Explained: The domestic VAT reverse charge procedure
The UK government has introduced a new VAT domestic reverse charge procedure that shifts VAT liability from the supplier to the customer.
The new rules affect companies that operate within the Construction Industry Scheme (CIS) (with a few exceptions that we’ll detail later on)and have an impact on VAT compliance, as well as cash flow.
By introducing the new rules, HMRC hopes to reduce ‘missing trader’ fraud, which occurs when a company sets up a construction business, charges VAT to customers and disappears (ceases trading) before tax is due, effectively pocketing money that doesn’t belong to them.
It’s estimated that tackling this VAT fraud will raise over £100 million a year.
In this post, we’ll explain what the VAT domestic reverse charge is, who it applies to and what you need to do to prepare.
Note: The VAT domestic reverse charge was initially delayed from 1 October 2019 to October 2020 due to concerns that businesses were unprepared for the changes. Due to the ongoing Coronavirus pandemic, its introduction has been delayed again to 1 March 2021 📣.
Table of contents
- What is the VAT domestic reverse charge?
- Who does the VAT domestic reverse charge apply to?
- When to use the VAT domestic reverse charge
- When are projects affected by the VAT domestic reverse charge?
- Invoicing for CIS VAT domestic reverse charge services
- Preparing for the VAT domestic reverse charge
- Wrapping up
What is the VAT domestic reverse charge?
To explain how the VAT domestic reverse charge works, it helps to briefly explain how VAT typically works.
As a VAT-registered business operating in the UK, you add the UK rate of VAT to your taxable sales, which is passed on to the customer. The customer pays the VAT as part of their invoice and you pay what you collect to HM Revenue and Customs (HMRC) on your VAT return.
You also get to reclaim the VAT you pay to other businesses on taxable purchases (as long as they are not VAT exempt or out of the scope of VAT).
With the VAT domestic reverse charge, rather than you collecting the VAT from the customer and paying it to HMRC on their behalf, the customer pays it directly to the government themselves. They may then recover the VAT amount as input tax, subject to the normal rules.
Here’s an example of how the reverse charge works in practice.
Subcontractor Stuart is hired by Contractor Colin for building work that costs £3000 + £600 VAT. This work is a business-to-business (builder-to-builder) supply so it falls under the reverse charge rule (more on these rules shortly).
Under the current (non-reverse charge) rules, Stuart invoices Colin for £3,600 (£3,000 + £600 VAT) and includes the £600 on his VAT return as output tax in box 1.
Colin then claims input tax of £600 in box 4 of his VAT return and records the next expenditure of £3,000 in box 7.
Under the reverse charge rule, Stuart instead invoices Colin for £3,000 and doesn’t include the £600 VAT. Instead, he adds a note that states Colin must deal with the VAT on his VAT return using the reverse charge.
Now, Colin has to enter the £600 VAT in box 1 of his VAT return.
So, the only change is that Stuart’s box 1 entry has shifted to Colin’s box 1 entry. HMRC still receives the correct amount of VAT.
Top Tip: The VAT domestic reverse charge is different from the reverse charge businesses must apply when selling goods and services outside of the UK. You can find out more about passing VAT onto customers in the EU in our guide to VAT rules and rates on exports ✅.
Who does the VAT domestic reverse charge apply to?
The VAT reverse charge applies for standard and reduced-rate VAT ‘specified services’ for VAT-registered individuals and businesses in the UK that operate within the Construction Industry Scheme (CIS).
If you’re a contractor that employs subcontractors or a subcontractor who is employed by contractors and you’re signed up to CIS, the VAT domestic reverse charge will apply to you.
Specified services are those services classed as construction operations under CIS. For example:
- Construction, alteration, repairs and demolition of building structures
- Civil engineering work
- Heating, lighting, power, water and ventilation system installations
- Prep work (e.g. site clearance, laying foundations and erecting scaffolding)
- Cleaning a site after construction work
The VAT reverse charge doesn’t apply to:
- Contractors or subcontractors whose businesses aren’t VAT-registered
- Zero-rated supplies
- Work done outside of the UK
- Employees and temporary workers your business is responsible for paying
- Intermediary suppliers**
*End-users are individuals or businesses who use construction services for themselves and don’t sell services as part of their business. For example:
- Housing Associations
- Domestic customers and consumers
**Intermediaries suppliers are VAT-registered businesses that are connected or linked to an end user. For example, a landlord and their tenant or a group of connected businesses that collaborate to purchase construction services.
