We have seen an increase in HMRC activity around the domestic reverse charge (DRC) for construction services in the past few months. It’s now 4 years since the DRC was introduced and it would appear that any “soft-landing” period is now over.
The DRC represents a significant shift in the way VAT is accounted for in the UK construction industry. It is an anti-fraud measure which aims to combat VAT fraud by shifting the responsibility for accounting for VAT from the supplier to the customer. This article provides an overview of the DRC, its implications, and the steps businesses need to take to comply with the new rules.
1. Understanding the Domestic Reverse Charge
The DRC applies to most supplies of standard and reduced-rated building and construction services made to VAT-registered businesses in the UK. The key criterion for the application of the DRC is that the services must be reported under the Construction Industry Scheme (CIS). The CIS is a set of rules for managing payments for the purposes of income tax and corporation tax between contractors and subcontractors in the construction industry.
Under the DRC, the supplier of construction services does not charge VAT on their invoice. Instead, the recipient of the services (the customer – possibly the main contractor) accounts for the VAT on their VAT return. This means that the customer must declare both the output tax (the VAT on the supply) and the input tax (the VAT they can reclaim) on the same VAT return. This mechanism effectively removes the opportunity for fraudsters to charge VAT and then disappear without paying it to HMRC.
2. Scope of the Domestic Reverse Charge
The DRC applies to a wide range of construction services, including but not limited to:
- Construction, alteration, repair, extension, demolition, or dismantling of buildings or structures.
- Installation of heating, lighting, air-conditioning, ventilation, power supply, drainage, sanitation, water supply, or fire protection systems.
- Painting or decorating the internal or external surfaces of any building or structure.
However, there are exceptions. The DRC does not apply to:
- Supplies to non-VAT registered customers.
- Supplies of services that are zero-rated.
- Supplies of services to end-users, such as property owners or tenants, who do not make onward supplies of the construction services.
3. Implications for Businesses
The introduction of the DRC has several implications for businesses in the construction sector:
- Cash Flow Impact
One of the most significant impacts of the DRC is on cash flow. Subcontractors, who previously charged VAT on their invoices and received this amount from their customers, will no longer do so. This change can affect their cash flow, as they will not have the VAT amount available to use as working capital until they reclaim it on their VAT return.
- Accounting and Invoicing Changes
Businesses need to update their accounting systems to handle the DRC. Invoices must clearly state that the DRC applies and that the customer is responsible for accounting for the VAT. The invoice should include the wording: “Reverse charge: Customer to pay the VAT to HMRC.”
- Compliance and Training
Businesses must ensure that their staff are trained to understand and apply the DRC correctly. This includes identifying which supplies are subject to the DRC and ensuring that invoices are issued correctly. Failure to comply with the DRC can result in penalties from HMRC.
4. Steps to Compliance
To comply with the DRC, businesses should take the following steps:
Review Contracts and Supplies: Identify which contracts and supplies are subject to the DRC.
- This involves reviewing all ongoing and new contracts to determine if the DRC applies.
- Update Accounting Systems: Ensure that accounting systems are updated to handle the DRC. This includes setting up the system to account for VAT on purchases rather than sales for DRC supplies.
- Train Staff: Provide training for staff to ensure they understand the DRC and can apply it correctly. This includes training on identifying DRC supplies, updating invoices, and accounting for VAT.
- Communicate with Customers and Suppliers: Inform customers and suppliers about the DRC and how it affects invoicing and payment processes. This helps to ensure that all parties are aware of their responsibilities under the DRC.
- Monitor Compliance: Regularly review and monitor compliance with the DRC. This includes checking that invoices are issued correctly and that VAT is accounted for properly on VAT returns.
Conclusion
The DRC represented a significant change in the way VAT is accounted for in the UK construction industry and is coming under increasing scrutiny from HMRC.
While it aims to combat VAT fraud, it also brings new challenges for businesses, particularly in terms of cash flow and compliance. HMRC’s view is that the DRC should be the default position, so any business in the construction industry which believes its supplies should not be subject to the DRC should take advice and carefully document its reasoning to protect against potential penalties being levied if that decision is incorrect.
