The confederation had proposed a system of handing out gross payment certificates based on VAT receipts, rather than turnover, which would increase the number of contractors eligible for tax relief.
But the government rejected that idea last month (30 January, page 15).
Gross payment certificates are granted to traders to compensate for the CIS deduction, which takes £18 of every £100 spent by builders.
To qualify for the certificate contractors now have to show a clean taxpaying history and have a turnover of £30,000 per trader.
Liz Bridge, the confederation's director of tax, has written to Dawn Primarolo, the paymaster general, to tell her that industry talks with the government to reform the scheme could collapse.
Bridge, writing on behalf of the Construction Industry Joint Taxation Committee, said the recommendation that VAT registration be used as a fair measure of serious business intent had the support of the industry.
The letter said: "The strength of feeling around this topic is so high that negotiations on all other aspects of the scheme are likely to founder if this area is not addressed."
Bridge also asked Primarolo to have a meeting with the committee to discuss the issue.
The confederation believes the current system penalises small traders and encourages the growth of the black economy.
She said that a sole trader that turned itself into a company needed to have a turnover of £60,000 before it could benefit from the current system, so many missed out.
Bridge said: "The government likes the amount of tax that comes in under deduction from firms with a clean taxpaying record but cannot reach the threshold of £60,000."
n The Inland Revenue plans to fine construction firms £3000 a month if they do not properly declare their tax liabilities on official declaration forms, under new legislation to come into force in 2006.