In simple words, DRC is an accounting mechanism for accounting of VAT that finds its principal application in the building and construction industry. The major reasons for its introduction are avoidance of VAT fraud, which is mainly caused by a missing trader. The liability to account for VAT in this mechanism has been shifted from the supplier to the buyer. That means instead of the supplier charging it, VAT should be accounted for by the customer himself. It can, however, be accounted for and reclaimed on the same VAT return.
What is the Domestic Reverse Charge?
The Domestic Reverse Charge was developed as the reaction of the influence of fraud within those sectors that are vulnerable to such specific service frauds, particularly those concerning construction. Normally, the supplier has to charge the VAT in his invoices, collects that amount, and pays it across to HMRC. In a DRC, this responsibility is shifted onto the customer to declare and reclaim the VAT within their own VAT return.
This is VAT-neutral for both parties in cases where both are VAT-registered but prevents situations whereby a supplier may charge the VAT and then disappear without paying to HMRC.
When Does the Domestic Reverse Charge Apply?
The DRC applies principally to the construction industry under the Construction Industry Scheme. It will affect VAT-registered businesses that provide or receive construction services in the UK.
Reverse charge does apply if,
- Both the supplier and the customer, each being UK VAT registered.
- The services concerned are CIS.
- It is expected that the customer would make an onward supply of the services in that they would not be the last/end user.
- Services are or involve the labour or any goods embedded into the building and construction, alteration, repair, extension, or demolition of buildings.
When any of the above applies, the customer has to account for VAT and not the supplier.
In What Instances Does the Domestic Reverse Charge Not Apply?
Others amongst the following represent cases where the Domestic Reverse Charge does not apply:
Consumers: If the customer is a consumer of such service-the developer or property owner using that service himself then the DRC will not apply.
Intermediaries: Normal VAT rules operate when the customer is an intermediary related to the end user.
Exempt services: Some of the services are altogether exempt from the scope of CIS. The services mainly relate to architecture, surveying and some consultancy services.
Non-VAT-registered businesses: this simply means that in the case of one of these parties not being VAT-registered, the normal rules of VAT come into effect, and no reverse charge applies.
Normally, the supplier would charge the VAT and be paid by the customer.
H2: How Does the Domestic Reverse Charge Work?
The process would change gear in the form of accounting for VAT when the Domestic Reverse Charge applies:
- Supplier invoices, but charges no VAT. The invoice has to say so, though, to note that the Domestic Reverse Charge applies and that the customer is required to account for the VAT.
- The customer receives the invoice and declares the VAT in the VAT return. Besides output VAT, he declares as much input VAT - VAT on purchases. Here it is VAT-neutral if the customer is entitled to reclaim the VAT.
For example, if subcontractor provides another invoice for services supplied of £ 10,000, it would mean that a customer will have to declare his output VAT and Input VAT as 20% that is £2,000 in his VAT return. Thus, no more additional VAT will be payable to HMRC hence it would be neutral on VAT effect .
H2: Domestic Reverse Charge - Impact on VAT Return
Supplier's VAT Return:
He, however does not charge any VAT on the Invoice against the said services related to DRC. He declares the net sale amount in Box 6-total sales less VAT but does not declare any output VAT in Box 1, VAT on sales in his VAT return.
VAT Return of Customer:
He needs to account for both input and output VAT. In other words, he declares the VAT as if he charged it in Box 1 - output VAT - and reclaims in Box 4 - input VAT. Needless to say, if he is entitled to full VAT recovery, there will not be any cash impact.
A Simple Example of the Domestic Reverse Charge Scheme
Let's meet Jack, a Contractor
Jack is a subcontractor duly registered for VAT. He is in the building and construction industry. He is a subcontractor mainly providing services in the electrical installations for new buildings. One day, Sarah, who is a main contractor also duly registered for VAT hires the services of Jack to help him with electrical wiring of the works on big project.
The Construction Project
Sarah is constructing a commercial property and will onward supply the completed construction services to her client. Both Jack and Sarah are registered for VAT and operating in the CIS.
Because Sarah is not the final consumer of the service-that is, she will onward supply the construction services-the Domestic Reverse Charge applies.
Invoicing Process
Jack does the electrical work and invoices Sarah for £10,000.00. If this was out-with the scope of the DRC, Jack would have charged 20% VAT (£2,000.00) - £12,000.00 in total. However, because of the DRC, Jack won't charge VAT. He will be invoicing £10,000.00 but states the following:
> "Domestic Reverse Charge applies: customer to account for VAT to HMRC."
Sarah's VAT Return
Meanwhile, the buyer, Sarah, accounts for the VAT. In her next VAT return:
- She declares the £2,000 VAT as output tax in Box 1-as if she had charged it herself.
- She declares the same £2,000 VAT as input tax in Box 4-as if she has paid it on her purchases.
This, in substance, is VAT-neutral, as Sarah will not be paying any more VAT on this transaction to HMRC and yet VAT has been accounted for correctly.
VAT Return of Jack
That is all so much simpler for Jack: he declares the £10,000 net sale in Box 6 of his VAT return and puts zero VAT in Box 1. In such a case, Jack has nothing more to do in accounting for the VAT because his customer Sarah declares it.
When the Domestic Reverse Charge Does not Apply
Let's say that Jack also works directly for Emily, a homeowner, who is renovating her home. Emily is not VAT-registered and represents the end user of the service. In this instance, the Domestic Reverse Charge would not apply.
Jack invoices Emily for the full amount plus VAT at 20% standard rate. If the service is £10,000, Jack would invoice for £12,000 (£10,000 plus £2,000 VAT). Since she is the last user, Emily cannot claim back the VAT because she is not VAT-registered.
Conclusion
Where relevance to the construction industry exists, the Domestic Reverse Charge would feature within the VAT mechanism of the concerned businesses for appropriate accounting and as a way of avoiding fraud. Application will be made in the case of services supplied between VAT-registered businesses in CIS but without application to either end users or services outside of CIS.
It will be pertinent to learn whether the Domestic Reverse Charge applies, how it influences the VAT return of the business, and hence follows the requirements of HMRC and maintains ease in their accounting for VAT.
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Some useful links:
https://www.gov.uk/guidance/vat-domestic-reverse-charge-for-building-and-construction-services