How Does Reverse Charge VAT Work?

The introduction of the new reverse charge VAT system has significantly changed the way UK construction companies handle VAT. Since it was implemented in 2021, contractors and subcontractors now have to invoice differently to account for this change. The aim of reverse charge VAT is primarily to reduce fraud, but it has also added a new layer of complexity that those in construction need to understand.

This is particularly important for those registered with the Construction Industry Scheme (CIS). Getting it wrong can lead to VAT mistakes and HMRC penalties. Here at Contractwise, we’re leading CIS compliance experts and provide a wide range of services, including payroll audits to safeguard against HMRC reclassification, that protect both contractors and subcontractors.

In this article, we’ll provide you with everything you need to know about reverse charge VAT and how it works.

Read on for more information…  

What is reverse charge VAT?

Reverse charge VAT is the new mechanism that shifts responsibility for accounting for VAT from the supplier on to the customer. Instead of the supplier charging VAT on an invoice and paying HMRC, the customer will record it themselves on their VAT return.

In the UK construction sector, this process is known as the VAT domestic reverse charge, and it applies to a wide range of building and construction services between VAT-registered businesses where those services are also reportable under CIS. The supplier does not charge VAT, but it will be the responsibility of the customer to calculate and declare it. They may also be able to reclaim it if eligible.

The system was introduced to combat fraud where suppliers collected the VAT but then did not pay it to HMRC. By removing VAT from the cash flow of suppliers, this fraud has been reduced.  

How does reverse charge VAT work?

To fully understand how reverse charge VAT works, it’s worth comparing it to the old, standard process before the change was introduced.

The standard VAT process (before reverse charge)

Under normal VAT rules, the following applies:

• A supplier charges VAT on the invoice
• The customer pays the invoice, including VAT
• The supplier declares the VAT as output tax and pays it to HMRC

This process meant that the suppliers temporarily held VAT as cash before paying it to HMRC, creating opportunities for fraud to take place.

The reverse charge process

Since 2021, this has been the VAT process in construction:

• The supplier issues an invoice without charging VAT
• The invoice clearly states that the reverse charge applies
• The customer independently calculates what VAT needs to be paid
• The customer declares the VAT as output tax on their VAT return
• Sometimes, the same amount can be reclaimed as input tax

For the supplier, VAT will no longer be part of their cash flow, minimising the risk of fraud. 

Benefits of reverse charge VAT

Although the new reverse charge VAT system might seem complicated at first glance, it actually provides several important benefits:

• Reduces VAT fraud: The biggest benefit of reverse charge VAT is that it prevents fraud by removing VAT transactions from construction businesses.
• Improves VAT compliance: By shifting responsibility to the customer, HMRC gains greater visibility over VAT reporting. This reduces mistakes and the risk of being hit with HMRC penalties.
• Removes VAT from subcontractor cash flow: Subcontractors no longer receive VAT that needs to be paid to HMRC. This reduces the risk of mismanaging cash flow.
• Protects contractors from unpaid VAT risks: Contractors are no longer exposed to situations where VAT is charged by the supplier but not paid to HMRC.
• Creates consistency with CIS: Because reverse charge VAT only applies to CIS-reportable services, it aligns with VAT more closely and supports existing tax rules.

How does it work when dealing with the EU?

Reverse charge VAT is not unique to the UK. The European Union (EU) has long used reverse charge mechanisms, especially when it comes to cross-border services and goods supplied between VAT-registered businesses in different member states. Let’s take a closer look at how the European system works:

EU reverse charge system

Within the EU:

• VAT on cross-border services between businesses is usually accounted for by the customer
• Suppliers do not charge VAT
• The customer applies the reverse charge under the EU’s VAT rules

This system is similar in principle to the way the charge works in the UK, but it is applied more broadly across goods and services in EU countries and not just construction.

UK and EU cross-border transactions

Since the UK left the European Union, the UK operates outside the EU VAT system and has had its own version since 2021. This means:

• Reverse charge VAT for UK construction services only apply within the UK
• Suppliers of services between the UK and the EU will usually apply the VAT system of the country where the services or goods are arriving in

While reverse charge VAT may still apply to certain services in the EU, it does not apply in quite the same way as the UK construction reverse charge. Construction businesses that trade internationally should carefully distinguish which system they are operating under.

How does reverse charge VAT link to CIS?

Reverse charge VAT and CIS are closely connected, but are not the same thing.

CIS governs how tax is deducted from payments to subcontractors in the construction industry. In contrast, reverse charge VAT applies only to services that are reportable as part of CIS. If a service falls outside the remit of CIS, reverse charge VAT will never apply.

With this in mind, businesses must:

• Identify whether a construction service is part of CIS
• Confirm the VAT status of both parties
• Determine if the customer is the end user

Misclassification under CIS can directly impact whether reverse charge VAT is being applied correctly, so proper compliance is a must.

At Contractwise, we help construction businesses across the UK stay compliant with their tax obligations, including CIS. We can also offer advice on the reverse charge VAT. To find out more, get in touch with our team today.