Important changes to VAT are to come into effect on 1 March 2021. They were due to have commenced on 1 October 2020, but the start date has been put back due to the coronavirus. In addition to this, an important alteration has been made to the new rules, and they will have to be applied only upon notification by the customer to the supplier.
From 1 March 2021, many contractors in the construction industry will stop paying VAT to their subcontractors. Instead, the contractor will pay the VAT directly to HM Revenue & Customs. An easy way to think of the new rules is as an extension of the existing Construction Industry Subcontractors (CIS) scheme to cover VAT as well as income tax & corporation tax.
This “domestic reverse charge” (DRC) will have a number of consequences for many businesses. For many businesses, the new rules are an additional complication, and it will be important to get things right to avoid problems with invoices or with HMRC. However HMRC say will apply a “light touch” in first 6 months of the new regime, and not charge penalties for errors, so long as an honest attempt has been made to get the VAT right.
Who the DRC will apply to
The DRC will only apply within the chain of construction contractors. In general, if a contractor has to know the status of its subcontractor under the CIS (i.e. approved for gross payment or liable to deduction at 20% or 30%) when paying an invoice, then the contractor will no longer pay VAT to the subcontractor. The subcontractor will invoice the contractor without VAT, and the contractor will pay the VAT directly to HMRC by including it on its VAT return.
Most businesses will continue to make some supplies which are outside the DRC, on which they must carry on charging VAT as now. These include:
A supplier won’t necessarily know a customer’s status as end user or intermediary, and the recent change to the DRC rules clarifies what to do about this. The default position is that the supplier is to assume that the customer is not an end user or intermediary. This means that, provided the customer is VAT-registered and also registered with HMRC under the CIS, the supplier should apply the DRC. Once in receipt of written notification of the customer’s status as end user or intermediary, the supplier should charge VAT in the normal way.
If there is any doubt about whether the customer is registered for VAT or the CIS, the supplier should get written confirmation of that as well. If the customer is either not VAT-registered or not CIS-registered, VAT will still be charged in the normal way.
Services within the DRC
The list of services caught by the DRC is exactly the same as for the CIS, but there is an important difference in how the two schemes operate. While the CIS only applies to the charge for services, and excludes materials, the DRC covers the full amount of an invoice which has any element of DRC services. So materials and non-DRC services can be swept into the DRC.
Supplies of staff are outside the DRC, so the normal VAT rules continue to apply to them. It should usually be clear when a business is an agency supplying staff, rather than a subcontractor supplying construction services using those staff.
Consequences of the DRC
As well as knowing the rules of when to apply the DRC, businesses will need to be aware of its wider ramifications.
Cash flow: contractors’ cash flow will be improved, and subcontractors’ cash flow will be worsened. Subcontractors will no longer have the benefit of holding the VAT until its is due to be paid to HMRC.
Move to monthly VAT returns: some subcontractors will become VAT “repayment traders”, incurring more input VAT on materials and overheads than the output VAT they charge to customers. As a result they will regularly reclaim VAT from HMRC instead of having to pay HMRC. If you will be in this position, you should consider changing to making monthly VAT returns, to get your VAT repayments more quickly and to mitigate the hit to your cash flow.
DRC supplies are excluded from the Flat Rate Scheme. This could reduce the advantage that the FRS has over the standard method of accounting for VAT. So if you are currently on the FRS, you should check whether it will still be advantageous, and withdraw on 28 February if appropriate.
Invoicing and VAT accounting
Keeping track of the VAT is going to be more complex than before. You should have systems in place to distinguish between VATable and DRC supplies so you can easily identify VAT in payments received. A cloud accounting system such as Xero will enable you to do this with the minimum of difficulty.
VAT return entries: the new rules could have some unexpected effects on businesses’ VAT returns.
The DRC will apply to supplies made on or after 1 March 2021. So it will apply to all construction invoices issued on or after that date, except when the customer pays before that date.
Your invoices covered by the DRC will need to make it clear why no VAT is being charged. HMRC suggest the following wording for subcontractors: “Reverse charge: S55A VATA 1994 applies” or “Reverse charge: customer to pay the VAT to HMRC”. The invoice should however state the rate of VAT to be accounted for, 5% or 20%. For contractors self-billing, HMRC suggest the invoice narrative: “Reverse charge: we will account for and pay the VAT due to HMRC”.
If you have any questions about the DRC or its effect on your business, please contact Alastair Johnston or your usual William Duncan contact.
WILLIAM DUNCAN & CO LTD