When to use the VAT domestic reverse charge
HMRC says that you must use the VAT domestic reverse charge for the following services:
- 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 (in particular) 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 – including 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.
If materials are supplied and used directly in any of the above services, the reverse charge should be applied to those too.
The VAT domestic reverse charge must not be used for any of the following services when they’re supplied on their own:
- 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, or delivering any of these to site.
- 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, murals and other items that are purely artistic, signwriting and erecting, installing and repairing signboards and advertisements.
- Installing seating, blinds and shutters.
- Installing security systems, including burglar alarms, closed-circuit television and public address systems.
However, some services included in the above list can become subject to VAT reverse charge in certain circumstances, which can muddy the waters.
This will be the case in any of the following scenarios:
- If there is a reverse charge element in the supply chain, the whole supply becomes subject to the reverse charge. HMRC gives the following example: “A joiner constructing a staircase offsite and then installing it onsite is making a reverse charge service, even if the charge for installation is only a minor element of the overall charge.”
- If the VAT reverse charge has already been used between two parties, both parties can agree to future services on a site being subject to the reverse charge.
- If more than 5% of contracts (in value or volume) are subject to the VAT reverse charge, a contractor and subcontractor can agree to apply the charge to all contracts.
- In cases where’s there’s doubt over whether a service is subject to the VAT domestic reverse charge, the charge should be applied if the recipient is VAT-registered and payments are made within CIS.
Use this flowchart to see whether you should apply normal VAT rules or the domestic reverse charge:
When are projects affected by the VAT domestic reverse charge?
The VAT domestic reverse charge should be applied to all projects that start after 1 March 2021, as well as projects that started before that date but end after it.
For example, if supplies were entered into a customer’s account on 1 February 2021, but payment was made on 31 June 2021, the domestic reverse charge applies.
But if supplies were entered into a customer’s account on 31 January 2021 and payment was made on 28 February 2021, normal VAT rules will apply.
Invoicing for CIS VAT domestic reverse charge services
If you’re supplying a service where the VAT domestic reverse charge should be used, you’ll need to make tweaks to your invoices so that they include:
- No VAT
- A note that makes it clear that the reverse charge applies and the recipient needs to account for VAT on their VAT return. So that you meet the legal requirement, the words ‘reverse charge’ have to be used. These can be written in one of three ways:
- Reverse charge: Customer to pay VAT to HMRC
- Reverse charge: VAT Act 1994 Section 55A applies
- Reverse charge: S.55A VATA 94 applies
- Details on how much VAT is due under the reverse charge
Top Tip: When supplying a service subject to the VAT reverse charge, you must still include all of the information required on a standard VAT invoice, with the aforementioned amendments. To learn more about how to generate and send an accurate VAT invoice, read our complete guide to adding VAT onto invoices 🧾.
Preparing for the VAT domestic reverse charge
Whether your business purchases CIS services or supplies them, it’s important to be prepared for the VAT domestic reverse charge so that you can manage relationships, comply with VAT rules and maintain steady cash flow.
How you prepare differs slightly depending on if you’re a contractor or subcontractor.
Preparing for the VAT domestic reverse charge as a contractor
As a contractor purchasing services, the VAT reverse charge means that you pay VAT to HMRC directly on your VAT return instead of paying the VAT on CIS supplies to your suppliers.
This may mean a bit of a cash flow boost because VAT previously paid to subcontractors and reclaimed on a future VAT return can be netted off.
To ensure you’re paying the right amount of VAT, make sure the invoices you receive are correct (the right amount of VAT is applied and services are eligible for VAT reverse charge) and properly accounted for.
You’ll also need to ensure that all VAT and CIS registered subcontractors are aware of the VAT domestic reverse charge and how VAT liability will change. It’s a good idea to contact each subcontractor individually to update them on the new rules.
If you’re taking on a new subcontractor, you can confirm their CIS-registeration using the CIS verification system. VAT numbers can be verified on the European Commission website (a similar UK-specific site is likely to be launched after the end of the Brexit withdrawal agreement) or by calling the HMRC VAT helpline.
Preparing for the VAT domestic reverse charge as a subcontractor
As a subcontractor, the reverse charge doesn’t make a whole lot of difference accounting wise, as you’ll simply be passing on the VAT charge you would already account for.
