Construction Timebomb? Detonation Date: 1 March 2021
Qandor member Jonathan More is a partner at Spencer West LLP. In this article, he writes about the VAT Reverse Charge for construction services and its consequences in the industry - and how to start damage control right now.
Think of one of the worst things that could happen to the construction sector at this moment in time. What would it be? Something that takes cashflow out of the supply chain? New legislation which fundamentally changes tax regulations when there is limited money to ensure compliance with these changes?
You would be right on both counts and it’s happening. I introduce you to: the VAT Reverse Charge for construction services, with regulations due to commence on 1 March 2021.
This change impacts all stages of the “construction chain”, including developers and end users. It is not just contractors and suppliers that need to be prepared.
What the VAT reverse charge is and means I deal with below, but for those who want to read or research the specific legislation change being invoked, I direct you to the amendment to the VAT Act 1994 by Order, the “VAT Reverse Charge for Construction Services”, issued under section 55A.
Having been delayed twice since its anticipated initial “launch date” in October 2019 (due to Brexit and COVID-19 – and lobbying from construction industry groups), the new regime will “go live” on 1 March 2021, but there remains a concern within industry bodies that this is simply not the right time to impose such dramatic change on the construction industry. The industry is potentially neither ready for the practical requirements of this change, nor the practical commercial consequences.
The background to the change
Ignoring the timing, there is “reason” for this change, as the new legislation has been introduced to combat tax related fraud.
Over a number of years, an increasingly common unlawful behaviour has seen fraudsters “steal” VAT revenue from the Government.
This has been achieved by the fraudsters either setting up shell companies, or taking over trading companies, and charging VAT to customers in addition to the services provided in the normal way. However, rather than flow the VAT money through the system such that this money is eventually received by HMRC, they keep it. As a result, HMRC are deprived of significant sums of tax.
This is not a problem specific to construction; indeed, the figures show that the construction industry is a relatively minor percentage of the wider problem.
The Government’s solution to this tax evasion, however, is one that is likely to have significant ramifications for companies across the construction industry.
What is a reverse charge?
In layman’s terms, a company that is in receipt of “specified services” (most construction supplies and works) will not pay VAT to its supplier; rather, it will account for the appropriate amount of VAT on its VAT return. For the supplier, this means that it should not include, and should not receive payment for, VAT in its invoice.
The rules will apply to suppliers of certain construction “specified services” who are registered to the Construction Industry Scheme; the ultimate client/customer, defined in the legislation as the “end user”, will be the party liable to pay VAT to HMRC in respect of the services provided rather than the supplier(s).
The reverse charge does not apply to any of the following:
Supplies of VAT exempt building and construction services.
Supplies that are not covered by the CIS, unless linked to such a supply.
Supplies of staff or workers.
Non-VAT registered customers.
“End Users” i.e. VAT registered customers who are not intending to make further on-going supplies of construction (for example, businesses commissioning the services to build an office, or a main contractor that sells a newly completed building to a customer).
“Intermediary suppliers” who are connected e.g. a landlord and his tenant or two companies in the same group.
The consequences of the new regime
The Government has estimated this will impact up to 150,000 construction-sector businesses and admits that the administrative burden is likely to be significant.
Money paid for the VAT element of invoices will no longer flow between businesses. With each qualifying transaction, VAT will be calculated as a paper exercise 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 to pay the tax.
If an invoice wrongly adds VAT to the relevant amount due, it will have to be reversed (as will any monies paid).
The official guidance is that the reverse charge will not apply to all contractors, only applying to “specified services”. However, the definition of “specified services” mirrors those services defined as “construction operations” in the “Construction Act”. Thus, it will affect most construction companies to some extent.
If a supply contains a mix of specified and other construction services, it will be classed as a single supply of “specified services” and the reverse charge will apply.
Cost: There will, of course, at a time where liquidity is likely to be challenging at best, 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 costs which include: 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, and, crucially, obtaining evidence as to whether or not a customer is an end user.
Planning for this should really be finished by now, and if not should be expedited. The Government is being lobbied to delay the start date again, but we are now very close to the date of implementation.
In addition to the more predictable costs outlined above, the practical consequences of this new regime pose a number of risks to construction companies, with potentially significant consequences.
Risk 1: The requirement to reconfigure its accountancy practices and procedures. Such a significant change to accounting processes will always carry a heavy practical risk.
Risk 2: Reduced cashflow. Many construction businesses will no longer be able to rely on VAT money for cash flow. It goes without saying that VAT money should not be used in this way, but it is common practice throughout the supply chain. Preparation for this loss of cash flow requires to be factored in by any company who relies on or uses VAT money received as part of their working capital.
Risk 3: Main contractors, if they fall under the definition of “end user”, as they will 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 is a material risk to the industry as a whole.
Risk 4: Who is the “end user”? Where there is a defined term, there is often (not far behind) a legal argument about the interpretation of that term. This is a distinct possibility with the term “end user”, particularly with the responsibility falling on end users to pay significant amounts of money to HMRC. This contributes to the question of how will a sub-contractor know if its main contractor is the “end user” and what will be needed to evidence this? Current guidance from HMRC is unclear on such issues.
When I spoke to Alasdair Reisner, Chief Executive of the Civil Engineering Contractors Association (CECA) about this change in law when it was first due to commence in October 2019, he told me, “The new rules on reverse charge VAT are a timebomb for the industry with an increasingly short fuse. We are concerned that many businesses are still not aware that they will have to be compliant with the new rules this autumn, and that when they do have to change, they will find that the new model will mean that suppliers take a negative hit on cashflow.”
Right at the time when they are struggling with the biggest economic “hit” in a century, let alone still understanding the post-Brexit consequences.
The above risks have the potential to result in catastrophic consequences for companies that are not properly prepared this change. Specialist tax advice should be sought on this issue if not obtained already.
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