VAT on Retention Payment: Deconstructing the Complexity

“When is VAT payable on a sale of laptop with a 5-years warranty and 90-days credit terms?” I asked the CFO of a construction company.

“It is payable upfront at the time of sale.” the CFO replied.

“Correct, even though the contract of sale remains valid (i.e. not completed) for the next 5 years to guarantee the quality of supply and the payment is due only after 90 days.” I replied, “Should the VAT implications on the retention amounts be any different?”.

What is Retention and the tax issues?

Retention refers to a proportion of the contract price that is often held back by the customer to test that the supplier has done the work properly. This is a common feature in the construction contracts. Retention is payable after a stipulated time (referred to as ‘Defect Liability period (DLP)’).

In the construction industry, the supplier/contractor issues invoices as per the contractual milestones for the proportion of the work certified as completed. A proportional retention amount is deducted from the total payable amount in such invoices. After the completion of DLP, the supplier claims the retention amount from the customer.

The suppliers often contend that the contract of supply is not completed till DLP is over and hence VAT on the retention amount should be payable only at the time of receipt of money. Is it correct?

VAT liability and continuous supply

VAT is payable to FTA as per the ‘date of supply’. Supply contracts that includes periodic payments or consecutive invoices (e.g. construction contracts) are often referred to as ‘continuous supply’ to determine the ‘date of supply’.

The Real Estate VAT Guide has already clarified that no special rules apply for determining the date of supply of retention payments for ‘continuous supplies’. For ‘continuous supply’, the normal rules require that the VAT be paid at the earliest of (i) issue of an invoice, (ii) the receipt of payment and (iii) completion of 12 months from the delivery of goods/services.

The Guide further state that ‘even where the services are contractually complete, there is no tax point until an invoice is issued or payment is received or 12 months has passed – whichever is earlier.’

Issue of invoice and Retention Payment

The retention amount is generally claimed by issuing what is called an ‘invoice’. Accordingly, it is contended that VAT is payable only at the time of issue of such invoice.

However, it is often overlooked that such invoice is not booked as revenue in the books of account. Complete revenue and expenses (including the value of retention money) are accounted for in the books of the supplier and the customer respectively as per the periodic milestone invoices itself.

Just because the retention amount is not immediately payable, could it be contended that an invoice has not been issued? Even as per IFRS 15, 100% revenue (including retention amount) should be recognized by the supplier at the beginning itself. It has been clarified that the delayed payment terms are intended to provide some security to the customer against the work quality. Thus, could the claim of retention amount be treated as an invoice even though it is just a security deposit?

Even assuming that the claim of retention amount is equivalent to an invoice, the 12-month rule could still create tax risks on the supplier/contractor. The DLP starts from the certification of last milestone of supply and not from each certified milestone. If the time period between the progressive milestones and the claim for retention amount exceeds 12 months, VAT would still be payable on the completion of 12 months from each progressive milestone and cannot be deferred to the completion of DLP.

“The stakeholders in the construction industry should take note of the intricacies of the VAT laws to ensure comprehensive compliance. A general clarification the FTA as to whether the claim for retention can be treated as invoicing would also help the industry.” I concluded as we finished our lunch together.