue and Custom’s ‘Construction Industry Scheme’

What do these words mean?

A ‘property developer’ could be an individual, a partnership, or a limited company. The key is, do they earn their profits by doing building work – either by new builds which they then sell, or by buying an existing property and improving it and selling it on.

A ‘contractor’ is someone whose business involves using other people’s labour to carry out building work. Almost all ‘property developers’ use the services of independent bricklayers, carpenters, painters, electricians, plasterers, and so on. So almost all of them will be ‘contractors’.

A ‘Buy to let’ investor will probably not be a ‘contractor’, because although he may use the same tradesmen to do work on his properties, he makes his income from renting them out, not from selling them – he is an investor, not a trader.

The ‘Construction Industry Scheme’ imposes very onerous duties on ‘contractors’ and ‘subcontractors’. In order to understand why the scheme is as it is we need to look at its history.

Back in the 1960s, the construction industry in the UK was notorious for widespread tax evasion. Workers on building sites, who told the foreman their names were ‘Michael Mouse’, or ‘Roy Rogers’, got paid in cash, and had never seen a tax return in their lives. When the taxman attempted to trace them, to his surprise there was no Mr Mouse at the address he had been given – and often the address was false as well.

There were two basic problems:

• Some of the ‘Mickey Mice’ were really employees of the building contractor, and should have had PAYE deducted from their wages

• The rest of them, though genuinely self-employed, did not declare their income and pay tax on it as they should have done

Against this background, the ‘Construction Industry Scheme’ (‘CIS’) was first introduced in 1970. Since then, it has been much modified – with a major ‘reform’ in 1999, and more major changes planned for April 2007. The basic concept of the scheme remains the same, however.

The CIS seems to be based on HMRC’s apparent distrust of those involved in the construction industry. It assumes that if builders are allowed to conduct their tax affairs like any other business in the land, they might lie and cheat and not pay their tax.

It is easiest to explain how the CIS works with an example:

Jack owns a plot of land with planning permission to build a house on it. He decides he will build a house and sell it.

At this point, Jack has decided to trade as a property developer – a speculative builder in fact – so he is now a ‘contractor’ for CIS purposes. Jack must register with HMRC as a ‘contractor’. He will be sent a huge envelope containing a supply of the various documents he needs to operate the CIS, and several trees’ worth of booklets telling him what to do.

Jack talks to Bob (the builder), and they agree a price for Bob and his men to build the house. It is agreed that Jack will pay Bob £5,000 when his men start work.

Jack must ask to see Bob’s CIS registration documents. What he does next depends on what sort of card Bob produces.

Bob shows Jack a ‘Subcontractor’s Tax Certificate CIS6’.

Jack must ‘satisfy himself it is genuine’ (you have to be an expert on forged documents to operate this scheme!) and if it is, he can pay Bob his £5,000. Bob must give Jack a ‘CIS24 payment voucher’ (top and third copies only). Jack records all the details of the payment and the number of Bob’s CIS Certificate, and sends the top copy of the ‘CIS24 payment voucher’ to HMRC, having written his 13 digit ‘Contractor Reference’ on it in the space provided.

Jack has also asked an electrician, Michael Faraday, to do the wiring on the new house. Before paying him, he asks to see Michael’s CIS documentation. Michael looks rather embarrassed, and produces a ‘Registration Card CIS4(P)’.

A CIS4 means HMRC do not trust Michael as much as they trust Bob. Jack must deduct 18% tax from the payment to Michael, and give him the second copy of a completed ‘CIS25 Tax Payment Voucher’ showing what has been deducted. Jack must send the top copy to HMRC, and keep the third copy for his records.

Once a month, Jack must send the tax he has deducted to HMRC. This must be done within 14 days of the end of the month (but Jack must remember that a CIS month ends of the 5th day of the following month, so in fact he has until 19 July to send in his deductions for June).

That was a VERY abbreviated version of how the scheme works – the reality is much more complicated and difficult to comply with. I haven’t even started on the returns Jack has to make at the end of each tax year!

Why bother?

The short answer is; penalties!

If Jack failed to register as a contractor, or failed to deduct tax from payments to Michael, or trusted that Bob’s certificate was genuine when it wasn’t, he could be liable for:

• Penalties of up to £3,000 for each mistake he makes;

• Unless he can satisfy HMRC that Bob and Michael have paid their tax themselves, the 18% tax he should have deducted from the payments he made to them.

If you are trading as a property developer, building (or buying and improving) properties for sale, you are a ‘Contractor’ and liable to operate the CIS.

One of the many unjust features of the CIS is that there are probably a lot of small scale property developers out there who do not know they should be operating the scheme. Those who comply with the scheme are at a disadvantage, because many small ‘domestic’ building firms will simply not work for a CIS ‘contractor’ because of the bureaucratic hassle involved – builders who work only on people’s own homes are not required to be in the CIS.

James Bailey
November 2006

To learn more about the CIS and other taxes facing property developers and renovators please refer to the guide, Tax Secrets for Property Developers & Renovators written by James Bailey, which is available through the Property Tax Portal website.