You finish the job, you raise the invoice, and the contractor holds back 5%. That held-back slice is the retention, your customer's insurance against snags and defects. You will not see it for months, sometimes a year or more after practical completion.
Here is the part that catches a lot of construction businesses out. Depending on how you account for your profits, you can end up paying tax on that retention before a penny of it lands in your bank account.
This guide explains why that happens, how retentions are treated in your accounts, where the Construction Industry Scheme (CIS) fits in, and how to stop a retention turning into a cash-flow and tax headache. It is written for subcontractors and contractors running as sole traders, partnerships and limited companies.
If you want this handled properly, that is what we do for construction businesses.
What is a retention in construction?
A retention is a percentage of each payment that your customer withholds and pays later, once the work has been signed off and any defects put right. It is standard practice up and down the industry, written into most building contracts.
The mechanics are usually the same. The contract sets a retention percentage, commonly around 3% to 5%. On every valuation or invoice, the paying party deducts that percentage and keeps it. Typically half is released at practical completion and the other half at the end of the defects liability period, which can run six or twelve months later, sometimes longer.
So the retention is money you have genuinely earned. You have done the work. You just have not been paid for it yet, and you may not be for a long while. The question for your accounts and your tax bill is: when does that earned-but-unpaid money count?
Why do you pay tax on retentions before you are paid?
It comes down to which basis you use to work out your taxable profit. There are two, and they treat retentions very differently.
Under the accruals basis (also called traditional accounting), you recognise income when you earn it, not when you are paid. You did the work, so the income, including the retained portion, goes into your accounts for that period. That means it can be taxed in the year the work was done, even though the retention is still sitting unpaid with your customer.
Under the cash basis, you only record income when the money actually reaches you. Tax follows the cash, so you are not taxed on a retention until it is released and paid.
The split matters because of who can use which method:
- Limited companies cannot use the cash basis. They prepare accounts under accruals accounting and recognise the full contract income, retention included, as it is earned. So a construction company is, in the normal course, taxed on retentions before receiving them.
- Sole traders and partnerships (without corporate partners) can use the cash basis, and from the 2024/25 tax year the cash basis is the default. You only fall under the accruals basis if you elect for it. On the cash basis, you are not taxed on a retention until it is paid.
That is the heart of the issue. A limited company building firm books and is taxed on retained income up front. A self-employed subcontractor on the cash basis is not. Same retention, very different timing on the tax.
How are retentions treated in your accounts?
For any business using the accruals basis, including all limited companies, retentions are accounted for as part of your revenue and shown as a debtor (money owed to you) on the balance sheet.
When you recognise income from a construction contract, you bring in the whole amount you have earned for the work done in the period. The retention is not carved out just because the cash is delayed. It sits within trade debtors (or as a retentions debtor) until it is released and paid, at which point the debtor clears and the cash comes in. There is no extra income recognised at that later date, because you already recognised it when you earned it.
This is why your accounts can show a healthy profit while your bank balance tells a tighter story. The profit includes earned retentions you have not yet collected, and your statutory accounts have to reflect that under UK accounting standards.
There is a sensible bit of protection built in. If a retention looks doubtful, say the customer is disputing defects or is in financial trouble, you can make a provision against it or write it off as a bad debt, which reduces your taxable profit. You cannot simply leave good retentions out of income because the cash is slow, but a genuinely doubtful debt is a different matter and should be reviewed at each year end.
On the cash basis, none of this applies. You ignore the retention entirely until it is paid, then record it as income in the period you receive it. Simpler for cash flow, but it is only open to unincorporated businesses.
Does CIS apply to retention payments?
Yes, and the timing has a twist worth understanding.
Under the Construction Industry Scheme, a contractor deducts money from a subcontractor's payments and passes it to HMRC as an advance towards the subcontractor's tax and National Insurance. The deduction rates are:
| Subcontractor status | CIS deduction rate |
|---|---|
| Registered for CIS | 20% |
| Not registered for CIS | 30% |
| Gross payment status | 0% |
The deduction only applies to the labour element. The cost of materials the subcontractor has paid for is taken out first, along with VAT, before the rate is applied.
HMRC's guidance is clear that there are no special rules for retention payments. They are treated the same way as any other payment under the scheme. The important consequence is in the timing: whether a retention is paid gross or under deduction depends on the subcontractor's tax status at the date the retention is actually paid, not when the work was done.
That can cut either way. If a subcontractor had gross payment status when the work was carried out but has lost it by the time the retention is released, the retention is paid under deduction. If they were on the 20% rate during the job but have since gained gross payment status, the retention can be released in full. Always check the subcontractor's current status before releasing a retention, because the rate that applied to the original invoices is not necessarily the rate that applies now.
If CIS is a regular part of your work, our guide to support for CIS contractors covers how the scheme fits into your wider tax position.
How do the April 2026 CIS changes affect retentions?
The mechanics of CIS on retentions are not changing, but a package of CIS reforms takes effect from 6 April 2026, and two of those changes touch the world of retentions, especially through gross payment status (GPS), which is exactly what decides whether a retention is paid in full or under deduction.
Gross payment status lets a subcontractor be paid without any CIS deduction. To get it and keep it, you pass a turnover test (broadly £30,000 of net construction turnover per relevant person, with the test treated as passed once HMRC sees turnover of £200,000 or more), a business test and a compliance test of filing returns and paying tax on time. VAT compliance was already folded into that test under the earlier April 2024 reform, so keeping your VAT returns filed and paid on time has supported your GPS since then, not just from 2026.
