Changes to VAT legislation may not seem like headline news. But if you’re a construction business then upcoming changes to the way VAT is collected and paid to HMRC could have a significant impact on your financial administration – and (importantly) your cashflow position.
Matt Thorpe, Partner at Haines Watts Hornchurch, explains how VAT for construction businesses is changing, and the key ways to minimise the potential effect on your company.
How is VAT for construction changing?
The treatment of VAT in the construction industry is changing. From 1 March 2021, HM Revenue & Customs (HMRC) is introducing a domestic ‘reverse charge’ rule that will change which entity in the construction industry supply chain is responsible for collecting and reporting VAT.
The key impact of these changes, where applicable, are as follows:
Main contractors will now be wholly responsible for tracking, collecting and paying the VAT that’s owed on construction supplies.
Subcontractors will no longer be responsible for collecting and paying the VAT on these supplies.
On first glance, this may sound like bad news for large main contractors, and good news for smaller contractors. But the reality is slightly more complex, as I’ll explain.
Why were these changes to VAT needed?
You may well ask why a specific reverse charge on VAT for construction was needed. But there is a very clear reason for HMRC to take this approach.
HMRC has always been a little mistrustful of the construction industry and doesn’t tend to trust contractors and subcontractors to pay tax effectively. And this belief is driven by the level of VAT fraud and late VAT filings within the construction industry.
By introducing a reverse charge for VAT, HMRC hopes to create a simpler way to collect VAT from construction businesses, making the whole process less complex – and with the emphasis on the main contractor to do most of the heavy VAT lifting.
Why is VAT on construction supplies so complicated?
VAT on construction supplies is complex, for a number of reasons. And it’s this complexity that HMRC is aiming to streamline and reduce.
For most construction projects, the supply chain is as follows:
Ultimate client – this could be a pension trust that owns the land, or a developer looking to build a new development. They’re the people who contract out for the build.
Main contractor – generally, this will be a larger multi-discipline construction business, who will manage and deliver the project for the ultimate client. They’ll also subcontract out for many of the specialist areas of the build.
Subcontractors – these are the smaller construction businesses who supply the more specialist services, such as electrical, plumbing, plastering or flooring services.
The complexity comes from the sheer number of subcontractors working on a single project – and the fact that the main contractor will be working on multiple projects at the same time.
How does VAT on supplies work at present?
Ordinarily, the way that VAT would work is for the main contractor to charge VAT to the ultimate client. The main contractor would be charged VAT by every one of the individual subcontractors, meaning you need to net the two amounts off and make a payment to HMRC at the end of the quarter.
Subcontractors operate in exactly the same way – they would charge their main contractor VAT and would be charged VAT by their own supply chain – netting the two off and making a payment at quarter-end.
What changes has HMRC made?
The way that the VAT supply chain was managed meant that HMRC had a huge number of subcontractors to keep track of, which made it hard to stay on top of the VAT that was owed.
HMRC’s thinking is that the bigger main contractor is more robust and more trustworthy, and that it’s much easier to just let the main contractor collect all of the VAT within the chain. So, the new changes mean that, generally, the smaller subcontractors no longer have to charge or collect VAT.
In essence, HMRC has taken out all of the middle layer from the process of collecting VAT.
Is this good news for subcontractors?
The short answer is ‘Yes, and no’! For subcontractors, these changes simplify their admin processes, but they also will have a significant impact on their cashflow.
To summarise the impact:
The good news: with no need to charge or collect VAT where the new rules apply, subcontractors have less financial admin to carry out each quarter.
The bad news: with no VAT being paid to them by their main contractor, there’s suddenly a huge hole in the subcontractor’s cashflow – and although likely to be short-term, this could be critical.
In real terms, many subcontractors rely on that VAT money to finance their business. Historically, a subcontractor could collect £200,000 in cash throughout the quarter in VAT – and use that liquid cash to pay suppliers and staff, before their quarterly VAT bill is due.
Eventually, you do have to pay that VAT to HMRC, of course. And that may mean scrabbling around at the end of the quarter to find that money. But having that VAT cash on hand really was a lifeline for subcontractors that found themselves in a precarious cashflow position.
