On the 1st of October 2019, significant changes are going to be introduced to the VAT treatment of supplies in the construction industry.
The Domestic Reverse Charge (DRC), a piece of legislation announced in the 2017 budget, is being implemented on this date by HMRC and is set to come as an unpleasant surprise to the two thirds of construction SMEs who (as of July 2019) are not aware of it, according to a survey conducted by the Federation of Master Builders.
What are the VAT changes?
Instead of VAT being paid between construction firms and then being accounted for in the usual way via a VAT return, it will be ‘reverse charged’, meaning that it will be paid directly to HMRC by the contracting company.
To illustrate the change, consider a situation where company A contracts company B to perform some construction services. Prior to this legislation company B would have charged VAT on its services which company A would have paid directly to them. When company B came to do its VAT return it would account for this payment and subsequently pay HMRC the VAT.
Under the new legislation company A no longer pays the VAT to company B, now it retains the VAT charged on company B’s invoice and pays it directly to HMRC itself.
This turns the way VAT has always operated on its head, and has caused widespread concern within the sector. In this article we examine why and how it’s been introduced, and some of the fine print that companies affected need to be aware of.
Why is this change happening?
One of the most common types of VAT evasion in the construction industry is ‘missing trader fraud’, committed by subcontractors who work for construction services.
Missing trader fraud works by a subcontractor charging for their labour plus VAT to a contractor that they are working for. What should then happen is that the subcontractor will account for this VAT on their return and pays it to HMRC. However, having been paid for their time, they then disappear before paying the VAT payment they received from the client over to HMRC making it difficult, if not impossible, for HMRC to recoup this debt.
HMRC estimate that they lose up to £100m a year to this type of fraud. Various attempts to end this in the past, including asking for security deposits in advance, have been unsuccessful. HMRC state they are certain that this measure will be more successful, as the VAT owed is coming straight from the source to the government, without the subcontractor ever seeing it.
How the reverse charge will work?
Once the reverse charge scheme is underway, any VAT-registered business supplying construction services to another VAT-registered business for onward sale is required to state on their invoice that the service is subject to the DRC. The recipient of the invoice will then account for the VAT due on their VAT return instead of paying it direct to the supplier.
Applying the DRC is a two step process:
The contractor will treat the supply from the subcontractor as if it was supplied by itself, charging itself VAT at the normal rate (5% or 20% depending on the business). VAT is charged to the end user, meaning that it is treated as expenditure to the main contractor and is recoverable in the same way as any other tax.
The VAT is paid to HMRC in the VAT return. Although the DRC prevents the subcontractor charging VAT and then not passing it on, it does not create any extra burden on the main contractor, making it tax neutral.
Who is affected by these changes?
These changes apply to those in construction services only, as defined in the Construction Industry Scheme.
The categories of construction services which are affected include:
- General construction
- Groundwork construction
- Renovation and maintenance services
- Internal cleaning of buildings which is carried out during construction
- Painting and decorating of buildings and structures
The categories of services which are not subject to the reverse charge include:
- Drilling for oil or extracting natural gas
- Constructing underground works for extracting minerals
- Manufacturing components for drainage, sanitation and water supply systems, air-conditioning, ventilation, power supply and fire protection systems, and delivering them to site
- Manufacturing building supplies, materials, plant or machinery and delivering them to site
- Architects, surveyors, landscape consultants
- Making or installing artistic works such as sculptures
- Installing blinds and shutters
- Installing security systems
- Signwriting and erecting, installing or repairing signs
An important point to note is that the charge does not apply to businesses who supply services to consumers, only to businesses who supply services to other businesses who then sell on the service.
What should you do now?
In order not to fall foul of the DRC, businesses need to look at the suppliers that they work with to ensure that they have identified those who are subject to the reverse charge. If you are unsure about any customer’s VAT status it is worth asking to be sure that they are subject to the reverse charge. If you are still unsure, you can check that your customer’s VAT number is valid and belongs to them on the European Commission website.
Once these suppliers have been identified, new rules should be put into place to ensure that these suppliers are invoiced in accordance with the DRC, and that the right amount of tax is being paid. Be aware that suppliers in the construction industry can be charged VAT at 0%, 5% or 20%, so you need to be sure that you are paying the right rate.
Both contractors and subcontractors will need to put a few processes into place to ensure that they are ready for the reverse charge. This would include:
- Checking whether your sales or purchases are affected by the charge, or both. It is possible that you will have to handle both sides of the reverse charge if you are passing on sales and supplies.
- Getting your accounting software up to date so that it can deal with the reverse charge.
- Getting your VAT accounting staff up to date with the reverse charge, using the software and sure of who they need to apply the charge for and who they do not.
- Looking at how this might affect your cash flow and making adjustments if required.
HMRC has stated that it intends to implement a ‘light touch’ period of six months during which any errors related to the DRC will be dealt with in good faith, allowing businesses to get used to the process and helping companies to correct mistakes. During this time, penalties will mostly be given only where HMRC deems a business to have deliberately tried to evade tax when using the system.
Should you be worried
For larger companies with dedicated account processing teams the new legislation will cause few issues, as they will have the resources to implement the changes required.
For smaller companies who don’t have these resources then it may be more problematic. Accounting systems used by smaller companies may have problems recording the VAT correctly, raising the potential that mistakes will be made.
In addition, the widespread unawareness of the DRC in small to medium sized businesses in the sector suggests that companies will only become aware of it at the last moment. This situation is obviously far from ideal and in itself is likely to cause errors as companies rush to comply.
If you find yourself in this position and need help then the team at TFMC can help. Our accountants and advisers can assist you in understanding this change and implemented systems to make sure you fully comply. Contact us on 0800 470 4820 or email firstname.lastname@example.org for more information