Where you will notice a difference is in VAT-registered customers withholding VAT for CIS supplies, which will mean any VAT you would normally hold onto before paying it to HMRC on a quarterly return can no longer be relied upon to keep cash ticking over.
Because you’ll no longer be paying VAT on your sales, but still claiming VAT on purchases, you might become a ‘repayment trader’.
This will mean you’re able to move to monthly (rather than quarterly) VAT returns to speed up any payments you’re owed. You can request to switch to monthly returns via your VAT online account.
Before the reverse charge comes into effect on 1 March 2021, contact any CIS and VAT-registered contractors you deal with to make them aware of the changes.
Top Tip: A positive cash flow is critical in helping your business survive and thrive. To help you estimate how much money will move in and out of your business under the VAT domestic reverse charge rules, check out our guide to creating a cash flow forecast 📈.
If you’re part of the Flat Rate Scheme
The Flat Rate VAT Scheme is designed to simplify VAT returns for small businesses by allowing you to pay a fixed percentage of your annual turnover.
Unfortunately, reverse charge supplies aren’t accounted for under the scheme and need to be accounted for and reported under the standard scheme.
If you use the Flat Rate Scheme, it means that less of your turnover will be used as a basis for reclaiming VAT, making the scheme less appealing.
You should talk to your accountant or a financial adviser to see whether the scheme is still beneficial to your business.
Top Tip: An accountant can play a critical role when it comes to offering advice and guidance on your business’s financial dealings. While you can certainly self-manage your day-to-day accounts as a new business owner, an accountant can help you save valuable time and avoid making common VAT mistakes when filing your return. To learn more about how an accountant can help you save time and money, read our guide to hiring an online accountant for your business 💡.
If you use the Cash Accounting Scheme
Similarly, the Cash Accounting Scheme can’t be used for the supply of services that are subject to the VAT reverse charge as no VAT is paid to suppliers by their customers.
However, you’ll still need to use cash accounting for purchases, so you may find that the scheme is no longer useful for cash flow. If this is the case, you can withdraw from the scheme.
Again, it’s best to speak to your accountant or a financial adviser to decide on the best course of action.
Make changes to your VAT returns
As we mentioned in the earlier example, the reverse charge means that the recipient rather than the provider is responsible for accounting for VAT on their VAT returns.
Where services provided are subject to the VAT reverse charge:
- Leave box 1 (output VAT) empty
- List the net value of invoices issued in box 6
Where services received are subject to the VAT reverse charge:
- Include the VAT element in box 1
- Leave box 4 empty
- List the net value of invoices received in box 7 (input VAT)
Update your accounting software
So that the right invoices can be issued and reverse charge accounting is facilitated, your accounting software must be up to date and capable of handling the CIS VAT domestic reverse charge.
If you’re using cloud accounting software such as KashFlow, Sage, Xero, FreeAgent or Intuit QuickBooks, your platform will be updated automatically.
If you’re using a desktop accounting system, make sure you have the latest version.
Ideally, software should also be Making Tax Digital for VAT (MTDfV) ready so that you can easily store records digitally and automate payments and returns to reduce the risk of falling foul of the new changes.
You can find a full list of MTDfV cloud software on the GOV.UK website.
Top Tip: Tide seamlessly integrates with leading cloud accounting software to help you track your income and expenditure and get your accounting right the first time around. Check out our accounting integrations to see how easy it is to get started 🙌.
The VAT domestic reverse charge mechanism is a big change that will take some getting used to for businesses.
The key things to remember when using the reverse charge are:
- Only VAT-registered businesses supplying and receiving CIS regulated services are eligible
- It only applies to work that is subject to VAT at 5% or 20%. It doesn’t apply to work that is zero-rated or subject to VAT exemption.
- The business receiving the service (the customer) is responsible for paying the VAT
- VAT invoices must make it clear that the customer has to make a reverse charge entry
- It applies to all projects completed on or after 1 March 2021
If you’re unsure about if or when you should use the reverse charge, speak to your accountant or seek help from an HMRC VAT adviser.
And if you’re worried that you’ve made a mistake on your VAT return, don’t panic.
HMRC understands that there’s a learning curve and says they’ll apply a “light touch” in dealing with any errors for the first six months, as long as businesses are trying to comply with the new rules and have acted in good faith.
Photo by Ivan Samkov, published on Pexels