The VAT Domestic Reverse Charge (DRC) was designed as an anti fraud measure for building and construction services in the UK. A few years on since its introduction, the DRC is causing significant administrative complexity, which is often disproportionate to the tax at stake. This is because of the way the DRC interacts with the Construction Industry Scheme (CIS).

How the DRC and CIS work together

The two regimes have distinct purposes:

• CIS is a tax mechanism designed to combat tax evasion. It requires contractors to deduct tax at source from subcontractor payments (if they don’t have gross payment status).
• DRC is a VAT measure that shifts the obligation to account for VAT from the supplier to the customer. It helps prevent ‘missing trader’ VAT fraud.

However, the rules between the two are intrinsically linked as HMRC uses the CIS definition of ‘construction operations’ to assess whether the reverse charge applies. This means that transactions subject to CIS reporting are typically also within scope of the DRC. On the flipside, where a payment doesn’t need to be reported under CIS, the DRC is unlikely to apply too.

Importantly, CIS can apply even when a business does not consider itself to be carrying out traditional construction activities. As a result, transactions may unexpectedly fall within the DRC.

Given the different purposes of the regimes though, taxpayers must assess both in parallel to determine the correct VAT treatment of the supply.

The ‘end user’ trap and documentation requirements

One of the most problematic areas of the DRC is the ‘end user’ exception, which means the DRC doesn’t apply where the customer doesn’t onward supply construction services.

Crucially, HMRC requires that the customer confirms this status in writing to the supplier before services are provided. In addition, HMRC do not permit retrospective correction with a late notification.

If there’s no written statement:

• the supplier must not charge VAT, even if it is obvious that the customer is an end user; and
• the end user must account for the VAT due using the DRC.

This situation creates a well-documented compliance trap. In practice, businesses often:

• fail to comply with the obligations to get written confirmation of end user status;
• rely on commercial understanding rather than formal evidence; and
• apply normal VAT treatment in good faith.

HMRC risk areas and penalties

HMRC may challenge the VAT treatment. It can deny input tax recovery for the end user or assess the end user for under-declared output tax that should have been accounted for under the DRC (even though the supplier may have already accounted for this VAT).

We have seen examples where the end user has been assessed for significant amounts of VAT. The only way to prevent this becoming an absolute cost is to unwind historical transactions and apply the DRC rules correctly. This is often a big administrative burden and can lead to cash flow problems. It is not easy to achieve either, particularly if there has been a dispute between the parties.

While there may be no net loss of tax to HMRC, we are increasingly seeing HMRC apply interest and penalties where the DRC has not been correctly implemented.

This cost is particularly frustrating for businesses in cases where:

• supplies have already been invoiced and paid;
• both parties are fully taxable; and
• the only issue is the lack of written end user confirmation.

From a policy perspective, the DRC is targeted at fraud prevention. However, in practice, many compliance issues occur in commercial supply chains where there is little to no risk of fraud.

Practical steps for construction businesses

The DRC is a clear example of the complex relationship between VAT and the CIS.

Although conceptually straightforward, applying the DRC has practical challenges. This is because it relies on CIS definitions, even though CIS works differently to VAT, and there are strict procedural rules, particularly around confirming end user status.

As HMRC increases its focus in this area, businesses need robust processes for CIS classification, DRC considerations, customer status and documentation. Having these in place is essential to avoid extra admin and unexpected costs.

We recommend that businesses involved in supplying construction services take these proactive steps to avoid penalties:

• consider CIS and whether payments are reportable;
• review whether the DRC applies to the supplies they offer and receive;
• confirm end user (or intermediary supplier) status and keep hold of written evidence;
• assess supply chains for consistency of treatment;
• review VAT return positions, particularly where repayment profiles have arisen; and
• ensure systems and processes support correct VAT treatment.

How we can help with CIS and DRC compliance

We can assess how CIS and DRC apply to your business, identifying areas of exposure across your supply chain, advising on process improvements and controls, and supporting you in responding to HMRC enquiries. A short, targeted review often finds issues early before they become a more significant cost to your business.

Given the complexity of the rules and HMRC’s focus, taking early action can help reduce risk. Get in touch with Simon Atkins, Peter Graham or your usual RSM contact for our help in managing compliance.

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