What you need to know about the new VAT reverse charge

New rules are being introduced regarding the payment of VAT.  Such changes are known as the reverse charge.

For most classifications of construction works, it will be the contractor rather than the subcontractor who will account for VAT from 1 October 2020. This change will have an impact on contracts entered into prior to that date. With this in mind, it is important to make advance preparations now. 

At the moment, the contractor pays VAT to the subcontractor, who accounts to HMRC for this payment. However, from 1 October 2020, VAT will be paid from the contractor directly to HMRC. This means that the subcontractor no longer invoices or is paid the VAT directly. 

The reason why the VAT reverse charge is being introduced is to combat “missing trader fraud”. This is where the subcontractor claims the extra VAT from the contractor but fails to account for it and effectively absconds (becomes a “missing trader”).  To combat that, it is thought best that the contractor operates the reverse charge and accounts for the VAT direct to HMRC. 

Such changes are likely to have an effect on the subcontractor’s cashflow.  Typically, a subcontractor is paid in monthly interim payments, whereas payments to HMRC operate on a quarterly basis. The supplier would invoice for the 20% and be paid that sum and will account for it in the next quarter VAT return. During that period, the subcontractor could use that 20% to provide working capital for their business. 

However, once the reverse charge applies, the subcontractor is not paid this VAT amount and so cannot rely upon it to temporarily fund the works. This could have a severe cashflow impact for subcontractors, particularly when procuring materials in advance.

In order to mitigate the effects of this, subcontractors should consider now how they can procure materials to limit the financial impact of these changes.  For example, it might be better for main contractors to order expensive materials to ease the sub-contractors cashflow.

For all stakeholders, it will become increasingly important that payment terms are properly set out and understood and that payment notices / pay less notices and VAT invoices are in accordance with the contract. Consider the use of adjudication to resolve disputes quickly, as maintaining cashflow on the project will become more of a priority.