UK VAT domestic reverse charge for buildings and construction

Where the scheme applies, VAT-registered contractors receiving supplies of construction services from VAT-registered subcontractors have to pay the VAT directly to HM Revenue & Customs (HMRC) rather than paying it to the subcontractors. Previously, VAT charged on the supplies would have been paid to the subcontractors who would then have accounted for the VAT to HMRC. Under the DRC rules, supplies made to 'end users', supplies between connected parties and supplies between landlords and tenants may be excluded if the customer notifies the supplier that the exemption applies.

The DRC specifically targets VAT fraud - where a supplier charges VAT on supplies, but then fails to account to HMRC for the output VAT. The introduction of the DRC has had a significant impact on how businesses within the construction sector account for VAT and manage their cash flows.

How does the DRC work?

Ordinarily, where VAT is charged on supplies, the customer pays the VAT to the supplier, and the supplier is responsible for accounting for the 'output VAT' to HMRC. The DRC is a mechanism that shifts the liability for accounting for output VAT from the supplier to the customer. Where the DRC applies, the customer pays the supplier net of VAT and the customer accounts for the output VAT to HMRC, so suppliers should not charge VAT when invoicing customers. It is important that both customers and suppliers properly assess whether the DRC applies to avoid the customer being exposed to the risk of penalties.

Who does the DRC apply to?

The DRC applies to VAT-registered building contractors, where they engage VAT-registered subcontractors to provide construction services; and equally to VAT-registered subcontractors engaging additional VAT registered subcontractors to provide construction services down the supply chain.

The DRC does not apply when either the supplier or customer are not required to be VAT registered, or the customer is not receiving the supply in the course of carrying on a business.

Exemptions

There are several exemptions from the DRC. There is an exemption for end-users, such as occupiers and developers. The effect of this exemption is that the DRC should not apply to the final customer in a supply chain for building and construction work. Broadly, an end-user is a customer that has to report its payments for specified supplies through the Construction Industry Scheme (CIS) but does not make supplies of construction services itself. In this context, an example of an end-user would be a large retailer, which spends significant sums on construction services but uses its properties for its retail business.

There is also an exemption for supplies of construction services between group companies, which applies where the customer is an end-user and the supplier is part of that customer's corporate group. Another exemption is available for supplies of construction services between landlords and tenants. These exemptions are subject to a notification requirement, whereby the customer must notify the contractor in writing that a relevant exemption applies. The DRC will continue to apply if the customer does not notify the contractor. Under the notification requirement, end-users effectively have the choice of whether to apply the DRC.

The DRC should not apply to supplies of staff by an employment business to a construction business, even if those the supply would be within the scope of the CIS.

When considering whether the DRC applies, the default position is that it applies unless specifically excluded.

For mixed supplies, where only certain elements of the supply are subject to the DRC, the whole supply is subject to the DRC.  However, HMRC’s guidance provides for a concession where, broadly, the DRC applies to no more than 5% of the whole supply.

What supplies are subject to the DRC?

The DRC only applies to supplies where VAT would be charged at standard (20%) or reduced rates and where payments are required to be reported through the CIS.

The DRC also only applies to supplies of “construction services”. “Construction services” is widely defined and includes: the construction, alteration, repair, extension, demolition or dismantling of buildings or structures and infrastructure such as roads, railways and waterways and civil engineering works, installation of heating and lighting. It also includes painting and decorating. Supplies of purely professional services of architects, surveyors and certain consultants are excluded from the definition.

What happens when the DRC applies?

If the DRC applies, the supplier should not charge VAT, although it still needs to determine how much VAT is due and notify the customer. HMRC has provided guidance on invoicing arrangements under the DRC.

Notwithstanding the application of the DRC, supplies are still included for the purposes of determining whether the supplier has met the VAT registration threshold.

Importance of contractual arrangements

It will be important to ensure that the contractual arrangements between the contractor and subcontractor detail whether the DRC applies. The parties should detail any works that would be outside the scope of the DRC, whether an exemption applies and how any notification requirement will be met and the contractual consequences where a notification is not made. The contract should also include an obligation on each party to notify the other, within a specified time period, of any change of circumstances relevant to the application of the DRC.