HMRC changes to CIS guidance: potential 30% tax on development loans?

Background

The construction industry scheme (the CIS) was originally introduced in 1999 and substantially revised in 2007.  Essentially it is a tool intended to combat tax evasion in the construction sector in the form of payments for building work not being declared as income for tax purposes.  It does that by requiring "contractors" to deduct tax from payments to "subcontractors" under "construction contracts", unless the subcontractor has been given CIS gross payment status by HMRC.  Many aspects of the rules are broadly drafted and uncertain in scope, but until now the general view has been that a payment by a lender to a borrower by way of a development loan is not within the scope of the CIS.

What's changed?

HMRC publish detailed technical guidance on how it thinks the CIS rules should apply.  Earlier this month they changed a key section of this guidance to say that a contract to fund construction operations could be a construction contract that the CIS applies to.  By itself the changed guidance is unhelpfully vague but not necessarily problematic – it could simply refer to forward funding arrangements, which are widely agreed to be within the scope of the CIS already.  However, we are now aware of several recent examples of HMRC taking the view that LMA-style development loans are construction contracts, and that making such loans is likely to mean a lender would cross the threshold to have to register as a CIS contractor (if not already registered). 

Broad as the CIS rules are, it would still be a very odd outcome if that view were correct.  Leaving aside more detailed objections, in big picture terms the CIS is aimed at situations where there is a perceived risk of payments not being declared as taxable income.  Loan drawdowns simply will not be income for borrowers, and so are not capable of giving rise to the sort of evasion the CIS is combatting.  Our view is that this interpretation of the CIS rules is wrong on both a policy level and a technical level.

We, and others, have raised this issue with several industry and practitioner bodies that are discussing this with HMRC urgently.  So far HMRC have said there has been no change in their approach and that they are not taking a general view that "pure financing" arrangements are within the scope of the CIS.  However, there seems to be a serious mismatch between that statement and the position we are hearing that HMRC actually take on the ground.

What's the impact?

If the CIS did apply to new development loan drawdowns this would create serious difficulty for the sector.  Many development borrowers are new SPVs that will not have CIS gross payment status, so typically lenders would have to deduct tax when funding drawdowns.  Although borrowers should in principle be able to reclaim that tax in due course, the delay in doing so would give rise to material cashflow issues for them and likely the need to borrow larger amounts to compensate for the tax withheld - if that increased funding would even be commercially available.  None of this would be positive for the real estate sector. 

If HMRC were to assess lenders under existing or historic development loans the position would be even worse. As borrowers would not have been registered as CIS subcontractors the lender may face a tax bill equal to 30% of the total amount drawn down – regardless of whether the loan has been repaid – plus interest and possibly penalties.  Lenders would need to consider whether they can or should attempt to recover that tax from borrowers (eg under LMA-style tax indemnities), but it seems unlikely that borrowers would have funds readily available to meet those demands, potentially placing further risks on development solvency in an already difficult market.  How reclaims from HMRC would work in that context is uncharted territory, as is the application of the defences in the CIS rules a contractor could raise against assessment.

Next steps and further thoughts

A number of bodies are pressing HMRC to clarify its position further, and more publicly, than it has done so far.  Ideally the changes to HMRC's guidance would be further amended to make it clear that normal loan agreements are not in scope of the CIS.  If HMRC do genuinely consider that development loans are within the scope of CIS then we think the law needs to be changed, urgently and possibly with retrospective effect, in order to prevent this issue hanging over the sector.  

In the meantime, both lenders and borrowers will need to consider how to address the potentially significant risk of the CIS being applied to loan drawdowns and how they want to manage this. While LMA-style facility agreements contain a very broad tax indemnity in the lender's favour, to our knowledge this has never been invoked in the UK. Well-advised borrowers may start to resist indemnifying for this issue, arguing that as a known issue it should be priced in rather than indemnified against. Failing that, to avoid solvency issues they may push to defer payments under the indemnity until any withheld tax is refunded by HMRC. 

More generally, it can only be described as regrettable that this situation has arisen.  Only limited familiarity with the CIS is needed to know that it was not intended to apply to normal loan arrangements, and that taking a contrary view would have an entirely unnecessary adverse effect on the UK construction sector.  At a minimum there seems to be a serious disconnect with government policy on housebuilding in particular.  It is also disappointing that the changes to the published guidance, which we understand were supposed to add clarity, were so vague and uncertain in scope.  That approach to drafting public guidance is ironic at a time when HMRC is consulting on broadening the uncertain tax treatment notification regime – in this case its own guidance is actively spreading uncertainty, not reducing it.