A construction contract with a 5% retention held back until practical completion, then half of that again until the defects liability period ends, feels like money you'll worry about later. For tax purposes, that's often the wrong instinct. Where a contractor's accounts recognise contract revenue as the work is performed, the retained percentage is usually already sitting in taxable profit years before it's actually paid.
Why retention creates a cash flow problem in the first place
Retention exists to give an employer leverage: a percentage of each certified payment, typically 3-5%, is withheld as security against defective work, released in stages once practical completion is achieved and again once the defects liability period runs out. Commercially that's a sensible protection for the party paying for the building. For the contractor or subcontractor doing the work, it means a meaningful slice of every payment application doesn't turn into cash for months, sometimes years, after the work itself is finished.
The tax problem sits on top of that commercial one. Most construction contracts of any duration are accounted for on a percentage-of-completion basis under FRS 102 Section 23 — revenue, including the retained element, is recognised as the contract activity is performed and reliably measured, not when an invoice is raised or cash changes hands. Corporation Tax generally follows the accounts absent a specific statutory override, so if the accounts have brought retention into turnover as work progresses, that profit is taxed in the same period, whether or not the retention has actually been paid.
The mismatch in practice
A contractor completing a £2m contract with a 5% retention has recognised the full £2m in turnover by practical completion, including the £100,000 held back. If half of that retention isn't released until the defects period ends twelve months later, the contractor has already paid Corporation Tax on profit attributable to that £50,000 a full year before it lands in the bank. Multiply that across a busy contractor running several contracts at different stages simultaneously, and the retention debtor on the balance sheet can represent a genuine and recurring drag on cash available to pay the tax bill that same debtor generated.
This is worth building into cash flow forecasting rather than discovering at the point a Corporation Tax payment is due. A contractor with several live contracts should be able to see, at any point, how much of reported profit is sitting as unreleased retention rather than cash, and plan tax payments accordingly.
When a retention genuinely qualifies for bad debt relief
Tax relief is available where recovery of a specific retention is genuinely in doubt, not simply because retentions as a category carry some risk of non-payment. A general provision, calculated as a percentage of all outstanding retentions on the basis that some proportion typically go unpaid, isn't an allowable deduction. What is allowable is a specific impairment against an identified debt, supported by evidence: an employer showing signs of financial distress, a formal dispute over the quality of work that puts the retention itself in question, or an actual insolvency. Where that evidence exists and is documented at the time, rather than reconstructed later, the specific retention can be written down for tax purposes even before the underlying contract dispute is resolved.
If a retention that's been written off is later recovered in full or in part, the recovery has to be brought back into taxable profit in the period it's received. Relief for a doubtful debt is a timing adjustment, not a permanent exemption.
VAT treats retention differently, and usually more kindly
The VAT position is a genuine point of relief that many businesses miss, because it works differently from the Corporation Tax treatment described above. Under the general tax point rules, VAT is normally due on the earlier of the basic tax point and the date an invoice is issued or payment received. Retentions have their own specific rule: the tax point for the retained amount is the earlier of actually receiving the retention or issuing a VAT invoice for it. In practice, that usually means VAT on the retained percentage is deferred until the retention itself is paid, rather than accounted for upfront alongside the rest of the application for payment.
That's a welcome contrast to the Corporation Tax position, but it only helps if it's applied correctly. Accounting software configured to raise a single VAT invoice for the full certified value of each application, retention included, misses the deferral entirely and brings VAT forward unnecessarily on cash that hasn't been received. Getting the invoicing mechanics right, so retention VAT is genuinely held back until release, is worth checking against how the site's actually issuing its applications for payment, not just assumed from the contract terms.
Where CIS fits in
The Construction Industry Scheme applies to payments actually made under a construction contract, so a retention held back from a subcontractor is simply outside CIS deduction until the point it's released. When it finally is paid, CIS deduction applies to that payment in the normal way, calculated on the gross labour element and using whatever verification status — gross, standard 20%, or higher 30% — the subcontractor holds at the time the retention is actually paid, which may not be the status they held when the original work was carried out. A subcontractor's verification status can genuinely change between certification and release, particularly on longer defects periods, and it's worth checking rather than assuming the original deduction rate still applies.
Practical steps for contractors and subcontractors alike
Keep a clear, contract-by-contract record of retention debtors separate from other trade debtors, so it's obvious at any point how much reported profit is sitting unrecovered. Build expected retention release dates into cash flow and Corporation Tax payment planning, particularly around the 3-5% typically held to the end of a defects period that can run twelve months or more past practical completion. Check that VAT invoicing genuinely reflects the retention deferral rather than bringing VAT forward on money not yet received. And where a specific retention looks doubtful, document the evidence for that at the time — a dispute notice, correspondence about an employer's financial position, an insolvency practitioner's appointment — rather than trying to justify a write-off retrospectively when the accounts are being finalised months later.
Common questions
Do I pay Corporation Tax on retention money before I've actually received it?
Usually, yes. Where a contractor's accounts recognise contract revenue as work is performed, the retention element is included in turnover as it's earned rather than when the cash is eventually released, and Corporation Tax generally follows the accounts. That creates a cash flow gap: tax is due on profit that includes money still sitting as a debtor on the balance sheet.
What's the VAT tax point for a retention payment?
Retentions have their own rule under the VAT Regulations. The tax point for the retained amount is the earlier of actually receiving it or issuing a VAT invoice for it, rather than following the basic tax point that applies to the rest of the contract. In practice this usually defers the VAT due on the retained percentage until it's released or invoiced.
Can I write off an unpaid retention as a bad debt?
Yes, but only where recovery is genuinely in doubt and there's specific evidence for it — an employer in financial difficulty, a formal dispute, or an insolvency. A general provision against retentions as a class, made just in case some of them don't get paid, isn't an allowable deduction.
Does CIS apply to retention payments made to subcontractors?
Yes. CIS deduction is applied when a payment under a construction contract is actually made, so the retained percentage is deducted from in the normal way when it's finally released, based on the gross labour element of that payment, using whatever verification status the subcontractor holds at that point.
How should retentions appear in the accounts?
As a separate debtor or contract asset, distinct from amounts already invoiced and paid, recognised as the underlying work is performed under the percentage-of-completion approach most construction contracts use. Keeping retention debtors clearly identified makes it far easier to track what's genuinely at risk if a dispute or insolvency arises later.
What happens to a retention if the employer becomes insolvent before releasing it?
Retentions are typically unsecured, so recovery in an insolvency is often partial at best. That loss can support a specific bad debt deduction for tax once it's genuinely established, and where VAT was charged on the retained amount, the VAT bad debt relief scheme may allow that VAT to be reclaimed once it's been outstanding for six months and written off in the accounts.
Kieran Holsgrove is a Director and Co-Founder of Grafene Accounting, the property tax specialist firm based in Liverpool. He advises property developers, investors and landlords across Merseyside, Greater Manchester, Lancashire and Cheshire on tax structuring, developer VAT, SDLT and the long-view decisions that compound over the life of a portfolio.
This article is general information, not personal tax advice, and tax rules change. Your own position depends on facts we cannot see from here — please take advice before acting on anything above.