The construction industry is facing a tough year with a number of new regulatory hurdles associated with VAT. Not only does it need to comply with the final phase of Making Tax Digital for VAT – the implementation of full digital links from April 2021 – but it will also have to meet the demands of the domestic reverse charge, previously delayed for two years but which came into effect from 1 March 2021 and is thought to affect around 150,000 businesses. Both will significantly shake-up the way the sector processes its VAT.
Domestic reverse charge
Speaking on our recent webinar, Glyn Woodhouse, VAT Partner at BDO, said the domestic reverse charge “could be painful for VAT processes, especially on top of MTD” as it will require significant changes to be made. The reverse charge sees a CIS (Construction Industry Scheme) registered business (i.e. the contractor) taking construction services from a VAT registered entity (i.e. the sub-contractor) become responsible for the payment of that VAT. The changes are being introduced as an anti-fraud measure to combat situations where a sub-contractor charges VAT but then deliberately fails to pay the amount over to HMRC.
The sub-contractor no longer charges VAT on services; instead, the recipient (contractor) charges VAT to itself which is then shown on the VAT Return. Consequently, the domestic reverse charge is expected to impact cashflow: positively for the contractor who will experience a short-term benefit but negatively for the sub-contractor who will no longer be in receipt of the VAT.
So far so good but where things get complicated is exactly what comes in scope. As well as construction services, non-construction services must also comply with the reverse charge if ancillary to those construction services or if the relevant parties choose to apply the reverse charge to those non-construction services.
The reverse charge also does not apply where the customer is the end user ie they intend to make use of those construction services for their own ends or business (such as where it is a property owner’s business) and not to pass on usage of those construction services to another. In these instances the end user is supposed to notify the contractor of their status.
Identifying whether a customer has end-user status or not is crucial for both parties. If the business incorrectly applies a VAT treatment which HMRC discovers it will need to reissue invoices to end user/s. Or, if the reverse charge is misapplied, the customer will be responsible for VAT which will need to be paid and they will then have to seek a refund from the supplier.
To help deal with this, many businesses are putting a clause in their contracts that assumes the customer is an end user. The onus is then placed on the customer to declare if this is not the case. Where the reverse charge does apply, the business will need to note this on VAT invoices stating that the customer is obliged to account for VAT.
Complex calculations
Many construction businesses already have complex VAT needs and so use partial exemption (standard or special method) as the most efficient way to calculate their recoverable input VAT. Partial exemption special method (PESM) involves complicated cost attribution steps to identify recoverable VAT. For the construction sector, the process often involves tens of thousands of transactions and there may be numerous data sources, dozens of spreadsheets and manual aggregations/calculations to manage.
Those using a PESM will have an agreement in place with HMRC which must be adhered to and compliance must also be shown in the event of any changes, or additions, to cost centres or ERP systems (these need to be reflected in calculation algorithms) and transactions (which must be accurately classified and allocated to their appropriate sectors). A failure to evidence compliance can result in an investigation by HMRC, during which time all repayments are suspended, or the PESM may even be rescinded.
Making Tax Digital as a compliance tool
Being able to prove who is responsible for VAT under the domestic reverse charge or how the conditions of a PESM have been met is one of the potential benefits that can be achieved through implementing automated processes as a part of your Making Tax Digital (MTD) roll out.
The digital links mandate requires businesses to put digital links in place to create an end-to-end digital process. While this is not obligatory for complex calculations, incorporating these within the digital links process using compliance software can be invaluable as it effectively creates a digital audit trail. It then becomes possible to track back through the process to the transaction layer, so that time-stamped calculations can be used to evidence compliance.
Even for those industrial or commercial construction businesses that don’t use partial exemption, through automated processes they can evidence compliance with the domestic reverse charge and improve the way VAT is processed. Typically, construction businesses are divisionally based and have a separate finance team that then pulls all the required data together. That equates to multiple spreadsheets flying around the business, with potentially lots of manual transposition and lots of opportunities for error.
But MTD is just the start
While regulatory change in the shape of MTD and the domestic reverse charge provide two very good reasons to invest in the overhaul of the VAT process, they’re not the only ones. MTD for VAT signifies the beginning of HMRC’s ten year plan to modernise the tax system leading to real-time risk assessment in a bid to close the tax gap. The plan will see the digitalisation of income tax and corporation tax with all three set to be moved into a single digital account using proprietary technology to integrate with HMRC’s systems.
Yet regulation alone should not be the chief motivator. We’ve found plenty of instances where businesses are fully MTD for VAT compliant (including digital links) and still have inaccuracies in their return. Of 170 VAT processes we have recently reviewed in medium and large corporates, almost half had errors that had a meaningful effect on submission accuracy.
It’s here where software compliance technology comes into its own, providing the mechanisms to not only ensure compliance but to improve data handling. Up to 80%[1] of compliance time is currently dedicated to data management and spreadsheet integrity. The good news is software automation of the collection, management and preparation of data can significantly improve efficiency, often saving hundreds of hours a year[2]. This frees up more time for the review process (often 3 to 5 days per quarter[3]), making it more likely your return will be right first time. Less time spent on the process also reduces costs, particularly if your advisor usually charges you for additional reviews.
A compliance engine doesn’t use spreadsheets which can suffer from incorrect formulas, broken macros, and ownership issues, so automating the process also significantly reduces the margin for error. Plus, the digital linking process itself can be used to create time stamped events resulting in a digital audit trail which can be used to rapidly address any queries from HMRC and prove your compliance.
To find out more about how our compliance software platform – AlphaVAT – can help you meet regulatory demands, evidence your compliance, and improve your VAT process, contact us to arrange a free technology review.
[1] Based on the experiences reported by AlphaVAT customers
[2] Ibid
[3] Time gains reported by customers that have moved from AlphaBridge to AlphaVAT
