The Tax Gap Explained: What HMRC Expects from Construction SMEs

Introduction - The Tax Gap Explained

In plain English, the tax gap is the difference between what HMRC should collect and what it actually collects.

That gap exists because of mistakes, late filing, under-reporting, avoidance and, in a small proportion, deliberate evasion.

HMRC publishes a formal “Measuring Tax Gaps” report each year and, most recently, estimated the UK-wide tax gap at 5.3% of total theoretical liabilities (about £46.8bn) for 2023/24. Put another way, HMRC collected 94.7% of the tax it believes is due, and is investing heavily to close the final slice. 

For construction and engineering SMEs, this matters. Your projects generate high volumes of invoices, CIS deductions, VAT complexities (including the Domestic Reverse Charge) and payroll cycles, all areas where HMRC is actively tightening controls to reduce error and non-compliance.

What you need to review — CFO view for construction & engineering

1) VAT & Domestic Reverse Charge (highest impact).

If you supply or buy building and construction services caught by CIS, VAT often switches from supplier to customer under the Domestic Reverse Charge (DRC).

Misapplying DRC (charging VAT when you shouldn’t, or failing to apply it when you must) distorts cash flow, creates costly rework, and risks penalties.

Directors should confirm DRC scope, update price lists and contracts, and ensure invoice wording and accounting mappings are correct in your system.

Train site and purchasing teams so POs and subcontractor invoices match the VAT position you intend.

2) CIS status, verification and deductions.

CIS is a HMRC anti-avoidance regime for contractors/subcontractors. Common trip-ups include paying gross without verification, miscoding labour vs materials, and late/incorrect monthly returns.

These are classic “tax-gap” drivers in construction because of volume and complexity.

You need a clean onboarding workflow (UTR, insurance, status), real-time verification, and reconciliations from ledger to monthly CIS return.

3) Accuracy of transaction posting (job costing & WIP).

Errors and omissions in day-to-day postings (job codes, cost categories, retentions, variations) compound quickly across hundreds of transactions.

This fuels the tax gap via mistakes (VAT claims, CIS) and also degrades your management information. Enforce 3-way match (PO–delivery–invoice), automate capture, and reconcile control accounts weekly (VAT, CIS, PAYE, retentions).

4) Filing discipline and Making Tax Digital (MTD).

HMRC’s digital programme is designed to shrink the tax gap by cutting error and late filing. MTD for VAT is live; MTD for Income Tax is staged from April 2026. Expect more digital nudges, standardised penalty regimes and data-matching.

Get your digital links in place now and remove spreadsheet “breaks” that create risk. 

5) Governance & evidence.

HMRC’s strategy is to prevent, promote, and respond more guidance and “nudge” messaging, more targeted checks, stronger penalties for persistent or deliberate errors, and expanding compliance teams.

Your policy library (VAT/DRC, CIS, expenses, director loans), approval limits, audit trails and board-pack visibility are your defence.

Why it matters for businesses

If ignored:

• Financial risk: Misapplied DRC or CIS errors lead to incorrect VAT claims, under/over-deductions, interest and penalties. A few small mistakes across dozens of suppliers and jobs can snowball into five-figure liabilities.

  
  

  HMRC is recruiting thousands of additional compliance officers and modernising powers to accelerate casework expect more interventions, not fewer. 

  
  

• Operational drag: Teams firefight corrections, reissue invoices, and reconcile conflicting spreadsheets. Month-end slips; cash forecasts lose credibility.

  
  

• Reputational impact: Supplier relationships suffer if you short-pay VAT or CIS. Clients may doubt your control if applications contain errors, delaying certifications and cash.

If done right:

• Cleaner cash flow: Correct DRC/CIS treatment stops VAT being trapped and keeps supplier payments accurate.

  
  

• Audit-ready records: Digital links and weekly reconciliations reduce risk in a compliance check and shorten any HMRC enquiry.

