The reverse charge VAT implications for construction services is arguably one of the most significant changes in British VAT legislation in recent years.
The operational and financial impact on businesses throughout the building supply chain should not be underestimated. Such is the size of the change that HMRC had originally announced in September 2019 a twelve-month postponement to the policy implementation to 1 October 2020, citing widespread industry concerns around sector readiness.
When the policy implementation was subsequently further delayed by HMRC to 1 March 2021, due to the various disruptions to the sector caused by COVID-19 implications throughout 2020, many in the industry believed that reverse charge VAT would be scrapped altogether. However, this was not the case and the policy came into effect on 1 March 2021.
Whilst we wait to see how the actual impact of reverse charge VAT plays out over the coming months, it certainly has the potential to place significant additional cashflow pressure on businesses that are already under significant financial stress.
Why the change?
The objective of reverse charge VAT is to eradicate so-called missing trader fraud. It seeks to prevent unscrupulous subcontractors within complex supply chains charging VAT on their supply to customers but then failing to pass the VAT over to HMRC.
From 1 March 2021, the customer will now pay across the VAT directly to HMRC instead of the supplier of the service, eliminating the opportunity for VAT to ‘go missing’ somewhere within the supply chain.
Reverse charge turns the core principle of VAT on its head, in that VAT no longer ‘flows’ through the supply chain as ‘value’ is added to a product or service. It requires, amongst other things, the ‘end user’ to be clearly identified throughout all account documentation, as this entity will now be the one liable to pay over the total amount of VAT liable for any given supply. Further details are provided by HMRC here.
Reverse charge is not a new idea - it has already been deployed in very specific sectors such as mobile phone imports where similar fraud had been detected. The difference between this and previous implementations of reverse charge VAT is the sheer number of businesses likely to be affected. HMRC estimate that up to 150,000 businesses could be impacted in the construction supply chain and coming alongside far wider transition of Making Tax Digital.
What is the impact on the sector?
Although HM Treasury expects to gain £100m a year from reduced levels of tax evasion, for businesses complying with the current rules the change is cost-neutral, the same amount of VAT will be paid across to HMRC under reverse charge as was previously paid.
The impact on businesses is therefore two-fold.
The first is the short-term practical challenge of shifting across from one system to another. Understanding who the ‘end users’ are in any particular supply may not always be straightforward and requires each entity understanding their own role within the chain and how suppliers and customers all fit into the bigger picture. Having the right accounting systems, processes and personnel familiar with the new rules will be essential to avoid costly errors.
The second impact, and perhaps one which is more difficult to overcome, is that the as-yet unpaid VAT will no longer act as a form of short-term working capital. Under the conventional VAT regime, businesses making quarterly VAT returns may hold onto the tax charged to the customer for up to four months before paying it across to HMRC. Many contractors have historically used this cash resting in their bank accounts to effectively support their immediate cash requirements. Under reverse charge, that cash is instead paid directly from the customer to HMRC, meaning it never touches the contractors’ bank account and is unavailable to support their day-to-day liquidity.
Although this may sound like a relatively minor shift on paper, in practice the impact on contractors could be significant. Although mitigated somewhat by the fact that supplies down the supply lines will also be sold with no VAT included, many businesses have become dependent on holding VAT monies as a buffer for day-to-day expenses.
The impact is worse for businesses who use invoice discounting, as funding will instead be applied to net value of goods, not the gross amount, potentially causing a further deterioration in their cash flow position.
Practical Implications for Contractors
- Ensure that the CIS register is up to date for subcontractors
- VAT to CIS subcontractors should be withheld for any purchases after 1 March 2021
- Withheld VAT will be included on future VAT returns
- The new regime could result in contractors moving from a VAT reclaim to a VAT payment position
- Contractors need to ensure accounting systems are in place to reflect the change in VAT accounting
Practical Implications for Subcontractors
- Invoice will only be paid net of VAT from 1 March 2021, potentially impacting the cash available in the business
- Funding from Invoice Discounting or Factoring will be on the net value of invoices, not the gross value, exacerbating the cash impact
- The new regime could result in the business moving from a VAT payment to a VAT reclaim position
- If the business is a contractor to other subcontractors then the implications for the rest of the supply chain must be considered
What can businesses do?
Now that the policy has come into effect, it is crucial that construction businesses have their ‘house in order’ and consider if they need to explore alternative financing requirements where necessary. This also presents an ideal time to understand how the working capital requirement of the whole business can be reduced, bringing down financing costs and potentially improving operational efficiency in the process.
Further mitigating actions may include:
- Renegotiating payment terms with customers given their improved cash position further along the supply chain
- Reviewing whether more of the supply chain can be subcontracted, thereby obtaining the cash benefit from withholding VAT; and
- Reviewing stock levels, payment processes and cash management processes in order to smooth cash cycles
How can Interpath help?
At Interpath we have a team of sector experts based across the UK ready to help businesses facing this situation. We have extensive experience supporting construction businesses of all sizes respond to sudden liquidity challenges and identify opportunities to enhance working capital throughout their operation.
We believe it’s possible to improve working capital performance by up to 15% using a range of measures, which when actioned can help to mitigate the cash impact of reverse charge VAT. These can be identified through our proprietary benchmarking and hypothesis validation and realised through detailed planning and implementation. Our approach takes a holistic approach to cash improvement, not just focusing on working capital – we place cash improvement at the heart of your business strategy and drive sustainable change through robust processes and improved visibility and control.
If you would like to discuss the implication of reverse charge VAT in more detail, please get in touch with one of our sector specialists.