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Out-Law Guide | 09 Aug 2019 | 9:27 am | 12 min. read
In response to growing missing trader VAT fraud in the construction sector, which is valued at £100 million a year, the UK government is introducing a VAT domestic reverse charge for building and construction services with effect from 1 October 2019.
The change is significant and affected companies will need to change their systems and processes and train staff. It will also create cash flow issues for suppliers.
The reverse charge aims to combat construction sector fraud where suppliers do not account to HMRC for VAT they have charged to their customers. The new reverse charge means that instead of suppliers collecting cash from their customers in respect of VAT and being liable to pay the VAT to HMRC, customers will pay the net of VAT amount to the supplier and account for the VAT on their own VAT return. The VAT liability itself is not changing, only the way it is accounted for.
The reverse charge will affect 150,000 business. There are significant changes to be made to IT and accounting systems, staff training, transitioning periods to the new arrangement and, undoubtedly, a negative impact on cash flow. Worryingly, a recent survey by the Federation of Master Builders found that 69% of SMEs were not aware of the pending reverse charge and that of those that were aware only one-third were ready to implement the new system.
Suppliers of goods and services in the construction sector that are registered for VAT currently charge their customers VAT and later account to HMRC for the sums charged, usually on a quarterly basis. This means that suppliers hold money earmarked for HMRC for a while before paying it over. It also means that it is possible for unscrupulous suppliers to charge customers an amount purporting to be VAT but never account to HMRC for the same.
A business that receives supplies subject to the reverse charge on or after 1 October 2019 must account to HMRC for the VAT rather than the supplier. The supplier will raise an invoice, which must specify that the reverse charge applies and that the customer must account to HMRC for this amount. The customer accounts for the reverse charge VAT as output tax on its own return and recovers it as input tax, subject to the normal VAT recovery rules. For most transactions the VAT is simply netted off.
A recent survey by the Federation of Master Builders found that 69% of SMEs were not aware of the pending reverse charge and that of those that were aware only one-third were ready to implement the new system.
The reverse charge will apply to the whole construction supply chain up to the point where the customer receiving the supply is no longer a business that makes supplies of construction services - the end user. There are some limited exceptions for certain intermediaries. The only party in the construction supply chain who will charge VAT in the normal way will be the main contractor, collecting it from the end user or client and paying it over to HMRC.
Whether the reverse charge applies to projects that have already commenced before 1 October 2019 will depend on when the tax point is, meaning the date of issue of the VAT invoice, or receipt of payment – whichever happens first. If the tax point is on or after 1 October then the reverse charge will apply, if the tax point is before then, existing rules apply. Some argue this will further confuse matters and the reverse charge should only apply to projects commenced after 1 October 2019.
The reverse charge will only apply to:
The Construction Industry Scheme (CIS) is where a contractor deducts money from a subcontractor's payments and passes it to HMRC in respect of the subcontractor's tax obligations. Subcontractors satisfying certain conditions and registered with HMRC can receive gross payments from the contractor.
Specified construction services are construction services and associated goods supplied. CIS defines construction services widely and includes construction, alteration, repair, extension or demolition of buildings and civil engineering works, installation of heating, lighting and other services, and includes both preparatory work and completion work. It even extends to painting or decorating, whether internal or external, of any building or structure.
However, the reverse charge will not apply to recruitment businesses supplying construction workers. The important distinction between supplying staff and supplying construction services is that the individual workers are employed or paid by the employment business and not by the construction business that uses them to provide construction services.
Excluded supplies - the reverse charge does not apply to certain excluded goods and services. Who will be responsible for auditing the services provided to ensure that the reverse charge is applied where necessary? If not properly monitored, could this be a potential area for abuse by suppliers who can mischaracterise supplies as being excluded?
Mixed supplies – if a supply which would ordinarily be caught by the reverse charge, is part of a bigger supply of goods or services, the whole supply will be caught by the reverse charge, provided the customer is VAT registered and the payments are subject to CIS. This is to make it simpler for the supplier/customer to avoid the need to apportion or split out the supply. However, what will be the implications if a supplier is not aware of the 'catch all' element and there is a discrepancy between the VAT held back by the supplier?
Residential property – where the supply may be zero rated for VAT there is no reverse charge. Before 1 October, the supplier generally makes the decision as to the VAT liability of construction services relating to dwellings as they have the output tax liability if they get it wrong. In the new regime this risk passes to the client, who if not an end user, may have to account for the VAT if it incorrectly fails to apply standard rating.
End users – these are classified as entities that receive construction services but do not make an onward supply of them, for example a developer which owns land and receives construction services, but then immediately sells the building on or lets it out on completion of the works. The reverse charge does not apply to end users, with the usual VAT rules applying.
It is the customer's responsibility to inform the supplier they are an end user. But if they fail to do so and the supplier applies the reverse charge and does not charge the customer VAT, HMRC expects the customer to notify the supplier that it is an end user and request a corrected invoice. Another complication is that the customer's status could change mid-contract. For example a developer which was an end user because it intended to sell a completed building, may sell a partly completed building and carry on supplying construction services to the buyer, so that it is no longer an end user. The customer would need to notify the supplier because the reverse charge would begin to apply.
To prepare themselves for the implementation of the reverse charge businesses will have to incur costs in changing their accounting systems and training staff. Those costs will of course vary depending on the size and complexity of the business. For this reason the industry called on HMRC to introduce a long lead time for implementation of the reverse charge, with clear comprehensive guidance to assist businesses in making the necessary changes.
