Domestic reverse charge
From 1 March 2021, HMRC plans to overhaul VAT liability within the construction supply chain by introducing a new VAT reverse charge.
This will affect a wide range of contractors and sub-contractors throughout the construction industry, from those erecting a new building to decorators and repairers. The plans were originally scheduled for 2019 and then delayed to 2020 as it became apparent that further questions needed to be answered. COVID-19 put a further spanner in the works resulting in a decision to postpone the changes to 1 March 2021 – despite the fact that the pandemic is still raging and many businesses are now having to deal with additional Brexit-related administration.
By implementing a reverse charge for VAT-registered sub-contractors, HMRC is hoping to combat what has been generally perceived to be widespread ‘trader’ fraud within the industry. The concern has centred on the ease with which a sub-contracting company could be established, charge the appropriate rate of VAT on services supplied and then ‘disappear’ without accounting for its VAT liability. The changes to the system will mean that VAT-registered sub-contractors will not charge the relevant VAT amount on their invoices; instead the customer employing their services will account for both output and input VAT on their tax returns.
Who is affected?
All VAT-registered sub-contractors and contractors should be preparing for the change. The supplies affected include (but are not limited to) those required to be recorded through the Construction Industry Scheme. This is drawn widely and includes work carried out in the UK relating to site preparation, alterations, dismantling, construction, repairs, installation, decorating and demolition among others. When caught by the new rules, sub-contractors will no longer be paid VAT by their customer and customers will be required to account for the VAT on qualifying purchases. This may cause cash flow challenges for the sub-contractors but will boost cash flow for the customers.
Those customers now responsible for accounting for the VAT liability are defined as companies that are directly involved in supplying construction services, such as main contractors. Other end users, defined as businesses that have commissioned the building work but do not supply construction services onwards are excluded from the reverse charge and will account for VAT normally. Private individuals using construction services are also excluded from paying the reverse charge; contractors supplying services to private householders will simply present their invoice which should include the correct VAT amount.
What will those affected need to do?
The most immediate issue with which sub-contractors will need to grapple is ensuring that their accounting systems are updated before 1 March 2021 to deal with the changes. They will also have to check whether their supplies are reverse charged or subject to VAT as usual. This will involve a number of steps, ranging from checking the nature of the service supplied, to understanding the customer’s status for VAT, CIS and whether it qualifies as an end user or is linked to an end user, before then understanding the wider implications such as agreements relating to non-construction services. Only then can the supplier correctly determine whether or not their supply is caught by the domestic reverse charge and issue a sales invoice with the correctly apportioned values, correct rate(s) of VAT and the correct wording.
Sub-contractors should be considering the impact on their business too. Their cash flow is likely to be negatively impacted and it might be possible to take steps to address government schemes and timings being used where alternatives might be more suitable.
Customers will also have their own issues to address. Although their cash flow position may improve, they should consider what terms to include in their contracts with sub-contractors. Systems too should be able to distinguish purchases which fall under the reverse charge from those that do not, identify how to apply and apportion the rate of VAT appropriately and determine those occasions when an end user declaration should be made to suppliers. There are also optional steps which might make life easier for certain customers which should be considered and followed where helpful.
What will be the impact on the construction industry?
Most observers have noted that the timing of the implementation is unhelpful given everything else that is going on. Nonetheless, it is written into legislation and affected businesses will need to get their house in order in double quick time if they haven’t already. We’ve already touched on the potential impact these changes may have on the cashflow situation for those sub-contractors that rely on VAT payments made to them to tide them over in the period between payment in and payment out. There are various ways businesses can reorganise their accounting processes in order to soften the blow but they will need to consult professional advisers to make sure they are set up correctly.
The different types of work, materials, suppliers and customers should be reviewed and supply chains tested (both buying and selling) to ensure robust systems are in place to get the VAT right. There are a wide variety of ways a construction project might be structured, such as joint ventures, design and build companies, overseas companies, public-private ventures, sale and leaseback, s106 and other planning gain agreements and so on. Each have their own complexities when it comes to determining whether the reverse charge applies, to which elements of a supply and what the appropriate rate of VAT is.