Under the new rules, you’ll no longer have that flexibility in managing cash flow.
Has HMRC underestimated the impact?
What HMRC hasn’t seen is just how huge the impact is going to be for subcontractors. They believe subcontractors will be in no worse a position – that VAT cash belongs to the revenue, after all. But, in real terms, many construction businesses will be worse off financially.
For affected subcontractors it means:
- No VAT cash coming into the business –removing the cash inflows on which many subcontractors have been relying to keep their businesses afloat. Essentially, not having to pay the money out in three months, does not ease the immediate pain of not having it today!
- Poor cashflow as a result – smaller subcontractors are already struggling in the current economic environment, so this reduction in incoming cash further dents their ability to pay their own liabilities on time, snowballing down the supply chain.
- Little ability to negotiate a better deal with clients – in construction, the supply-chain hierarchy is like a pyramid; all the power is at the top and the lower down you get, the less control you have to negotiate your position and improve cashflow.
As you can see, the VAT changes are more than a minor inconvenience. For some construction businesses, these new rules could prove highly challenging – or even fatal!
Will main contractors also be affected?
The flip side of the new rules will also have a major impact for the larger main contractors, albeit a slightly less significant one than for subcontractors.
The good news: companies no longer need to pay out VAT to subcontractors, leaving more money in the bank gathering interest until VAT payments to HMRC are due.
The bad news: the finance team now has a huge amount of VAT admin and financial reporting to carry out quarterly around their VAT liabilities and the pressure on smaller businesses in the supply chain will undoubtedly lead to issues in project delivery.
Taking advantage of their bargaining position
An additional issue is the potential for main contractors to use their strong negotiating position in the wrong way.
The supply chain relationship in construction is a delicate one, and things can be somewhat ‘dog eat dog’ when times are hard. If main contractors see that subcontractors are struggling, they may offer to help by reducing payment terms down to 14 days – getting the subcontractor their money quicker. But any astute main contractor will also look to get a cheaper price through an early settlement discount in this scenario.
So subcontractors may get paid quicker, but the overall margins and income they make on each job may end up dropping as a result.
Equally, if main contractors squeeze their subcontractors too hard, they could drive them to fail – leaving the bigger entity without the specialists they need to complete projects.
A quantum shift for the sector
As you can see, what might seem like a small change to VAT legislation is likely to have a wide-ranging and potentially destructive impact across the construction sector.
In an industry where supply-chain dynamics are fragile, and cashflow is so delicately balanced, introducing this reverse charge for VAT on supplies is going to have an impact that reverberates through the sector – potentially sounding the death knell for ill-prepared subcontractors.
How we can help
For subcontractors, keeping a tight rein on your finances is going to become increasingly vital, and there are some key areas where we can help with this:
Our team of construction accountants can:
- Enhance your bookkeeping – providing a cloud-based accounting platform, like Xero, and automated bookkeeping apps such as Receipt Bank, to ensure you’re keeping timely records of all sales and purchase transactions.
- Deliver real-time reporting – so you can see your cashflow, debtor and balance sheet positions as they stand right now, allowing you to manage your financial health more accurately and proactively – and avoid cashflow holes.
- Review your financial model – helping you to finance the business in a more productive and planned way, so there’s no need for the historical reliance on VAT cash to provide working capital, and cashflow is enhanced to keep you in a positive position.
- Provide access to funding – so the business has access to tools such as invoice financing, asset finance and business loans to provide working capital, or to fund the next stage in your company growth.
Talk to us about these VAT changes
If you’re a construction business and have concerns about the new reverse charge on VAT for supplies, please do come and talk to us.
We’ve got decades of experience working with the UK construction companies, so we know the cashflow and funding challenges you face. We’ll work with you to mitigate the impact of these VAT changes and will help you get back in control of your numbers.
Talk to one of our specialist construction accountants in Essex about preparing for the VAT changes.
Haines Watts are accountants in Essex working with SME business owners.
Want to know more? Call us on 01708 475220 or email email@example.com