By the implementation in October almost two years will have passed since the government's decision to introduce the charge, but little has been done by HMRC to produce user-friendly guidance for business to prepare them for the changes. Finance providers should already be having discussions with affected their clients to ensure that they have a plan to implement these new processes.
Given the uncertainty in the industry about the implementation of the reverse charge and the practical implications there is a significant risk that businesses will be charged VAT incorrectly. Those business may find themselves out of pocket if they pay to the supplier an amount purporting to be VAT when the reverse charge should have applied as they will not be able to recover the purported VAT as input tax, yet will be liable to HMRC for the VAT under the reverse charge.
Penalties are imposed for errors in VAT returns. In a guidance note issued in June 2019 HMRC said that it will "apply a light touch in dealing with related errors that occur in the first six months of the new legislation, as long as you are trying to comply with the new legislation and have acted in good faith".
Perhaps the main concern in relation to invoice financing under the new reverse charge regime is the validity of the invoice that a customer presents to an invoice financing company.
At least in the first few months after the reverse charge has been adopted, finance providers should check that their customer, as supplier, has correctly decided to apply or not apply the reverse charge by asking for confirmation that due diligence was undertaken, and to also inspect the invoice generated using the checklist below.
Specifically, they should check that the invoice has been annotated to show that the reverse charge applies and that the customer is liable to account for the VAT. HMRC does not require specific wording, but has provided the following examples of acceptable wording:
The invoice should also state how much VAT is due under the reverse charge, even though that VAT has not been included in the amount charged to the customer.
This is complicated, however, by the inevitable uncertainty and confusion in the construction sector when these changes come into force in October. HMRC recognises in its Guidance Note that in some circumstances, especially where one or more of the areas of uncertainty mentioned above are present, it will not be clear whether the reverse charge should be applied. The effect of this confusion may be to cause invoice financing companies to exercise caution when lending to suppliers operating in the construction sector. Debtor customers may also be slower to pay invoices and might query issues such as whether the calculations are correct and whether the reverse charge should be applied. This might affect the debt turn of a business and the time in which invoices are paid to the invoice financing company.
Of most obvious concern will be the cash flow of suppliers. They currently enjoy an inflated bank balance through collecting VAT from customers, before accounting to HMRC several months later. Under the reverse charge, this 'extra cash' will no longer be sloshing around in their bank accounts and will be unavailable for them to use in the period between collection and having to account to HMRC.
On the one hand, this means that suppliers may have more need to obtain invoice financing services to ensure a steady cash flow is maintained. On the other hand, the liquid assets of suppliers will be diminished and could adversely affect the business of the suppliers and, in turn, the ability of the invoice financer to collect out on the invoice if a contract has only been partially completed.
Given the uncertainty in the industry about the implementation of the reverse charge and the practical implications there is a significant risk that businesses will be charged VAT incorrectly.
The Federation of Master Builders and the Chartered Institute of Taxation have written to the government asking for the reverse charge to be postponed for six months to allow more businesses to prepare. With the uncertainty around Brexit, no doubt a delay will be a welcome relief to those still grappling with the amendments to be made.
Based on the legislation and the guidance produced by HMRC to date, there is no indication that finance providers must ensure compliance. However, we recommend that finance providers start having discussions with their construction clients immediately to ensure relevant plans and new systems are in place. Whilst there may not be a responsibility, the finance provider will of course want to ensure that their client is prepared for the administrative burden and the likely affect on its cashflow and work with the client to make sure they can trade through the first months post implementation.
Unfortunately, if any of the services in supply are subject to the reverse charge, then all other services will be subject to the charge. It will be irrelevant whether a service would be excluded if it was a single supply. However, once implemented this will be a positive outcome for clients and finance providers, who will only have to have one ledger per client, rather than potentially multiple ledgers covering different supplies and different VAT charges.
Finance providers lending against invoices in the construction supply change where the reverse charge applies will have to be adjusting their advance rate to take into account the 20% overall net reduction in the value of the client's invoices. In turn, they will have to be mindful of the negative impact on the client's cashflow and work with the client to address this and consider what other assets or debts might also need to be financed to bridge the shortfall.
Mainstream lenders who have provided an overdraft or term loan will not be directly affected by the reverse charge as they have not purchased the client's debt and, therefore, will not be directly involved in the invoicing and recovery process. However, they should be mindful of the same cashflow issues that will no doubt arise and work with the client to make sure they will still be able to meet any monthly repayments.
From April 2020 HMRC will rank as a secondary preferential creditor for VAT, PAYE Income Tax, Employee National Insurance Contributions and Construction Industry Scheme Deductions. This will rank HMRC behind other preferential creditors, but before floating charge holders, for these debts. The reverse charge VAT liability will therefore attract preferential status come April 2020.
It is anticipated that many businesses will not be able to plug the cashflow gap caused by the introduction of the reverse charge, likely causing an increase in insolvencies across the construction sector where margins are already extremely tight. We do not anticipate that there will be a spike in insolvencies prior to April 2020 solely to avoid incurring HMRC's preferential status as creditor. Some query whether in fact HMRC may refrain from taking debt enforcement action and commencing winding-up proceedings until after April 2020 to truly realise the benefit of its revised creditor status.
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