Taxing Construction Delays and Damages
Updated: Jun 15, 2020
With many building projects now delayed following recent adverse weather conditions here we examine the tax treatment of the most common contractual mechanisms used by clients and contractors when things don’t go to plan:-
Liquidated and ascertained (L&A) damages
Extension of time
Loss and expense
Liquidated and ascertained (L&A) damages
Many contracts include a provision for a contractor to pay liquidated damages to a client in the event that the contract is breached. The most common example in a building contract is where a contractor fails to achieve practical completion by the completion date set out in the contract.
Liquidated damages must be “ascertained” at the time the contract is entered into and must be based on a genuine calculation which might include things like:- loss of rent/income, fees, finance etc.
In most cases these payments will be taxable under income or corporation tax rules and for capital allowances should be ignored because they are a compensation to cover the reimbursement of expected trading expenses and not a reduction in the cost of construction.
If you receive liquidated damages, you are not receiving payment for a supply by you and no VAT is due on that amount. If you are due to make a payment for liquidated damages and due to receive from the other party a payment for a supply made by you, you cannot reduce the value of your supply (and therefore cannot reduce the amount of VAT chargeable) even if you set the amounts off against each other.
Sometimes however, a negotiated reduction in the contract value is agreed between the contractor and client instead of invoking the L&A damages provisions. In these circumstance, the tax treatment will be based on the particular facts of the agreement involved.
Extensions of time Construction contracts generally allow the construction period to be extended where there is a delay that is not the contractor’s fault. This is described as an extension of time.
When it becomes reasonably apparent that there is, or that there is likely to be, a delay that could merit an extension of time, the contractor gives written notice to the contract administrator identifying the relevant event (e.g. exceptionally adverse weather) that has caused the delay. Relevant events should be clearly defined in the building contract.
If the contract administrator accepts that the delay was caused by a relevant event, then they may grant an extension of time and the completion date is adjusted accordingly.
The contractor is required to prevent or mitigate the delay and any resulting loss, even where the fault is not their own. As a result, assessing claims for an extension of time can be complicated and controversial. There may be multiple or concurrent delays, some of which are the contractor’s fault and some not.
Claims for extension of time can run alongside claims for loss and expense (see below) however, one need not necessarily lead to the other.
Loss and expense Construction contracts will generally provide for the contractor to claim direct loss and/or expense as a result of the progress of the works being materially affected by relevant matters for which the client is responsible.
Common examples include:- delays in receiving instructions, discrepancies in the contract documents, disruption caused by works being carried out by the client, failure by the client to supply goods or materials, instructions relating to variations and expenditure of provisional sums, and inaccurate forecasting of works described by approximate quantities.
The contractor must give written notice of a claim as soon as it becomes reasonably apparent that the regular progress of the works is being materially affected. This need not necessarily result in a delay to the completion date, and so claims for loss and expense and claims for extensions of time do not necessarily always run together.
The payment of compensation is generally accepted as being outside the scope of VAT; however, when the payment is in relation to some construction work (i.e. the additional costs incurred by the contractor arising from a relevant matter) then the payment will likely be within the scope of VAT. Whether VAT will actually be due will depend on the characteristics of the supply made.
Payments for loss and expense are most likely to be regarded as capital for corporation/income tax purposes and linked to the overall cost of delivering the construction project. To what extent any tax relief might be available will be very much dependant on the facts of each case. If the payment can be linked to the delivery of a qualifying item for capital allowances purposes then allowances should be available and detailed evidence must be obtained supporting the link and costs involved.
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