Lawyers Ronan Lowney and Michelle Essen from Womble Bond Dickinson give a detailed overview to the upcoming VAT reverse charge.
You have probably heard about VAT changing for the construction industry later this year, but some of the information about those changes can be very complex for non-tax-experts.
How VAT currently works
A very simplified structure for a construction project could be as follows:
- Developer wants to build the project, enters into a building contract with a contractor
- Contractor agrees to build the project, enters into the building contract with the developer, and a subcontract with a subcontractor
- Subcontractor agrees to help the contractor build the project, enters into the subcontract with the contractor.
In this scenario, VAT broadly works like this at the moment:
- Developer pays VAT to the contractor on amounts invoiced by the contractor
- pays VAT to HMRC for works and services that it provides itself, and
- pays VAT to the subcontractor for works and services that the subcontractor provides and invoices to the contractor
- Subcontractor pays VAT to HMRC on the works and services that it provides and invoices to the contractor.
So all the VAT payments cascade downwards, with more than one party paying VAT to HMRC on the project.
How VAT is changing
On 1st October 2019 VAT will change for construction, with “reverse charge” VAT rules coming into force – through section 55A of the Value Added Tax Act 1994.
(Some works and services will still fall under the current VAT regime, but we expect the reverse charge VAT rules will apply to many projects and construction industry businesses, bringing major change to VAT obligations and processes in construction.)
It is called “reverse charge” because the flow of VAT is going to change from the downwards process (set out in the example above) to an upwards one.
Subject to the below, under the new rules, the “recipient” of the works and services up the chain will, instead of paying the VAT to the party charging it, retain that VAT and pay it to HMRC (essentially discharging the VAT liability of the supplier of the works and services).
However, if you are the “end user” of the works and services, then you are not that recipient.
What does that actually mean?
It means that the simplified structure above would change so that it would work like this instead:
- Developer is the last party in the chain and is the end user of the works and the services – so, as before, the developer pays VAT to the contractor
- Contractor is now the last recipient of the works and services before the end user – so it retains the VAT chargeable on the invoice supplied by the subcontractor (instead of paying the VAT to the subcontractor). It then pays to HMRC (i) that VAT it has retained, and (ii) after accounting for that retained VAT as “input tax”, the balance of the VAT it charges the developer. In essence, this means that it would account for the full amount of VAT expressed in the invoice to the developer, whereas in the past it would have only accounted for the amount by which that exceeds the “input VAT” which the contractor itself had been charged by the subcontractor
- Subcontractor is not the last recipient of the works or services before the end user – so no longer pays the VAT to HMRC on the works and services that it provides as this is done on its behalf by the contractor. It will still invoice the contractor for VAT, but the contractor will withhold or deduct the VAT from its payments to the subcontractor. In its tax return, the subcontractor informs HMRC that VAT was invoiced but that it was paid by the contractor.
So the VAT payments flow upwards now, with only one party (in this example) paying VAT to HMRC on the project, including on others’ behalf.
Changes to the chain
The chain above could change though, for example if a purchaser wanted to buy the project from the developer while works were continuing. That would make the purchaser the end user, and the developer the last recipient of the works and services before the end user, so the developer would have to account for the VAT which it had been charged by the contractor.
How does this affect me?
The first thing to consider is whether the reverse charge VAT rules actually apply to your project, works or services. In particular consider whether any exemptions apply eg for new buildings, or zero-rated supplies of goods or services.
If the rules do apply, points to consider include:
- what is your status in the chain – eg are you an end user or the one who has to pay the VAT to HMRC (there may be more than one end user eg the property owner and a tenant depending on the facts)
- if the chain changes – reassess your position in the chain and whether your obligations in relation to the reverse charge have changed
- do you need to make changes to your building contract or subcontracts to reflect the parties’ obligations under the reverse charge rules eg if you are the one who has to pay the VAT to HRMC, does the contract allow you to withhold or deduct VAT from your payments to others down the chain? Does the contract cover a scenario where the end user changes if it could affect you?
- are your accounting staff sufficiently trained on the VAT changes and are your accounting systems updated to process the reverse charge VAT
- will the reverse charge impact your cash flow (because the 20% VAT payment is no longer passed down to you when your bill is paid, or because your bill is queried by the party who is to pay it)
- whether you should be applying the reverse charge on ongoing contractual payments (as the reverse charge will apply to all construction contracts which are operational on 1 October 2019, not just new contracts entered into from that date). HMRC will grant a grace period of 6 months as suppliers and recipients come to terms with the new regime (as mentioned below), and will allow supplies between the same parties to be treated in the same way while the parties determine whether the rules apply to each type of contractual supply
- the position of developers can be quite sensitive in this new regime. In many cases it may be obvious that it is the end-user, but a change of intention or a further supply of a completed building by the developer to an investor could raise tax complications and contradictory tax objectives due to the interaction of SDLT and VAT rules.
HMRC has issued guidance VAT: domestic reverse charge for building and construction services which includes helpful information, such as a list of services affected by the reverse charge and list of services excluded from it.
Finally in the guidance, HMRC has clearly stated “HMRC understands that implementing the reverse charge may cause some difficulties and will apply a light touch in dealing with any errors made in the first six months of the new legislation, as long as you are trying to comply with the new legislation and have acted in good faith. Any errors need be corrected as soon as possible… HMRC officers may assess for errors during the light touch period, but penalties will only be considered if you are deliberately taking advantage of the measure by not accounting for it correctly.”
The above has set out some very simplified examples of how the reverse charge will work, and some key points for you to think about. In practice, the VAT landscape is inevitably going to be far more complex than those examples, and the points that you need to consider will vary from project to project.