VAT fraud in construction sector supply chains presents “a significant risk to the Exchequer”, according to HMRC’s policy paper of 7 November 2018. Consequently, in an attempt to tackle this fraud, the government is, with effect from 1 October 2019, to introduce a VAT reverse charge for certain supplies of services by construction businesses to other construction businesses. So, how is this to work and who will it affect?
Background
VAT fraud typically occurs in the construction industry where the supplier of the relevant construction services charges VAT and, having recovered this from its customer, does not account to HMRC for it and, instead, keeps it and then disappears, leaving HMRC out of pocket.
The reverse charge essentially makes the VAT-registered recipient of the relevant supply the VAT collector and stops VAT being paid to those who could then go missing with it.
The recipient is required to charge itself VAT on the relevant supply to it and to then account for such VAT to HMRC through its VAT return at the appropriate rate. The recipient may then recover that VAT from HMRC, subject to the normal rules. The recipient must not pay VAT to the supplier if the reverse charge applies.
Which services will it apply to?
The types of construction services caught by the reverse charge are based on the definition of “construction operations” used in the Construction Industry Scheme (CIS).
The services caught are very wide and include:
- Construction, alteration, repair, extension and demolition of buildings or structures, docks, harbours, industrial plant and installations
- Internal cleaning of buildings and structures, so far as carried out in the course of their construction, alteration, repair, extension or restoration
- Painting or decorating the internal and external services of any building or structure.
Annexe 1 in the HMRC guidance note VAT: reverse charge for building and construction services, published in November 2018, contains a flow chart to help suppliers of construction services assess whether the reverse charge should apply.
Building and construction materials that are supplied with construction services caught by the reverse charge will also be subject to the reverse charge. It follows that building and construction materials supplied separately from the relevant construction services will not fall within the reverse charge.
If a supply has several separate elements, the reverse charge will apply to the entirety of the supply if any element of it is caught by the reverse charge rules.
There is no supply threshold to the reverse charge and it will apply regardless of the cost of the relevant construction services.
For a business trading below the VAT registration threshold, construction service reverse charge supplies should not be counted by it when considering whether the amount of its supplies require it to register for VAT.
Exceptions
Certain construction services are excluded from the reverse charge including:
- The extraction of minerals, oil or gas
- The manufacture of building, engineering, heating, lighting, air conditioning or drainage components
- The installation and repair of artistic works
- The installation of security systems, seating, blinds and shutters.
Those supplies which are not required to be reported to HMRC under the CIS are not within the scope of the reverse charge.
Supplies to “end-users” are not within the scope of the reverse charge. End-users are essentially those persons who do not supply on the construction services received by them – for example, retailers or office owners who engage contractors to undertake construction services on premises owned by them.
Supplies to intermediaries, namely those recipients of construction services who supply these without any material alteration, are also not within the scope of the reverse charge if either of the following apply:
- The intermediary is connected with the expected end-user – for example, supplies of construction services commissioned by a group company which are supplied on to another group company
- The intermediary and the expected end-user both have an interest in the relevant land – for example, a landlord or tenant where one commissions construction services and supplies these on to the other. This may occur where a tenant (via its own contractors) is fitting out a property to its specification and is requested by a landlord to undertake some works which the landlord will pay the tenant for.
It is possible, in certain circumstances, for parties to agree that the reverse charge will apply to supplies that are excluded from the scope of the reverse charge.
Invoicing and contracts
When making a supply to which the reverse charge applies, suppliers must:
- Show all the information normally required to be shown on a VAT invoice
- Annotate the invoice to make it clear that the domestic reverse charge applies and that the recipient of the supply is required to account for the VAT.
HMRC has confirmed that the following examples will fulfil this requirement:
- Reverse charge: section 55A of the VAT Act 1994 applies
- Reverse charge: customer to pay the VAT to HMRC.
The amount of VAT due where the reverse charge applies should be clearly stated on the supplier’s invoice but should not be included in the amount shown as total VAT charged.
Contracts will need to be reviewed carefully and consideration should be given as to whether warranties are required from recipients of supplies to which the reverse charge could apply (for instance, whether a recipient is an end-user or an intermediary). Thought should also be given to the recourse the supplier may have to such recipients should there be any breach of the warranties given.
Confirmation as to whether the transaction is within the reverse charge and what is required to be paid by the recipient (a sum net of VAT) should ideally be addressed in the contractual documentation so that all parties know what the VAT position is expected to be.
Penalties
A recipient of a reverse charge that fails to account to HMRC for VAT due from it will be subject to interest and penalties in the usual manner.
HMRC’s guidance confirms that if a supplier incorrectly charges VAT when the reverse charge applies, the recipient will still be assessed for VAT on the supply. It will then be for the supplier to return the money collected as “VAT” to the recipient and make the appropriate amends to its VAT records and returns.
If the supplier incorrectly applies the reverse charge due to being misled by the recipient, HMRC will not seek to recover VAT from the supplier on the relevant supply and instead pursue the recipient for such VAT. This will only occur, however, if the supplier can demonstrate that it undertook reasonable checks of the VAT registration status of the recipient.
HMRC has confirmed that it will operate a light-touch approach to penalties for genuine mistakes for a six-month period after the introduction of the new rules.
Practical implications
The new rules will increase the administration of suppliers as they will need to undertake various checks to verify whether the reverse charge rules apply to supplies made by them. The VAT status of recipients will need to be checked and HMRC suggests (in VAT Notice 735) that if a supplier proceeds with a reverse charge where there are doubts about its applicability, the supplier should consider asking for a deposit equivalent to the VAT they could become liable for if the reverse charge is applied in error.
Adaptations to accounting systems may be needed to deal with the changes.
Many suppliers will lose the cashflow advantage of receiving VAT that they may not need to have accounted for to HMRC for several months, which could lead to increased finance costs.
The key is to put in place the necessary systems as soon as possible and to review projected construction supplies to and from your business from a VAT perspective to make sure the new rules are applied correctly.
What to expect
The new rules will cause considerable upheaval in the construction sector and will clearly take some time to get used to.
HM Treasury now estimates that up to 50,000 businesses will be affected and that the new rules will raise around £500m from 2019 to 2023. For that reason, expect HMRC to implement these new measures with some vigour after the “light-touch” period has passed.
Alex Barnes is a partner at Memery Crystal
