Reverse VAT: what can you expect?

After several delays, the domestic reverse VAT charge will finally come in next March. Liam Tumulty explains all.

Why is the domestic reverse VAT charge being introduced?

HMRC has been experiencing substantial levels of fraud from criminals who have taken control of subcontractors within the construction industry. They have been VAT registered, so charging VAT on their invoices to contractors, but have then disappeared without paying this VAT over to HMRC. This is a type of ‘missing trader’ fraud which has cost the UK government many millions of pounds. The ‘reverse charge’ system is designed to combat this.

How will the VAT charge work?

From 1 March 2021, subcontractors in the UK construction industry will no longer add VAT to their invoices when working for other contractors. Instead they will just indicate on the invoice that the VAT needs to be dealt with by their customer – the main contractor – under the ‘reverse charge’ system. Their customer will enter the VAT amount on their VAT return as if they had raised the sales invoice, as well as entering it on their VAT return in the normal way.  

Why has HMRC not zero-rated construction services for VAT?

If HMRC had zero-rated construction services, it would have lost a significant amount of VAT. Although it may appear that the VAT cash flows for the reverse VAT charge are the same as if zero rating had been applied, this is not always the case.  

How will this impact the industry? 

Firstly, this is a huge administrative change for the UK construction industry. The industry is very diverse and comprises a very large number of small subcontractors in addition to medium and large contractors. Those without specialist tax, accounting and IT expertise will find it hard to understand the changes. There is likely to be confusion and misunderstanding, which will result in errors on invoices, payments and VAT returns. These, in turn, may cause disputes between contractors and subcontractors on whether the reverse charge should apply.

Secondly, there will be a cash flow impact which will adversely affect subcontractors and could cause financial difficulties. Under the current rules the subcontractor has the cash flow benefit of receiving VAT from customers which may not need to be paid over to HMRC for around three months, but from 1 March 2021, the subcontractor loses this benefit. This will be a particular problem in the first few months following the change.  

Will there be penalties for not applying the reverse VAT charge?

Yes, HMRC will be able to impose penalties if construction businesses do not apply the construction reverse charge rules or apply them incorrectly. However, according to the published guidance: “HMRC understands the difficulties businesses may have in implementing the domestic reverse charge and will apply a light touch in dealing with related errors that occur in the first six months after introduction, where businesses are trying to comply with the new legislation.” 

How construction firms should plan for the reverse VAT charge:

  • Understand the rules and how they apply to your business.
  • Put in place appropriate business processes for the reverse charge.
  • Identify subcontractors and customers impacted by the change (subcontractors will need to be notified in advance).
  • Implement and test software changes.

Liam Tumulty is a financial consultant with COINS.

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