Out-Law Guide | 28 Jan 2022 | 3:43 pm | 5 min. read
A customer within the construction industry receiving the supply of construction services now has 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 are excluded from the rules if the customer notifies the supplier that the exemption applies.
The reverse charge has a significant impact on how businesses within the sector account for VAT and manage their cash flows. The introduction of the measure was initially delayed from 1 October 2019 to 1 October 2020, because there were concerns that many businesses were unprepared for the changes. It was then further delayed until 1 March 2021 due to the impact of the coronavirus on the construction sector.
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 reverse charge is designed to address VAT fraud.
The reverse charge has a significant impact on how businesses within the construction sector account for VAT and manage their cash flows
HMRC has published a guidance note to the reverse charge.
The domestic 'reverse charge' is an anti-fraud measure that has also 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 only affects 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 does 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 are excluded from the domestic reverse charge where the customer has notified the supplier that the exemption applies:
Where suppliers are supplying mixed supplies and only certain elements of those supplies are subject to the domestic reverse charge, the whole supply is subject to the reverse charge.
As of 1 March 2021, a VAT registered business receiving supplies of construction services from another VAT registered business where the reverse charge applies has 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 applies 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.
When the rules were originally enacted the exemption from the reverse charge for end users, connected parties and landlords and tenants was mandatory, but this meant that the supplier had to check the status of the customer. The rules were amended in July 2020 so that the exemption now only applies if the customer notifies the supplier of this in writing. This effectively gives end users, and other customers who may be able to claim the exemption, the choice of whether to apply the reverse charge or not. Some customers may prefer the reverse charge to apply because there could be cashflow benefits.
There is no set wording for the notification, 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."
For residential property if the supply is zero rated for VAT there is no reverse charge. Before 1 March 2021, the supplier generally made 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 has passed to the client who, if not an end user, may have to account for the VAT if it incorrectly fails to apply standard rating.
Suppliers 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:
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.