Construction sector VAT: Assessing the working capital impact of the domestic reverse charge

17 June 2021

Now that the introduction of the domestic reverse charge for construction services (the DRC) has been delayed until 1 March 2021, it would be very tempting to similarly delay your preparations. But the DRC could require you to make changes that will take some time to implement and acting now will help you avoid unwelcome surprises in April 2021.

Here’s what you need to know about the DRC and how to get ready.

What is the domestic reverse charge?

The DRC will result in a significant shift in the way VAT is brought to account in construction industry supply chains. In many cases it will result in the customer, rather than the supplier, being required to account for the VAT due on supplies they receive.

The main aim of the DRC is to combat fraud within the construction sector. But it also introduces some new and unfamiliar concepts that are likely to require significant changes in VAT accounting controls and procedures.

In addition to deferring the DRC, HMRC has also made some changes to the scheme. These changes will require the recipient of construction services that are within the scheme to notify their suppliers in writing whether they are an ‘end user’ or an ‘intermediary’.

The impact of the DRC

The introduction of the DRC represents a major change in the way VAT is accounted for, which will have a profound impact on cashflow for many contractors and will require significant changes to accounting processes and controls.

The new rules are simple in concept yet complex in the detail, and construction businesses will need to be fully aware of their obligations to avoid creating unnecessary VAT costs.

Here are some of the ways the DRC will impact businesses:

Subcontractors will lose the cashflow benefit of the VAT element of their sales invoices as a result of the requirement for their customers to self-account for the VAT due.
There will be uncertainty about which services are subject to the domestic reverse charge. As the new rules apply to defined categories of work, this will result in grey areas where the correct VAT treatment is unclear.
Systems and processes will need updating and new tax codes may need to be introduced. The new rules are being introduced not long after the end of the Brexit transitional period and at the same time that most taxpayers will need to ensure they are fully compliant with Making Tax Digital for VAT.
There will be a greater need to manage risks around existing and new contracts, and on the recovery of incorrectly charged input tax.
There will be uncertainty around whether a customer is an end-user or intermediary supplier, particularly where there are complex commercial arrangements such as joint ventures, forward funding arrangements and complex ownership structures.
There will be uncertainty around the prospect of not charging VAT, and the risk that a mistake could lead to HMRC seeking recovery from the business.
Care will need to be taken around how the DRC interacts with self-billing and authenticated receipts.

Steps to take now

As a minimum, you should use this additional time to make sure you are clear on the scope of the new rules and how they will affect you. It is widely considered that many sub-contractors are unprepared for the cash flow impact that will arise as a result of the changes. Many businesses use the VAT that they collect from their customers as working capital before it is required to be paid to HMRC, which can be up to three months after payment has been received. The loss of that working capital in affected businesses on top of the challenges posed by the coronavirus is inevitably going to result in financial difficulties for businesses.

Carry out a readiness assessment or gap analysis to identify changes you will need to make to current systems and processes to ensure compliance with the rules.

For many businesses, the DRC scheme’s introduction will coincide with the VAT period in which any VAT that has been deferred under coronavirus needs to be paid to HMRC. This makes it vitally important to consider the cashflow implications of the introduction of the new scheme.

Construction businesses whose main source of income comes from sub-contractors should act now to model the anticipated cashflow impact and avoid any unexpected surprises in March. Main contractors who engage sub-contractors should also consider the commercial effect of this cash flow impact for sub-contractors to minimise the disruption for their business.