The new VAT reverse charge: how will it impact banks and funders?

Coming down the track in Q1 next year is the introduction of the construction industry’s new VAT reverse charge. This has the potential to significantly impact the sector as well as the banks and funders who finance businesses which fall into these categories, specifically in terms of what the supplier (sub-contractor) notes upon the invoice and/or on the application.

An overview of the scheme

The Construction Industry Scheme (CIS) VAT reverse charge will apply to construction services from 1 March 2021. The aim of the measure is to reduce VAT fraud in the construction sector. The measure was due to commence in October 2019 but has been delayed twice due to Brexit and Covid-19.

The key principles of the scheme will be:

• When the reverse charge applies the customer accounts for the supplier's output VAT.
• This measure only applies to construction supplies made by a business to business.

Example: How the CIS reverse charge works in practice

ABC Ltd [“ABC”], the sub-contractor who is VAT registered supplies the materials and installs insulation in a new office building for XYZ Ltd [“XYZ”] who is also VAT registered and, in turn, supplies its construction services to “the developer”, also VAT registered. The developer finds and develops land and then hands over, once complete, the finished commercial building to an end user, its client.

ABC would under the old VAT system invoice XYZ £120 comprising of his £100 bill for materials, labour and works, plus £20 in VAT (at 20%).

However, from March 2021, under the new CIS reverse charge mechanism, the process will be that:

• ABC will invoice £100. The invoice states that 'the CIS reverse charge applies and that the applicable rate of VAT is 20%’.
• XYZ will pay ABC the net £100. They will then account for output and input VAT of £20 on the supply on its own VAT return.
• ABC will not account for output VAT having only invoiced their fee of £100.
• As a consequence of the reverse charge procedure, ABC will charge and receive £20 less than under the old system (where they would charge £100 + VAT). They will not need to account to HMRC for any output tax on the transaction.
• When ABC are paid by XYZ, they will include the value of the sale in box 6 of their VAT Return. They do not add VAT to box 1 as they receive no output VAT.
• The change may well impact ABC’s cash flow, as under the old rules, if XYZ were a prompt payer ABC could hope that they could use the £20 in VAT to purchase materials. ABC would then be able to purchase materials and offset the input tax paid against output VAT.
• XYZ has a cash flow advantage; it does not have to pay ABC the £20 and then at the end of its VAT quarter it cannot reclaim £20 as it is accounting for the reverse charge and the output VAT offsets the input VAT.
• As XYZ is supplying CIS services they will also need to consider the reverse charge. Will their client, the developer, be involved in the onward supply of CIS services? In this scenario, this may be difficult to determine as apparently the developer is selling a finished building to an end user as an investor and the reverse charge does not apply. It is the developer's responsibility to notify down the supply chain. 

Treatment of existing contracts to be ready for 1 March 2021

The VAT treatment is determined for payments due on any supplies entered into your accounting system before 1 March 2021, but paid on or after 1 March 2021.

For contracts starting after 1 March 2021, you should decide whether the reverse charge applies from the start of the contract.

Services that fall under the scheme: what is and isn’t included? 

Which services are within the CIS reverse charge?

• Constructing, altering, repairing, extending, demolishing or dismantling buildings or structures (whether permanent or not), including offshore installation services.
• Constructing, altering, repairing, extending, demolishing of any works forming, or planned to form, part of the land, including walls, roadworks, power lines, electronic communications equipment, aircraft runways, railways, inland waterways, docks and harbours.
• Pipelines, reservoirs, water mains, wells, sewers, industrial plant and installations for purposes of land drainage, coast protection or defence.
• Installing heating, lighting, air-conditioning, ventilation, power supply, drainage, sanitation, water supply or fire protection systems in any building or structure.
• Internal cleaning of buildings and structures, so far as carried out in the course of their construction, alteration, repair, extension or restoration.
• Painting or decorating the inside or the external surfaces of any building or structure.
• Services which form an integral part of, or are part of the preparation or completion of the services described above. This includes site clearance, earth-moving, excavation, tunnelling and boring, laying of foundations, erection of scaffolding, site restoration, landscaping and the provision of roadways and other access works.

Excluded services

• Drilling for, or extracting, oil or natural gas.
• Extracting minerals (using underground or surface working) and tunnelling, boring, or construction of underground works, for this purpose.
• Manufacturing building or engineering components or equipment, materials, plant or machinery, or delivering any of these to site.
• Manufacturing components for heating, lighting, air-conditioning, ventilation, power supply, drainage, sanitation, water supply or fire protection systems.
• The professional work of architects or surveyors, or of building, engineering, interior or exterior decoration and landscape consultants.
• Making, installing and repairing artworks such as sculptures etc.
• Signwriting and erecting, installing and repairing signboards and advertisements.
• Installing seating, blinds and shutters.
• Installing security systems i.e. burglar alarms, closed-circuit tv and public address systems.

Certain services can become included

• If there is a reverse charge element in a supply, then the whole supply will be subject to the domestic reverse charge. 
• If there has already been a reverse charge service between two parties on a construction site, and if both parties agree, any subsequent construction supplies on that site between the same parties can be treated as reverse charge services.
• If there is doubt whether a type of works falls within the definition of a specified service, as long as the recipient is VAT registered and the payments are subject to CIS, the reverse charge should apply.
• The contractor is asked to consider all construction contracts with a sub-contractor. If they can see that reverse charge applies to more than 5% of contracts (by volume or value) with that sub-contractor, then the reverse charge may be applied to all the contracts.