HMRC have issued draft legislation to introduce a VAT reverse charge on certain construction services. A six week consultation into the legislation closed on 20^th July 2018 and the final legislation is due to be published in October 2018.

The intention of the legislation is to remove the opportunity for fraudsters to charge VAT and then go missing before paying it over to the Exchequer.

What is the issue?

Construction sector fraud occurs when organised crime gangs artificially extend the supply chains within the sector. They do this by setting up businesses with the intention of failing to pay VAT and making incorrect income tax deductions. This is commonly referred to as ‘Missing Trader’ fraud (“MTF”) whilst operating alongside actual construction services.

This is most commonly found among sub-contractors who provide groups of workers to the construction sector. Their main cost is wages which when paid directly to employees is not subject to VAT. However, VAT is charged on the supply of construction services.

There are two potential ways in which the current system could result in fraud:

1. In the first type of attack, the fraudsters take over a legitimate business with a gross payment status and then start misdeclaring its CIS submissions and VAT liabilities
2. In the second type of attack, the fraudsters obtain a new ‘off the shelf’ company fronted by a ‘puppet’ director with a clean compliance record. This enables the company to pass the test for CIS and register for VAT.

In both scenarios, the supply chain is artificially lengthened. The aim is to delay the time it takes for HMRC to identify mismatches between the main contractors CIS declarations with those of all subcontractors below it by making checks more difficult to be recognised. By the time HMRC does spot these mismatches, the misdeclaring businesses have gone missing i.e. will have disappeared before passing the output VAT to HMRC. Meanwhile, the workforce are moved to another business to continue the fraud.

This perceived fraud has posed a problem for the government for many years. HMRC believe they lose over £100 million each year in VAT fraud related to the construction industry and so the Chancellor announced a consultation in the Spring Budget 2017 to address this. The outcome of this consultation was to introduce a reverse charge to the construction industry which comes into effect from 1^st October 2019.

What is the reverse charge mechanism?

Currently, the supplier charges and accounts for output VAT on supplies which they make whether attracting the standard or reduced rate of VAT. The new reverse charge will shift the responsibility for the VAT payment to the purchaser which is intended to remove the opportunity for it to be stolen. This ensures the supplier of goods or services is not involved in the payment of output VAT to HMRC and therefore does not have the opportunity to commit fraud. The purchaser will declare the output VAT due on its own return. Typically, the same amount is recovered as input tax on the same VAT return. This means that for most transactions the VAT is simply netted off and is no more than an accounting entry.

During the consultation process, there was concern that due to the huge size of the construction sector, implementation of a reverse charge throughout the sector would disproportionately impact on honest, smaller businesses. Despite this, after the consultation in 2017, it was recognised that the reverse charge mechanism is likely to be the most effective measure at preventing MTD.

The introduction of a reverse charge does not change the liability of the supply of the specified services. What does change is the way in which the VAT on those supplies is accounted for.

When will this apply?

A domestic reverse charge only applies when:

1. Both the Supplier and Purchaser of the transaction are registered for VAT.
2. The supplier is involved in standard rated construction services. It does not apply to zero rated supplies of construction services.

Building and construction materials will be included when provided as part of the supply of construction services.

The types of construction services covered are as follows:

• Construction, alteration, repair, extension, demolition.
• Dismantling of buildings or structures, of any work forming part of the land.
• Installation in any building or structure.
• Internal cleaning of buildings and structures.
• Painting or decorating the internal or external structures.
• Any service which form an integral part of, or are preparatory to, or are for rendering complete, the services just described.

The reverse charge excludes supplies of specified services that are made to non-construction businesses such as a high street retailer and to commercial property developers who are buying reverse charge construction services to make an onward sale or lease of newly constructed retail premises. Also excluded are supplies of specified services where the supplier and purchaser are connected in a particular way, and for supplies between landlords and tenants.

What are the potential impacts?

The introduction of the reverse charge in the industry means that businesses will need to adapt their systems and manage their cash flow differently. Due to the large number of small business potentially affected by a reverse charge for construction services the government has given a long lead-in time to help businesses adjust.

Impact on businesses

The reverse charge will help level the playing field for businesses by ensuring that VAT fraud is removed from supply chains. This measure will impact on around 100,000 to 150,000 businesses in the construction and building sector.

The additional administrative burden for all business affected may be significant and one off costs will include training staff on the new rules and adapting VAT accounting packages.

The reverse charge will impact on small and micro businesses, particularly in respect of loss of cash flow where VAT is no longer charged. Some businesses, particularly smaller businesses, use the VAT they collect as working capital before they pay it over to HMRC.

A number of sub-contractors in a reverse charge construction supply chain may shift from being quarterly VAT payment trades to monthly VAT repayment traders. This will be the case if they buy in materials in the course of making the reverse charge supplies.

Further difficulties can arise for suppliers in the construction sector as the intended use by the purchaser is often relevant to the VAT liability to be applied and the intention can change after the supply has been made. No clarity on this technical issue has been provided but it is useful to note that HMRC are undertaking a separate detailed technical consultation.

HMRC will incur initial operational costs currently estimated at less than £1 million but in the longer term compliance resources are expected to remain roughly the same. HMRC will need to ensure the reverse charge is being applied correctly.

Brian Birt is a Manager in Indirect Taxes with Deloitte NI Limited

Email: bbirt@deloitte.ie