Sub-contractors and contractors might also consider a recent addition to the rules, being a kind of de minimis rules called the “5 per cent disregard”. In certain circumstances the reverse charge element can be set aside, but unfortunately the test is not as simple as whether there is a single supply of a construction service where only a small element would qualify for the reverse charge.
Businesses and their advisers might consider asking a specialist to review their supply chains at an early stage to prevent larger issues arising in the years to come, when HMRC begin to question what has been done.
Example 1: contractor purchases from decorator
A main contractor constructs a wholly new office block for a VAT-registered company and purchases various services from sub-contractors including the final painted finish.
The supply of the works by the main contractor will be standard-rated without the reverse charge and the main contractor should retain evidence on its files that its customer, although perhaps VAT-registered as a business itself, qualifies as an end user.
The main contractor, however, if registered for CIS, is likely to receive invoices from its decorator sub-contractor referring to the reverse charge and the main contractor will determine the amount of VAT to declare in its VAT returns.
This example is often more complicated in reality. For example, if the office block contains some residential accommodation which might be new or which might incorporate part of an existing building or which might have been empty for two or 10 years etc, different rates of VAT will apply to different elements of the construction and of the decorator work which will now be the main contractor’s responsibility. It might even be the case that the rate of VAT charged on the sale does not match the rate of VAT accounted for on the purchase. The decorator will have their own issues, such as whether their supplies are partly reverse chargeable and partly not; whether the de minimis “5 per cent disregard” rule applies; whether an optional agreement has been reached with the customer for a wider application of the reverse charge. Advisers will assist in training staff and help to get systems right.
Example 2: electrician sells services to law firm
A law firm sub-contracts the installation of new wiring in their building to an electrician. Before new VAT rules, the electrician would determine the nature of the wider project they are working on in order to determine the appropriate rate of VAT to charge on their invoices.
From 1 March 2021, the electrician will approach the VAT position differently. First, the electrician will consider whether the supply is within the new domestic reverse charge. If the law firm declares that they are an end user, the electrician will then determine the appropriate rate of VAT for its invoices.
In reality, the customer’s situation may be more complex. The law firm (the customer) might confirm that it only occupies part of the building and not the whole, at which point the electrician will consider whether the law firm qualifies for a domestic reverse charge, whether the de minimis test is met or whether the domestic reverse charge applies and even whether the optional reverse charge applies more widely to their work across the site. If all other requirements are met, the electrician will enter no VAT charge on part of its sales invoices and refer to the Section 55A reverse charge, making its customer responsible for paying VAT to HMRC.
The Construction Industry Scheme (CIS)
The CIS is an anti-fraud measure applying to payments made by a “contractor” to a “subcontractor” which relate to certain construction work.
Where the CIS applies, deductions have to be made from those payments, which count as advance payments towards the sub-contractor's corporation or income tax and National Insurance (NIC) liabilities. It is perhaps helpful to think of the CIS as the opposite way around from VAT: generally, the responsibility for operating VAT correctly falls on the person making the supply. Under CIS, it is the person making the payment who is responsible for making the deduction. The payor has to work out what is deductible and what the deduction should be, withhold the amount, and pay it over to HMRC (and if they don’t get it right they can be made liable by HMRC for the amount they should have deducted but didn’t).
The CIS generally applies to construction businesses, but can also apply to certain entities who are “deemed” to be contractors. These “deemed contractors” are required to report payments under CIS if their average annual expenditure on construction operations exceeds £1 million in each of the last three years. This typically catches businesses with a significant spend on construction such as large retailers and public bodies. However, from April 1, this is changing: businesses whose cumulative expenditure on construction operations exceeds £3 million within the previous 12 month period will be ‘deemed’ to be contractors. Businesses doing one-off refurbs or extensions etc, could be affected, although work carried out on property they occupy for the purposes of their business will be exempt under the CIS.
Kevin Hall, VAT Partner, Wright Hassall