How Does VAT Interact with CIS Payments

VAT and the Construction Industry Scheme (CIS) both apply to many transactions in the construction sector, but they operate in different ways. While CIS focuses on withholding tax from subcontractor payments, VAT deals with the tax charged on goods and services. Understanding how the two systems interact is essential for contractors and subcontractors to stay compliant and avoid confusion over invoicing, deductions, and payments. This article explains how VAT interacts with CIS payments, how to calculate the correct amounts, and what the domestic reverse charge means for your business.

How VAT and CIS Differ

Although both VAT and CIS are construction-related tax schemes, they serve separate purposes:

  • CIS ensures that subcontractors pay the correct amount of Income Tax and National Insurance by requiring contractors to deduct tax from payments.

  • VAT is a tax on goods and services that registered businesses collect and pay to HMRC.

The key interaction point is that CIS deductions are calculated on the net payment excluding VAT, meaning VAT is not part of the amount subject to CIS tax.

How VAT Is Treated on CIS Invoices

When a subcontractor invoices a contractor for work, the invoice should clearly separate the following:

  1. The total value of labour and materials.

  2. The VAT charged (if applicable).

  3. The total amount due before and after deductions.

CIS is applied only to the labour portion of the invoice, excluding VAT. Materials and VAT are never subject to CIS deductions.

Example:
A subcontractor invoices a contractor £1,000 for labour and £200 for materials. The subcontractor is VAT-registered and charges 20 percent VAT on the total (£1,200 × 20 percent = £240).

  • Total invoice: £1,440 (£1,000 labour + £200 materials + £240 VAT).

  • CIS deduction at 20 percent is applied only to the labour amount of £1,000, not the materials or VAT.

  • CIS deduction: £200.

  • The contractor pays £1,240 (£1,440 minus £200).

The contractor must then pay the £200 CIS deduction to HMRC and the remaining £1,240 to the subcontractor.

The Domestic Reverse Charge for VAT

Since March 2021, most construction businesses must use the VAT domestic reverse charge for building and construction services. This affects how VAT is handled between contractors and subcontractors.

Under the reverse charge:

  • The subcontractor does not charge VAT on their invoice.

  • The contractor accounts for VAT on the transaction instead.

  • The contractor both pays and reclaims the VAT on the same return, meaning no cash actually changes hands for VAT.

This rule applies to VAT-registered contractors and subcontractors who supply or receive construction services that fall under CIS.

Example using the reverse charge:
A subcontractor invoices £1,000 for labour. Instead of adding 20 percent VAT, the invoice must state:
“Reverse charge: Customer to account for VAT to HMRC.”

The contractor records £1,000 on their VAT return as both output tax (sales) and input tax (purchases), cancelling each other out if they can fully reclaim VAT.

This system aims to reduce VAT fraud in the construction industry by preventing subcontractors from charging and then not paying VAT to HMRC.

When the Reverse Charge Does Not Apply

The domestic reverse charge does not apply in certain cases, including:

  • When the subcontractor supplies services directly to an end user, such as a property owner or landlord.

  • When the work is zero-rated or exempt from VAT (for example, on new residential construction).

  • When the subcontractor is not VAT-registered.

In these situations, normal VAT rules apply, and the subcontractor should charge VAT on their invoice as usual.

It is important to confirm whether the reverse charge applies before issuing or paying an invoice, as incorrect VAT treatment can cause compliance issues and cash flow problems.

How Contractors Handle VAT and CIS Together

Contractors must manage both VAT and CIS obligations carefully. This includes:

  • Checking subcontractor status: Verify whether subcontractors are registered for CIS and VAT.

  • Calculating deductions: Apply CIS only to labour costs, excluding VAT and materials.

  • Applying the correct VAT treatment: Use the reverse charge if both parties are VAT-registered and the work falls within CIS scope.

  • Submitting returns: Include CIS deductions on monthly CIS returns and VAT on quarterly VAT returns.

Contractors must also keep detailed records of all invoices, deductions, and VAT entries to ensure consistency across both systems.

How Subcontractors Handle VAT and CIS

Subcontractors must:

  • Register for CIS and VAT if required.

  • Verify whether the reverse charge applies to their invoices.

  • Exclude VAT when calculating CIS deductions on payments they receive.

  • Report income on their Self Assessment tax return (if self employed) or company tax return (if incorporated).

If the reverse charge applies, subcontractors must still include the net value of the sale on their VAT return, even though no VAT is charged to the contractor.

Common Mistakes to Avoid

Errors often occur when businesses confuse how VAT and CIS interact. The most frequent mistakes include:

  • Deducting CIS on the gross invoice amount (including VAT).

  • Charging VAT when the reverse charge should apply.

  • Forgetting to include reverse charge wording on invoices.

  • Failing to reconcile VAT and CIS returns correctly.

To avoid these mistakes, double-check each invoice and verify both the subcontractor’s CIS status and VAT registration before processing payments.

Keeping Records for VAT and CIS

HMRC requires contractors and subcontractors to keep accurate records for both schemes. These should include:

  • Copies of all invoices and deduction statements.

  • Details of subcontractor verification checks.

  • Records of VAT applied or reverse charge transactions.

  • CIS return submissions and payment receipts.

Businesses must retain these records for at least six years in case of an HMRC audit.

How an Accountant Can Help

VAT and CIS are two complex systems that overlap frequently, and errors can easily lead to overpaid tax or penalties. An accountant who specialises in the construction industry can:

  • Determine whether the domestic reverse charge applies to your transactions.

  • Ensure VAT and CIS are calculated correctly on invoices and returns.

  • Prepare and file VAT and CIS submissions accurately.

  • Reconcile payments to HMRC and handle any discrepancies.

  • Train your team on how to manage both schemes efficiently.

Having expert guidance saves time, prevents costly errors, and ensures compliance with HMRC requirements.

Summary

VAT and CIS interact closely in the construction industry but apply to different parts of the transaction. CIS deductions are always calculated on the net amount excluding VAT, while VAT itself is handled separately, often through the domestic reverse charge. Contractors and subcontractors must understand when to charge VAT, when to apply the reverse charge, and how to report each correctly.

Accurate invoicing, record keeping, and timely submissions are key to compliance. Working with an accountant ensures your VAT and CIS processes align with HMRC rules and that your business runs smoothly without tax complications.