VAT Changes in the Construction Sector: Is Your Business Ready?
Updated: Sep 11, 2020
With the new VAT reverse charge rules coming into effect on 1st October 2019, there are widespread concerns that the construction industry is not prepared. There are also concerns about the impact it may have throughout the industry. What is the reverse charge, what impact is it likely to have, and how should construction sector businesses prepare themselves?
It has been a challenging couple of years for the UK construction industry. Whether it’s the collapse of Carillion in 2018, which sent shockwaves throughout the industry that are still being felt today, or political uncertainty caused by the Brexit impasse and the election of a new prime minister.
The industry is also seeing new challenges, and the one that is now focusing minds and receiving a lot of attention is the VAT reverse charge (also known as the Domestic Reverse Charge or DRC), that will come into force on 1st October.
That’s just over two months away, and there is widespread concern that the construction industry is nowhere near prepared for this change.
Concerns include the logistical implementation of the new rules, as well as their practical and commercial impact. Chief among these seems to be the significant negative impact on cashflow and working capital of construction businesses, whether large or small.
According to Alasdair Reisner, Chief Executive of the Civil Engineering Contractors Association (CECA):
“The new rules on reverse charge VAT are a time bomb for the industry with an increasingly short fuse. Many businesses are still not aware that they will have to be compliant with the new rules…The new model will mean that suppliers take a negative hit on cashflow, right at the time when they are struggling with a potential post-Brexit slowdown in the sector”.
What exactly is the VAT reverse charge?
In November 2018 a draft Order – the VAT Reverse Charge for Construction Services – was issued under Section 55A of the VAT Act (1994).
It introduces a VAT ‘reverse charge’ to certain construction services, meaning that the end-user (the ultimate customer, client or developer) will be responsible for paying the relevant VAT, not each of the suppliers or sub-contractors.
What’s behind the changes?
In a nutshell, it’s to combat tax fraud, whereby sub-contractors collect VAT from their customers but then either disappear or otherwise (often through fraudulent schemes involving shell companies) fail to pay it to HMRC.
As a result, HMRC has been losing huge amounts of tax revenue for many years. It hopes that the reverse charge will plug some of the leaks and increase its coffers.
This problem is not unique to construction, of course. However, the incoming VAT changes is likely to have significant ramifications for construction businesses of all sizes.
How exactly will the reverse charge work?
From 1st October 2019, for suppliers of certain ‘specified services’ in construction, the ultimate client/customer/developer, defined as the ‘end user’ in the new regulations, will be the party liable to pay VAT to HMRC.
The change will affect contractors and sub-contractors currently registered under the government’s Construction Industry Scheme (CIS).
This, of course, is a significant change from the current system in which each VAT-registered contractor in the supply chain charges its own VAT to its customers, then pays it to HMRC.
From October, any company that receives any of the ‘specified services’ will no longer pay VAT to its suppliers. Instead, it will account for the appropriate amount of VAT on its own VAT return and receive a corresponding offset in its own input tax.
For the supplier, this means that it should no longer include, nor receive payment for, VAT in its invoice.
What does it mean in practice?
The VAT element of invoices will no longer flow as cash between businesses in the supply chain. For each transaction, VAT will simply be calculated and registered on the invoice as a ‘reverse charge’. It will be the responsibility of the end-user at the top of the supply chain (often a property developer) to pay the VAT, with an input tax offset, where appropriate.
The government estimates that the changes this will impact up to 150,000 businesses in the construction sector. The administrative burden alone is likely to be significant, not to mention the commercial and practical implications, which we’ll come onto later.
Which ‘specific services’ are affected?
The official guidance is that ‘specified services’ mirrors those services defined as ‘construction operations’ in the ‘Construction Act’. They include:
· General construction
· Groundwork construction
· Renovations and maintenance services
· HVAC (Heating, Ventilation and Air Conditioning)
· Cleaning services
· Painting and decorating of buildings and structures
While there are some exceptions, it’s clear that the new laws will affect most construction companies to some extent.
What will be the costs to construction businesses?
There will, of course, be one-off costs to affected companies, including familiarisation with the new rules and adapting VAT accounting systems and processes to enable reverse charge supplies to be calculated and reported.
There will also be ongoing administrative costs, such as:
· Calculating the reverse charge
· Keeping records of all reverse charge supplies
· Checking the reverse charge is correctly applied
· Reporting reverse charge supplies on VAT returns
· Obtaining evidence as to whether or not a customer is an end-user
So just from an administrative perspective, there is a lot to prepare for. With only a few weeks until the new rules go live, for those companies affected by the reverse charge, they should be planning ahead now, if they are not doing so already.
In addition to the more predictable administrative costs outlined above, there are several practical consequences of the new regime that pose significant risks to construction businesses:
1. Accounting systems and practices: the entire construction industry will need to reconfigure its accountancy practices and procedures. HMRC has provided some guidance on particular wording to be used on invoices to clearly identify reverse charge transaction. However, such a significant overhaul to accounting processes always carries a heavy practical burden.
2. Cashflow/working capital: many construction businesses will no longer be able to rely on VAT money for cash flow and working capital. Whilst this money is a payable and should not be used in this way, in practice it has always been an important component of any company’s working capital. Preparation for this loss of cash flow requires significant planning before October.
3. Cashflow pressure on end-users: at the top of the chain, main contractors, if they fall under the definition of ‘end user’, as they often do, will require to pay a significant VAT bill, for all ‘specified services’ provided through the supply chain below. With narrow margins, and a squeeze in the market continuing for such companies, this poses a substantial risk to the whole industry.
The above risks, not to mention challenges around defining whether a company is an end user or not, may lead to significant negative consequences for companies that are not properly prepared.
The Final Word
The VAT reverse charge is a very significant development in the UK construction industry, likely to impact one hundred thousand businesses or more. With the industry as well prepared as it can be for Brexit, the reverse charge may well pose an even greater threat to the industry.
The introduction of the reverse charge VAT to construction services this year is something for which construction companies should be preparing themselves now. All businesses involved in the construction sector should review their supply chains to consider how they will be impacted by the changes.
In particular, it will be important to identify the categories of supplies which may be subject to the new reverse charge rules and update internal accounting processes accordingly. The impact on cashflow and working capital should also be considered, in order to minimise business risk.
Specialist tax advice can and should be sought on this issue, and preparations for 1st October should be well under way already. If they are not, we strongly recommend seeking professional advice to understand how the changes affect your business.
How prepared are you for the forthcoming VAT reverse charge? What measures has your business taken to get ready for 1st October? If you would like to speak to our VAT experts, please get in touch for a no-obligation consultation.