The reforms taking effect from 6 April 2026 are different, and three are worth knowing:
- A nil-return requirement. If you are a contractor and you pay no subcontractors in a tax month, you must either file a nil return or notify HMRC that you have no return to make for that period. Do neither, without a reasonable excuse, and a penalty can follow. This keeps your own filing record clean, which matters if you also hold GPS as a subcontractor.
- A public-bodies exemption. Payments made to local authorities and other public bodies fall outside the scope of CIS from 6 April 2026, formalising the long-standing concession. If a public body is the paying or receiving party, there is no CIS deduction to worry about on those payments, retentions included.
- A tougher gross payment status reapplication bar. Where the behaviour that leads to GPS being cancelled arises on or after 6 April 2026, the subcontractor cannot reapply for gross payment status for five years from the date of cancellation, up from the previous shorter wait.
The practical link to retentions is simple. If you lose gross payment status, retentions released after that point are paid under deduction at 20% or 30% rather than in full, and under the new bar it can now be a long five years before you can regain GPS. Protecting your GPS, which includes staying on top of your VAT and your CIS filing, protects the full value of retentions you are still waiting to collect.
Illustrative example: tax on a retention before it is paid
Illustrative example. Daniel runs a groundworks business as a limited company. In the year to 31 March 2027 he completes a contract worth £200,000 of labour. The contract holds a 5% retention, so £10,000 is withheld and will not be released until the defects period ends well into the following accounting year.
Because his company prepares accounts on the accruals basis, the full £200,000 is recognised as income in the year to 31 March 2027, including the £10,000 retention he has not been paid.
Assume that £10,000 of retained income falls within taxable profits charged at the small profits Corporation Tax rate of 19% for the financial year. The tax on the retention alone is:
£10,000 x 19% = £1,900.
So Daniel's company owes £1,900 of Corporation Tax on money it has earned but not yet collected. That £1,900 is due at the normal Corporation Tax deadline, nine months and one day after the year end, which may well fall before the retention is actually released.
Contrast that with Priya, a self-employed subcontractor on the same job structure using the cash basis. She would not recognise her share of the retention as income, and would not be taxed on it, until the cash is paid to her. Same retained money, but the company is taxed up front and the cash-basis sole trader is not.
These figures are illustrative. Your own position depends on your profits, your structure, your accounting basis and your actual contracts.
How can you manage the cash-flow and tax impact?
You cannot usually avoid recognising earned retentions if you run a limited company, but you can plan around them so the tax never blindsides you.
A few practical steps:
- Track retentions separately. Keep a live schedule of every retention: the amount, the contract, the expected release dates for the first and second halves, and the current CIS status of the counterparty. Retentions buried inside general debtors are the ones that get forgotten and written off too late.
- Set the tax aside when the income is recognised, not when the cash lands. If your accounts book a retention as income this year, the tax on it is due on the normal timetable regardless of when you collect. Ringfence it.
- Review doubtful retentions at year end. If a retention is genuinely in doubt, a provision or bad-debt write-off reduces your taxable profit. This needs to be a real, evidenced judgement, not a way to defer tax on good money.
- Protect your gross payment status. Keep every VAT, CIS and tax return filed and paid on time so retentions are released to you in full rather than under deduction. With the GPS reapplication bar rising to five years for cancellations triggered from April 2026, losing GPS is more costly than ever.
- Pick the right accounting basis if you are unincorporated. Sole traders and partnerships have a genuine choice between cash and accruals, and for a retention-heavy trade the cash basis can ease the timing of tax. It is not automatically better for everyone, so it is worth getting advice before you decide.
Getting the accounting basis, the CIS treatment and the retention schedule joined up is exactly the sort of thing our team handles for construction clients, so the tax on a retention never arrives before you are ready for it.
Want to make sure you are not paying tax on retentions before you have the cash to cover it? Book a free call with a Zmartly accountant and we will review where you stand.
Frequently asked questions
Do I pay tax on retention money before I receive it?
If you use the accruals basis, which all limited companies must, yes. You recognise and are taxed on the income when you earn it, including the retained portion, even though it has not been paid. If you are a sole trader or partnership on the cash basis, you are only taxed on a retention once it is actually paid to you.
Can a limited company use the cash basis to avoid being taxed on retentions early?
No. The cash basis is only available to sole traders and partnerships without corporate partners. Limited companies must prepare their accounts on the accruals basis and recognise contract income, including retentions, as it is earned.
Is CIS deducted from retention payments?
Yes, where the work falls under CIS. There are no special rules for retentions, so they follow the normal scheme. The deduction depends on the subcontractor's tax status at the date the retention is paid, not when the work was done, so always check the current status before releasing it.
What CIS rate applies to a retention if my status has changed?
The rate is set by your status when the retention is actually paid. If you have gained gross payment status since the original work, the retention can be paid in full. If you have lost it, the retention is paid under deduction at 20% if you are registered or 30% if you are not.
Can I write off a retention I am unlikely to collect?
If a retention is genuinely doubtful, for example because the customer disputes the work or is insolvent, you can make a provision or write it off as a bad debt, which reduces your taxable profit. You cannot leave a good retention out of income simply because the cash is slow to arrive.
