The tradesman who whispers that he’ll “do a discount for cash” is the image most people have of tax fraud in the construction industry.
Under the current system, construction companies charge their customers VAT on the work they carry out. But there have been cases of unscrupulous firms pocketing the extra money paid by the customer, and then disappearing without paying their VAT bill to HMRC.
Two years ago the government announced an overhaul of the VAT system in order to clamp down on the problem.
After repeated delays, the new VAT reverse charge regime for construction sector businesses is finally due to come into force on 1st March 2021.
The new rules will require any business that pays for the services of a construction firm to change the way they account for VAT.
But the reforms will also have serious cashflow implications for firms that supply construction services, meaning that any accountant acting for construction sector clients must prepare for the changes now.
The reverse charge regime shifts the liability for accounting for VAT from the supplier to the customer.
The structure of the construction industry, in which projects are typically worked on by a contractor and multiple subcontractors, means there are thousands of firms that are both supplier and customer – and that the impact of the new rules will ripple across the supply chain.
Under the new rules, contractors supplying construction services to a VAT-registered customer will no longer have to account for the VAT.
Instead, the customer employing them will account for the VAT and, if required, pay any VAT due directly to HMRC.
Clearly, the new rules will immediately impact the cashflow of suppliers, as they will no longer be paid VAT in addition to their fees. The net effect will be neutral of course as they will no longer need to account for the VAT with HMRC, but in the short-term, it will mean a fall in incoming cashflow.
Given the length of the supply chain in construction, many suppliers – typically the larger contracting firms which employ multiple subcontractors – will also be customers, so these businesses will be passing the VAT liability up the chain.
That liability buck stops with the business deemed the ‘end customer’. HMRC defines this as a business which does not supply construction services, and in practice end customers are likely to be those who use the building built by the contractors, whether as a developer, landlord, or tenant.
All change in accounting
The new rules will also require all businesses supplying construction services to change their accounting and invoice processes.
For a start, suppliers will need to change the way they reconcile customer payments against invoices issued, as any VAT-registered customers will cease paying the VAT element they paid previously.
Suppliers will also need to state on their invoices that the services they have provided are subject to the reverse charge mechanism. The VAT amount due under the reverse charge should be itemised on the invoice, but not charged to the customer.
In most cases, the end user will need to account for and pay the VAT due directly to HMRC. However the end user is also required to notify their supplier of its status as an end user, and whether it wishes the reverse charge to be applied to them or not.
Sleepwalking towards major change
The new rules are complex and will require construction firms, and those using their services, to overhaul the way they account for VAT – making it vital that their accountants seek expert advice on the implications of this major, but often overlooked, change.
For the UK’s army of VAT-registered building contractors and subcontractors, there will also be a significant hit to cashflow, as they will no longer be able to receive and retain VAT payments before paying their quarterly VAT bill to HMRC.
This will also force a recalibration of the way such businesses are valued, and the risk profiles lenders use to assess their eligibility for a loan.
The construction industry has endured a rollercoaster ride in 2020. According to the ONS, output collapsed by 40% in April, only to rocket back nearly 42% over the third quarter. The sector is still wrestling with the impact of Covid-19 and is now braced for the end of the Brexit transition period on December 31st, which could see materials and labour costs rise sharply.
With many businesses understandably focusing all their attention on dealing with the pandemic and Brexit, this is not the best time to be introducing a tax change with the potential to cause significant additional disruption.
But the government remains committed to pushing through the reforms, which were first announced in the November 2018 Budget.
HMRC has the power to impose penalties on those who make errors on their VAT returns. Construction firms and those advising them must get ready, and quickly.