VAT reverse charge: cash flow considerations

A major change affecting the way that VAT is collected in the construction industry is soon to take effect, meaning that customers will pay VAT directly to HMRC, rather than to their suppliers. Careful cash flow planning, including effective forecasting, will be essential to ensure that the new reverse charge regime doesn’t cause businesses in the sector to experience financial difficulties, potentially leading to insolvencies and difficulties throughout the supply chain.

First announced in the 2017 Autumn Budget, the construction sector’s VAT reverse charge aims to tackle the issue of ‘missing trader’ fraud, which reportedly costs HMRC in excess of £100M in ‘lost’ tax revenue each year. Currently, contractors on standard-rated construction projects charge their customers an additional 20% to cover VAT, with a responsibility to then file and pay the tax to HMRC. A contractor supplying a reduced rate service would add five per cent to their invoice. If the customer is a VAT registered business, they are usually entitled to reclaim the equivalent amount from HMRC when submitting their VAT return. However, this process has created an opportunity for fraudulent companies to abuse the system by failing to pay the additional VAT over to HMRC.

The new rules prevent this scenario by requiring the customer to pay the VAT on the services they receive to HMRC themselves and also reclaim it on the same VAT return, effectively cutting their supplier out of the VAT cash flow.

Originally expected to come into force next month, HMRC has decided to delay the domestic reverse charge on construction services by one year, until 1 October 2020. The move follows a warning made by construction industry bodies last month, over concerns that businesses in the sector are not prepared for the change. The delay will also allow HMRC time to address what some perceive as weaknesses in the existing guidance. For example,  a contractor will be reliant on the end customer in a supply chain to determine whether VAT is chargeable on the supplier’s services, however there is still a notable lack of awareness of this in the sector.

The changes to the way that VAT is accounted for when a contractor supplies services for a construction project could have a significant impact on its cash flow profile. Currently, many suppliers use the VAT they are paid by their customers to fund payments to their suppliers, until they are required pay it to HMRC with their next VAT return. However, businesses need to prepare for the fact that from October 2020, payments will be received net of VAT. A failure to consider this could leave them struggling to pay suppliers, and in the worst-case scenario, facing business failure.

Adequate cash flow forecasting is one way that companies can prepare for the financial impact of the VAT reverse charge. Updating their model for the changes to VAT cash flows in advance of October 2020, and ensuring that the business will still be able to meet its obligations when payments are received net of VAT, can help suppliers to ready themselves for the impact of the new rules. This exercise will enable businesses to decide whether a change between monthly and quarterly VAT returns would be beneficial.

As well as putting their own plans in place for the new VAT rules, businesses should take time to consider the wider supply chain picture. While large organisations are likely to have the resources and capacity to prepare for the changes in good time, smaller subcontractors may struggle to do so. If they fall into financial difficulties, this could cause disruption further up the supply chain. Main contractors should therefore take steps to ensure that key subcontractors are aware of the changes, know how to implement them and understand how they could affect their cash flow, in advance of their introduction.

The Government’s decision to delay the introduction of this VAT reverse charge is welcome news for the construction industry, and businesses should seize the opportunity to prepare. By ensuring that accounting systems are updated and ready to implement the change, understanding the impact on their cash flow and ensuring that key suppliers have done the same, businesses will be able to navigate the new rules smoothly.

Article submitted by Sarah Barron, VAT senior manager at accountancy firm, Menzies LLP.

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