This blog was first published on December 19, 2019. We have updated it to reflect the latest additions such as the 5% disregard rule.

The Domestic Reverse Charge legislation was expected to come into effect on 1 October 2020, having been delayed by a year.  However, it came into effect from 1 March 2021 having been delayed a further 5 months by HMRC to “avoid the changes coinciding with Brexit” and “to help businesses and give them more time to prepare.” It will have a cashflow impact on many project finance deals, particularly in the construction phase, and we could see the use of construction period VAT facilities fall away.

Key takeaways:

  • Funding requirement for VAT cashflows will change
  • VAT facilities may disappear
  • SPVs may no longer be repayment traders in their early years
  • DRC applies unless the customer states otherwise

Why introduce the Domestic Reverse Charge?

The DRC is being introduced by the UK government to counter VAT fraud in construction services and is a significant change in the way VAT is collected in the construction sector.  Some construction companies fail to declare and remit the VAT they charge and collect from customers, often in cases where they cannot recover any VAT from HMRC because their own costs, such as wages, do not attract VAT. The DRC is designed to prevent the haemorrhaging of this VAT from the UK Exchequer.

HMRC’s Solution

The concept of the reverse charge will be familiar to those who already reverse charge cross-border services to EU VAT registered customers.  It works by moving the responsibility for reporting VAT on construction services from the provider of the services to the customer unless that customer is an “end user”.

What is an End User?

The concept of the end user is very important for the DRC.  An end user is an entity which receives supplies of construction services for use in its own business and not for the purposes of making onward supplies.  An end user will be charged VAT by the supplier, with the VAT collected and remitted to HMRC by the supplier, as now.  Typically an end user will be a non-construction business, and can be a public body.

All entities will need to consider their status under the new regime.  Many entities will be end users on some contracts and an intermediate part of the supply chain on others.

Notification Obligations

An end user must tell its supplier in writing that it is an end user, otherwise construction services will be reverse charged.  The default position is that the DRC will be applied on all services within the regime unless end user status has been notified.

Key Features of the DRC

  • applies to entities which are both registered for VAT and the Construction Industry Scheme (CIS)
  • applies to standard and reduced rate construction services, but not zero rated services
  • applies to none of the supply if the component of the invoice that falls under the reverse charge rules is equal to or less than 5% of the total amount invoiced (5% disregard rule)
  • applies to all of the supply if the component of the invoice that falls under the reverse charge rules is greater than 5% of the total amount invoiced
  • does not count towards taxable turnover for the VAT registration limit
  • closely aligned with CIS concepts (another scheme developed to combat fraud in this sector)

How are Project Finance SPVs affected?

A project finance SPV which is CIS registered and in the middle of a supply chain is likely to receive DRC supplies from its construction contractor on which it will not have to pay out cash VAT.  It will still charge and collect VAT on its own supplies, as its public sector client is very likely to be an end user.

Construction Period Cashflows – All change

Currently SPVs need to fund the VAT element of their initial costs and a VAT facility has often been used to finance this VAT before it can be recovered from HMRC.

Once the SPV establishes its VAT credentials with HMRC (often after a few months), repayments of the VAT already suffered are cash inflows from HMRC and a source of financing.

These VAT repayments have been a key feature of project finance deals, with SPVs typically being repayment traders during construction as they have suffered VAT on the supplies of construction services but do not invoice their own customer until operations start.

With the DRC, this source of financing disappears, though equally the SPV will not need to finance the VAT cash outflows it previously suffered on the construction services.  The use of VAT facilities is likely to disappear from financial models, as this type of funding is unlikely to be required.  This should also mean an interest saving for SPVs in the early periods.

Those SPVs with a small amount of other activities during construction will still be repayment traders, but at a level that is likely to be insignificant in terms of cashflow.

Contractors or sub-contractors at the bottom of the supply chain for construction services may now be repayment traders for the first time, so will need to think through the cashflow implications.  Equally, those who relied on incoming VAT as a source of working capital before it needed to be handed over to HMRC will need to adjust.

Operation Period – As you were

A project finance SPV will still charge VAT on the unitary charge invoiced to a public sector body and pay VAT on all other applicable costs such as operating costs and professional services.

The SPV will be in a VAT payable position as revenue receivable by the SPV should exceed the VAT outflows on operating period costs.  The SPV will, therefore, submit quarterly VAT returns and pay VAT quarterly.

Ongoing lifecycle costs should be reviewed in detail to see whether they fall within the definition of construction services and are subject to the DRC. We expect most lifecycle costs to meet the definition of construction services.

Financial Modelling

VAT was modelled on all VATable costs, including construction costs, until 28 February 2021.

From 1 March 2021, the DRC applies to a typical SPV’s construction costs. We would expect most modellers to treat construction costs as “not subject to VAT” to reflect that the input and output tax should net to zero with no associated VAT cashflows.

VAT cashflows will not be shown on the SPV’s construction cost inputs from 1 March 2021 onwards, but will still be shown in respect of payments received from the public sector. VAT cashflows will also be modelled on applicable ongoing overheads and operating costs, as before.

Professional Services

Generally, the services of professionals, such as surveyors, architects or consultants are outside the scope of the DRC.  However, if the work goes beyond a consultative or advisory role and becomes the supervision of labour or the co-ordination of construction work using that labour, then the DRC will apply.

Where professional services are part of an all-inclusive executive and advisory contract, then all the services will be within the provisions.

Our view

In terms of financial modelling, the VAT cashflows during the construction period will differ from what we see at present, as many SPVs will be in the DRC regime.

There will no longer be a requirement to fund VAT on construction costs in the early periods but conversely, there will be a requirement to draw funds later on to finance ongoing construction costs that were previously funded by VAT rebates.

The timing of the funding requirement for infrastructure projects is likely to be different during the construction phase as a significant portion of the construction period VAT under the previous regime will no longer need to be funded. VAT facility loans during the construction period are likely to fall away.

If you have any questions about how the DRC will affect your financial model and would like to speak to me or a member of the Operis Accounting and Tax team, please get in touch.

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Please get in touch with either of our regional offices.

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Erwan Fournis
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