HMRC steps up enforcement of VAT domestic reverse charge for UK construction

HMRC is stepping up enforcement of the VAT domestic reverse charge (DRC) on construction operations with compliance checks, tax assessments and penalties targeting businesses across the supply chain that have failed to correctly implement the regime since it came into effect on 1 March 2021.

How the DRC works

The DRC fundamentally changed who accounts for VAT on relevant construction supplies. Introduced to tackle VAT fraud in the construction industry, including "missing trader" fraud, it has reversed the conventional VAT accounting process.

Under standard VAT rules, a supplier of services typically charges VAT to the customer and then accounts for it to HMRC as output tax. Where the DRC applies, the responsibility for accounting for output tax shifts to the customer. Supplier invoices are required to clearly state that the DRC applies and the amount of applicable VAT, but the supplier does not charge VAT and accounts for only the net amount in its VAT return. The customer adds the VAT amount to the output tax total on its own VAT return and can reclaim the equivalent amount of input tax (subject to normal VAT rules).

Subject to exclusions, the DRC applies where relevant construction services are supplied between UK VAT-registered businesses, and where the customer is required to report payments through the Construction Industry Scheme (CIS). If goods are supplied with construction services, that is treated as a single supply for VAT purposes. Unlike the CIS, there is no distinction between labour and materials.

The construction services subject to the DRC broadly mirror those within the scope of the CIS, with the exception of supplies of workers provided by employment businesses. These services are wide-ranging and include but are not limited to the construction, alteration, repair, extension, demolition and dismantling of buildings or structures; the installation of systems such as heating, lighting, ventilation, power supply and drainage; and preparatory or integral activities such as site clearance, excavation, scaffolding and landscaping.

The DRC does not apply to the final customer in a construction supply chain, such as a property owner or developer (referred to as the "end user"), or to supplies between businesses connected or linked to end users, or intermediary suppliers. End users are required to notify their status to suppliers in writing, otherwise the DRC will still apply.

HMRC enforcement

Errors throughout construction supply chains have proved widespread since the DRC came into effect, in part because the regime operates contrary to standard VAT accounting. In some cases, the issue has been entirely missed. A supplier and customer may mistakenly assume that their services fall outside the scope of the DRC, or end-user notifications may not have been issued at all.

While HMRC's approach may have been more "light touch" in previous years, particularly in the first few months of the regime, enforcement activity in this area is now rapidly increasing and becoming more aggressive. This can include targeted compliance checks and, where issues are discovered, the issuance of tax assessments, late payment interest and tax-geared penalties. HMRC is not typically receptive to arguments that errors have, in practice, caused no loss of overall VAT to the public exchequer, and cash flow issues flowing from this approach can be severe – in some cases, business-ending. 

Penalties and interest

Liabilities flowing from DRC errors can be material. The rate of late payment interest charged by HMRC now tracks at 4% above the Bank of England base rate. Errors considered by HMRC to be caused by  "careless" behaviour by or on behalf of a taxpayer (for example, situations where professional advice should have been sought but was not) may incur penalties as high as 30% of the tax that should have been payable. Where HMRC treat errors as having been caused by "deliberate" behaviour, penalties will be material (in some cases, as high as 100%: effectively doubling the liability).

That might be the case, for example, where a supplier has knowingly charged VAT on supplies subject to the DRC in order to obtain a short-term cash benefit. It might also apply where a business has consciously chosen not to seek advice when it had reason to suspect the DRC might have applied. Deliberate penalties also carry the risk of personal liability being attached to directors.

Supply chain risks

Errors made by one business can have knock-on consequences for others in the supply chain. Suppliers face exclusion from public bids if third parties including subcontractors) have been issued with a deliberate tax penalty.

There is also a risk of consequential contractual disputes between businesses in supply chains. A customer that has not properly accounted for VAT under the DRC and needs to make a payment to HMRC may seek to recover that amount from a supplier, who has overcharged VAT. That supplier would have already accounted for that amount to HMRC, however, and would face its own cash flow issue pending any VAT reclaims.

Well-drafted contracts can help limit future exposure if they clearly identify whether the DRC applies, set out applicable notification and other obligations, ensure that appropriate internal mechanisms are in place to operate the charge, and address what happens if HMRC challenges the treatment adopted.

HMRC scrutiny of the construction sector is increasing more broadly. From April, CIS changes will allow HMRC to cancel gross payment status, recover lost tax and impose penalties where a business knew or should have known that payments were connected with fraud. The test is closely modelled on the Kittel principle, under which a taxable person may be denied VAT recovery on transactions connected with fraud.

Osborne Clarke comment

Businesses involved in construction supply chains should check their position as soon as possible. If potential errors are discovered, they should seek privileged legal advice as an urgent matter and consider making a voluntary disclosure.

The UK tax penalty regime is designed to encourage taxpayer transparency and cooperation. A voluntary disclosure can significantly reduce the financial impact of an error, potentially reducing penalties to nil, as well as reducing the risk of HMRC asserting "deliberate" behaviour or deciding to open a wider investigation. For detailed guidance on voluntary disclosures.