This guide was updated in January 2019
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. Planning will need to commence well in advance of the implementation deadline of 1 October 2019.
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.
After a consultation in 2017 and 2018, the government has published a final version of the draft legislation which will introduce a VAT domestic reverse charge for building and construction services with effect from 1 October 2019. It has also published a guidance note, although it is expected that more detailed guidance will be published during the run-up to 1 October 2019.
The changes required to be put in place by businesses in order to comply with the new legislation will be significant and planning will need to commence well in advance of the implementation deadline.
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 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 2019, 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.
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.
For continuous supplies of specified services, being provided before and after 1 October 2019 invoices with a tax point before 1 October 2019 will be subject to the normal VAT rules; and invoices with a tax point on or after 1 October 2019 will be subject to the new domestic reverse charge rules.
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 2019.
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.
HMRC recognises the difficulties around implementing the new rules and has announced that it will apply a light touch in dealing with related errors that occur in the first six months after introduction.