VAT Rules Reconstructed

Changes to the VAT rules for construction services will be a significant challenge for suppliers and customers.  Businesses will need to familiarise themselves with the new rules and take action to ensure they are prepared.

HMRC have announced that the Domestic Revenue Charge (DRC) which was due to come in on 1st October 2020 will be delayed until 1st March 2021.

HMRC are introducing the Domestic Reverse Charge rule for construction services, to combat missing trader VAT fraud, which is estimated to cost £100 million a year in lost revenue.  DRC rules have been in place for some time in a number of other areas affected by missing trader fraud.  However, the construction sector is more complex than these other areas and, therefore, poses much greater challenges. 

Missing trader VAT fraud is simple, but highly effective.  A supplier charges VAT on construction services and collects the VAT from its customer.  Instead of declaring the VAT and paying it over to HMRC, they disappear with the money.  Hence the name ‘missing trader’ fraud.  

What is the Domestic Reverse Charge (DRC) rule?

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The DRC is, in principle, a simple mechanism, which removes the opportunity for fraudsters to collect large amounts of VAT.  Instead of the supplier charging VAT, the customer self-accounts for VAT on the services received, through its VAT return.  The customer also reclaims VAT in the usual way, meaning that, normally, the DRC will be neutral for the customer (i.e. DRC output VAT payable = DRC input VAT claimable).  

Whilst the concept is simple, the rules are complex, as not all construction services will fall within the DRC.  Businesses will need to have a good knowledge of when the DRC applies. Broadly, this is where the:

  1. Supplier and customer are both VAT and Construction Industry Scheme (CIS) registered;
  2. Supply includes ‘construction’ services; 
  3. Services are subject to 5% or 20% VAT;
  4. Payment has to be reported under the CIS rules; and
  5. Customer is not an ‘End User’.

Knowing whether the customer is an ‘End User’ (or deemed End User) is an area of particular concern.  HMRC’s November 2018 guidance said the default rule was to apply the DRC, unless the customer volunteered written confirmation of End User status.  This caused much concern, not least because it had no legal basis.  New guidance published on 7 June 2019 states that, in cases of doubt, the supplier should ask the customer if they are an End User and keep a record of their response.  In practice, it will be advisable for suppliers to either obtain written confirmation of the customer’s status or for this to be included in the contract between the parties.

What are the risks?

There are risks for suppliers and customers.  Suppliers risk an HMRC assessment for under-declared VAT, interest and penalties if they apply the DRC in error.  

Conversely, if a supplier charges VAT in error, HMRC may assess the customer for DRC output VAT, leaving them to seek a refund of the incorrectly charged VAT from the supplier.  This situation is likely to occur, especially where suppliers are unaware of the new rules or are uncomfortable with not charging VAT. 

This could be a very difficult situation, especially if the supplier has gone bust, disappeared or refuses to cooperate.

Suppliers and customers will need to ensure that staff dealing with contracts, invoicing, payments, accounting and VAT returns are properly trained.  Accounting systems may need to be updated to handle DRC transactions and DRC invoice templates will be needed.  Processes, controls and contracts should be updated to minimise VAT risks.  Suppliers should consider the cash flow impact of no longer charging and collecting VAT.

Businesses affected by the new rules should start preparing now.  If you would like to discuss how the new rules will affect your business, speak to your usual Menzies contact or contact our VAT team.

Menzies will be running a number of free seminars on the DRC rules over the summer to help businesses prepare. 

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Posted in Blog, Property & construction