In the construction sector, it is common for the developer to withhold 5% of the value of the works certificates from the builder as a guarantee of proper execution. Although it is commonly referred to as a ‘withholding’, it should not be confused with a tax withholding. It is a contractual or legal guarantee intended to cover any defects, reworks, finishing touches or liabilities arising from the execution of the works. Law 38/1999 on Building Regulations provides that the annual guarantee for material damage arising from faults or defects in execution affecting finishing elements may be replaced by a withholding by the developer of 5% of the cost of the physical execution of the works. Therefore, its purpose is not to reduce the price, but to ensure the proper fulfilment of the contractor’s obligations.
Work in progress and completed work
The first relevant distinction is whether the work is in progress or completed. During construction, the builder usually issues partial certificates for the work carried out. In such cases, the developer may pay the certified amount, deducting the 5% retention. This amount remains outstanding until the works are accepted, the warranty period expires, or correct execution is verified. Conversely, when the works are completed, the retention must be settled: it may be released and paid to the builder, used in full or in part to cover proven defects, or definitively reduce the price if so agreed and duly documented.
Specific treatment under VAT
From a VAT perspective, the 5% retention requires an analysis of the accrual and the taxable amount. In general, Article 75 of Law 37/1992 on VAT establishes that the tax becomes chargeable when the goods are supplied or the service is provided. However, where advance payments are made prior to the completion of the transaction, VAT becomes chargeable at the time of receipt, but only on the amounts actually received. Likewise, Article 78 of the VAT Act provides that the taxable amount consists of the total consideration.
This rule must be applied with caution where amounts are withheld as a guarantee and are not collected at the time of certification.
The Directorate-General for Taxation, in Binding Ruling V0053-13 of 9 January 2013, has stated that, in the case of works certifications constituting advance payments, the VAT taxable amount must consist of the amounts actually received, excluding amounts withheld as a guarantee that have not been collected. Thus, if a certification amounts to €100,000 and the developer withholds 5%, paying only €95,000, the VAT corresponding to that advance certification should be calculated on €95,000, not €100,000. The situation changes upon completion of the works. At the time of handover, making the property available or final acceptance, if the amounts withheld still form part of the price owed to the builder, they must be included in the VAT taxable base, unless a reduction is applicable due to defects, breaches of contract or an agreement between the parties. If the retention is applied due to defects in the work, it will be necessary to analyse whether this constitutes a price reduction, compensation or a set-off of claims, as each scenario may have different tax consequences. If there is a definitive reduction in the price, Article 80 of the VAT Act may apply and, where appropriate, a corrective invoice may need to be issued.
The builder’s and developer’s perspective
For the builder, the retention directly affects their cash flow and the correct charging of VAT. It is advisable for invoices to distinguish between the certified amount, the retained amount, the taxable amount and the amount actually received. For the developer, the retention constitutes a guarantee, but not an automatic price reduction. If they decide not to release it, they must have sufficient contractual, technical and documentary backing.
Furthermore, in the execution of property works, the possible application of the reverse charge mechanism provided for in Article 84.1.2.f) of the VAT Act must be analysed, particularly in contracts between the developer and the contractor relating to the development, construction or refurbishment of buildings. Binding Ruling V2583-12 is relevant in this regard. In conclusion, the 5% withholding tax must be carefully documented in the contract, certificates and invoices. A clear distinction between work in progress and completed work, together with the correct treatment of VAT, avoids the advance payment of tax on amounts not yet received and reduces tax risks for builders and developers.