  
  

• Better pricing & profit: When postings are right, job costing and WIP are right, so pricing, bids and resourcing are based on evidence, not guesswork.

  
  

• Board confidence: Directors can plan tax, payroll and materials with a reliable 13-week cash view; banks and insurers see stronger governance.

Strategy to get it right

Board-level actions

1. Adopt a written tax governance standard. One page per topic (VAT/DRC, CIS, expenses, director loans, subcontractor status) with who-does-what and links to HMRC guidance.

2. Own the calendar. Map all hmrc deadlines (VAT, CIS, PAYE, CT, accounts). Build a compliance dashboard into the monthly board pack.

3. Single source of truth. Commit to MTD-ready, end-to-end digital processes; avoid shadow spreadsheets that break digital links.

   
   

Finance team actions

1. DRC proofing: Update tax codes, invoice templates, PO forms and training decks. Run a one-off supplier/customer review to classify who is in/out of DRC. 

2. CIS control: Automate verification, map labour/materials split, reconcile CIS control accounts monthly to submissions and payments.

3. MTD discipline: Keep digital audit trails; align bank rules, invoice capture and job codes to eliminate manual rekeying. Prepare for MTD for Income Tax phases (pilot where sensible). 

Operations & site actions

1. PO before purchase. No PO, no pay, ensures the correct VAT/DRC and job code flow through.

2. Evidence on the day. Delivery notes and timesheets uploaded same day; weekly sign-off by the site lead.

3. Variation control. Don’t invoice or recognise revenue on variations without signed approval and correct VAT/DRC logic.

   
   

Commercial actions

1. Contract terms: Ensure VAT/DRC wording and CIS responsibilities are explicit in subcontracts.

2. Supplier segmentation: Identify high-risk suppliers (status changes, mixed supplies) for quarterly spot checks.

3. Training cycle: Short refreshers each quarter for site managers and administrators; share HMRC “nudge” updates when issued. 

Common mistakes

• Charging VAT where DRC should apply (or vice-versa). Consequence: repayment demands, interest, penalties; supplier disputes; cash flow shocks. 

• Paying subcontractors gross without verification. Consequence: CIS failures, penalties, rework of returns; potential assessments.

• Spreadsheet-only records for MTD scopes. Consequence: lack of digital links increases error risk; penalties under reformed regimes; extended enquiries. 

• Late or inaccurate filings. Consequence: penalties, interest, and for deliberate or repeated failings potential “deliberate defaulter” publication harming reputation.

• Poor evidence management (retentions, variations, zero/reduced-rate items). Consequence: VAT assessments; withheld client payments; margin erosion.

Misconceptions (quick myth-busting)

1. “DRC is optional if both parties agree.” False if the rules say DRC applies, it applies; you can’t opt out by contract

2. “My accountant will fix DRC/CIS at year-end.” Year-end can’t fix mis-raised invoices or wrong cash movements; errors must be prevented at transaction level.

3. “MTD only adds admin.” HMRC’s own analysis expects MTD to reduce error and narrow the tax gap fewer mistakes, fewer fines. 

Why professional support pays off

JFA embeds CFO-level control into busy site-led businesses. We:

• Map and fix your DRC/CIS exposure, cleanse supplier/customer lists, and correct templates and tax codes.

• Automate capture and approvals, removing manual rekeying that breeds errors.

• Install a compliance rhythm weekly reconciliations, monthly board packs, and digital audit trails fit for HMRC scrutiny.

• Coach your leaders and site teams so finance discipline becomes everyday habit.The result: time saved, risk reduced, stronger cash, clearer margins and a finance function that supports growth instead of slowing it down.

Key takeaways

• The tax gap is real, and HMRC is investing to close it with digital tools, more officers and stronger penalties. 

• Construction firms are high-exposure due to DRC, CIS and high transaction volume fix controls first. 

• Make compliance effortless: automate, codify, reconcile weekly, and keep clean digital links (MTD). 

• Partnering with JFA gives you control, visibility and confidence to grow profitably.

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