UK VAT reverse charge for building and construction services

Out-Law Guide | 09 Sep 2019 | 2:46 pm | 6 min. read

A VAT 'reverse charge', to be introduced in the UK for building and construction services, is designed to combat VAT fraud in the building and construction sector. It will have significant impact on VAT compliance and cashflow. It was originally due to come into force on 1 October 2019, but its introduction has been delayed until 1 October 2020.

A customer within the construction industry receiving the supply of construction services will have to pay the VAT direct to HM Revenue & Customs (HMRC) rather than paying it to the supplier. Supplies made to 'end users', supplies between connected parties and supplies between landlords and tenants will all be excluded from the new rules.

The reverse charge will have a significant impact on how businesses within the sector account for VAT and manage their cash flows. Significant process and systems changes will be required. The introduction of the measure was delayed from 1 October 2019 to 1 October 2020, because there were concerns that many businesses were unprepared for the changes.

Where historically fraud in labour supply chains was mainly related to direct tax, HMRC recognises an increase in VAT fraud within the labour supply chains in large construction projects. The Construction Industry Scheme (CIS) was introduced to address the direct tax fraud and the government has now looked at policy options to address VAT fraud, which is estimated to cost the UK Exchequer over £100m per year.

The reverse charge will have a significant impact on how businesses within the construction sector account for VAT and manage their cash flows. Significant process and systems changes will be required.

The regulations have been made which will introduce a VAT domestic reverse charge for building and construction services. HMRC has also published a guidance note.

The changes required to be put in place by businesses in order to comply with the new legislation could be significant and any affected business which has not yet taken steps to prepare needs to do so.

Domestic reverse charge

The domestic 'reverse charge' is an anti-fraud measure that has already been introduced for certain services and goods, such as telecommunication services, mobile phones and computer chips. The reverse charge mechanism shifts the liability for accounting for output VAT from the supplier to the customer. This prevents the supplier from charging what purports to be VAT to the customer, but then absconding with the VAT element and not paying it over to HMRC.

The domestic reverse charge will only affect supplies at the standard or reduced rates where payments are required to be reported through the CIS.

The CIS is scheme which involves amounts being deducted from payments made by a contractor to a subcontractor which relate to construction work. The amounts deducted count as advance payments towards the subcontractor's tax and National Insurance liability.

Obligations under CIS usually only apply to those operating in the construction industry. However, non-construction businesses are treated as 'deemed contractors' required to report payments under CIS if their average annual expenditure on construction operations over a three year period exceeds £1 million. This typically catches businesses with a significant spend on construction such as large retailers and public bodies. 

The construction services covered by the reverse charge are those falling within the definition of 'construction operations' in CIS. This wide definition includes the construction, alteration, repair, extension, demolition or dismantling of buildings or structures and infrastructure such as roads, railways and waterways. It also includes painting and decorating. Specified services are excluded, including professional services of architects, surveyors and certain consultants.

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.

The following supplies of services will be excluded from the domestic reverse charge:

  • supplies of construction services made to end users: an end user is a customer that has to report its payments for specified supplies through CIS, but does not make supplies of construction services itself. This could be, for example, a large retailer which spends significant sums annually on construction services but uses the properties for its own retail business;
  • supplies of construction services between group companies: this will only apply where the customer is an end user and the supplier is part of that customer's corporate group;
  • supplies of construction services between landlords and tenants.

Where suppliers are supplying mixed supplies and only certain elements of those supplies will be subject to the domestic reverse charge, the whole supply will be subject to the reverse charge.

VAT return and compliance

As of 1 October 2020, a VAT registered business receiving supplies of construction services from another VAT registered business where the reverse charge applies, will have to account for the reverse charge VAT on its own VAT return and will be able to recover that VAT on the same VAT return, subject to the normal VAT recovery rules. Where the reverse charge applies, a business will need to ensure that it does not pay over the VAT element to the supplier, as it will still be liable to account for the VAT to HMRC.

The reverse charge will apply throughout the supply chain up to the point where the customer receiving the supply is no longer a business that makes supplies of construction services.

Linking the reverse charge to CIS means that subcontractors should know if their customer is reporting payments under CIS, so that the reverse charge may apply, because they will have been asked to confirm their CIS status. Subcontractors and contractors will be able to assume that the reverse charge does not apply and that they should charge VAT in the normal way if their customer is not applying CIS. If the customer is applying CIS, suppliers will be able to assume the reverse charge applies unless their customer has confirmed in writing that they are an end user for reverse charge purposes.

There is no set wording, but this is an example from HMRC's guidance of suitable wording:

‘We are an end user for the purposes of section 55A VAT Act 1994 reverse charge for building and construction services. Please issue us with a normal VAT invoice, with VAT charged at the appropriate rate. We will not account for the reverse charge.’

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.

For residential property if the supply is zero rated for VAT there is no reverse charge. Before 1 October 2020, 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.

The implementation of the reverse charge was delayed from 1 October 2019 as there were concerns that the industry was not prepared for the changes.

Suppliers will have an obligation to issue VAT invoices stating that the services are subject to the domestic reverse charge mechanism and the amount due under the reverse charge should be clearly stated on that invoice, but not included in the amount shown as total VAT charged. HMRC does not require specific wording, but has provided the following examples of acceptable wording:

  • reverse charge: VAT Act 1994 Section 55A applies
  • reverse charge: S55A VATA 94 applies
  • reverse charge: Customer to pay the VAT to HMRC

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.

For continuous supplies of specified services, being provided before and after 1 October 2020 invoices with a tax point before 1 October 2020 will be subject to the normal VAT rules; and invoices with a tax point on or after 1 October 2020 will be subject to the new domestic reverse charge rules.

Implementation

The domestic reverse charge will have a significant impact on VAT compliance and cash flow management for the businesses involved. New systems and processes will need to be introduced or current systems and processes will need to be amended in order for businesses to be able to implement the new rules as of 1 October 2020.

Smaller sub-contractors may currently rely on the positive cashflow in respect of the VAT element of contract payments which will disappear in relation to reverse charge supplies. There are concerns that the reverse charge could cause significant cashflow difficulties for smaller sub-contractors. In order to minimise disruption to their supply chain, contractors may want to ensure that their sub-contractors have prepared for the reverse charge.

Penalties are imposed for errors in VAT returns. In its guidance HMRC says 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".

The implementation of the reverse charge was delayed from 1 October 2019 as there were concerns that the industry was not prepared for the changes.