Artificial Separation & VAT Disaggregation, What Construction Businesses Must Know

Introduction - Artificial Separation & VAT Disaggregation

If your construction or engineering business operates through multiple companies, perhaps one for labour, one for materials, or one for management, you could unknowingly be breaching HMRC’s VAT rules on artificial separation and disaggregation.

It’s a common trap for small and medium-sized construction firms. Many set up multiple entities for practical reasons, like dividing work or managing cash flow. But if those companies are essentially one business in HMRC’s eyes, you could face backdated VAT bills, penalties, and even investigations.

At Jones Financial Accounts (JFA), we help construction and engineering SMEs stay compliant while structuring efficiently for tax, cash flow, and growth. This blog explains, in plain English, what VAT disaggregation means, why it matters, what HMRC looks for, and how you can protect your business before it becomes a problem.

Understanding Artificial Separation & Disaggregation

Why It’s Important

Disaggregation (also called artificial separation) happens when a business is split into smaller entities to avoid VAT registration or reduce VAT liability. HMRC sees this as tax avoidance, not efficiency.

It’s particularly common in construction, for example:

• One company supplies labour; another buys and sells materials.

• Both trade under similar names, share staff, and serve the same clients.

• Combined, their turnover exceeds the £90,000 VAT threshold, but separately, they stay under it.

  
  

If HMRC judges that these businesses are really one single operation, they can:

• Combine the turnover and force retroactive VAT registration.

• Charge VAT on all sales from the past up to 4 years (sometimes more).

• Add interest and penalties for failure to register.

  
  

This isn’t just a “big business” issue, it affects small family-run firms, partnerships, and subcontractors more often than people realise.

How It Affects Construction and Engineering Businesses

Let’s say two related companies each turnover £70,000, one for labour, one for materials. Separately, neither hits the £90,000 VAT threshold.

But if they:

• Share the same directors, staff, office, or bank account;

• Trade under similar names or with the same customers;

• Split work artificially (materials invoiced separately for the same project),

HMRC can class them as a single entity with £140,000 turnover.

If that structure has been in place for three years, the potential impact is:

• VAT owed: £140,000 × 3 years × 20% = £84,000 (approx).

• Penalties: Up to 30% for careless errors.

• Interest: ~3–5% per year.

  
  

So a small construction business could easily face a £100,000+ VAT bill, even if they never intended to avoid VAT.

What You Need to Review

1. Common Control

   Do the same people own, manage, or control multiple companies? HMRC treats common control as a major warning sign.

   
   

2. Shared Resources

   Do entities share premises, staff, equipment, or systems? If so, they may be viewed as one combined business.

   
   

3. Client Base

   Are you invoicing the same clients under different company names? If yes, this is likely considered one “economic activity.”

   
   

4. Financial Links

   Are funds transferred freely between companies or paid into the same bank? That’s another red flag.

   
   

5. Nature of Work:Are the businesses providing separate services or simply splitting one job to appear below the threshold?

   
   

Strategy — How to Stay Compliant and Still Operate Efficiently

1. Understand the purpose of separation.

   If you have multiple businesses, there must be a genuine commercial reason, not just VAT saving.

   For instance:

   • A plant hire division with different staff, insurance, and client contracts.

   • A property investment arm managed separately from contracting.

     
     

2. Formalise everything.

   • Separate bank accounts, contracts, VAT numbers, staff, and accounting systems.

   • Charge at market value between entities (not zero or token rates).

   • Keep clear documentation proving operational independence.

     
     

3. Consolidate where necessary.

   If your companies share clients, teams, or overheads, consider merging for simplicity. While you’ll charge VAT, you’ll eliminate compliance risk and gain better credit ratings.

   
   

4. Regularly review turnover.

   • Track rolling 12-month revenue across all entities.

   • If combined turnover exceeds the threshold, register voluntarily before HMRC does it for you.

     
     

5. Get professional advice.

   HMRC reviews separation cases individually — there’s no “one-size-fits-all.” Get a VAT health check to ensure your setup stands up to scrutiny.

   
   

Real Example — When It Goes Wrong

A Midlands-based contractor created two companies:

• Company A: Supplies labour (£75k/year).

• Company B: Buys materials and invoices clients (£80k/year).

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HMRC investigated after seeing both names on invoices for the same sites. They ruled the setup was one entity.

Result:

• Backdated VAT of £82,000.

• £12,000 interest and penalties.

• Temporary cashflow crisis that halted new projects.

  
  

After restructuring with JFA’s support, they registered for VAT properly, streamlined billing, and reclaimed VAT on materials, improving net margins by 6% the following year.

Lesson: Honest mistakes can cost more than doing it right from the start.

Misconceptions

1. “It’s fine if both companies are under the VAT threshold.”False. HMRC looks at combined operations, not company names.

   
   

2. “It only matters for big firms.”Wrong. Small construction businesses with similar owners are HMRC’s main target for disaggregation checks.

   
   

3. “We can avoid VAT by using subcontractors under separate entities.”Dangerous assumption, if those entities are effectively controlled by you, HMRC can still aggregate turnover.

   
   

Key Takeaways

• HMRC can combine multiple businesses if they appear artificially separated to avoid VAT.

• The test isn’t about names, it’s about control, resources, and customer overlap.

• Ignorance isn’t a defence, review your structure now, not after an HMRC letter arrives.

• Professional review can save thousands in backdated tax and penalties.

If your construction or engineering business operates across multiple entities, now’s the time to check that your structure is VAT-safe. A 30-minute VAT health review with JFA could prevent years of stress and unexpected tax bills.

Download our free VAT Compliance & Risk Checklist on the Resources page, or contact us for a confidential structure review today.

Wrapping up today's insights, tomorrow we simplify another accounting challenge.