The Impact of the Reverse Charge on International Business Transactions

In this article we will give a comprehensive overview of how reverse charge VAT affects the sales and purchase transactions your business might be involved in, why reverse charge VAT is important, how to best manage it in your accounting system, and how to provide guidance to your teams dealing with reverse charges (eg the Accounts Payable Team).

What is Reverse Charge VAT

The reverse charge applies to services only rather than goods (although it can apply in certain situations where there are services with ancillary/incidental goods).  In this article we are discussing reverse charge VAT that relates to cross border transactions rather than some of the reverse charge systems applying to domestic transactions eg in relation to construction services.

Many countries worldwide have a reverse charge system and the UK and EU use it extensively to tax B2B cross border transactions.  It is essentially a way of taxing transactions where the business customer belongs – this effectively recognises the spirit behind VAT ie that it is a consumption tax.

Why do the Tax Authorities like Reverse Charge VAT?

The reverse charge is a way of self assessing VAT at your local VAT rate on purchases – you pay this VAT on your VAT return and on the same VAT return you get a credit for it (subject to the business’ normal VAT recovery profile – see more below).    The alternative if we did not have reverse charge systems would be to have your overseas suppliers VAT register in the UK and charge you the same local VAT you self assess.

The reasons the tax authorities prefer reverse charge mechanisms rather than having the overseas supplier VAT register are as follows:

• there is no value for the tax authorities in the additional admin created by having multiple suppliers from overseas VAT register as they need to audit them, process VAT returns etc. They get the same amount of VAT from you applying the reverse charge;
• it saves the tax authorities overseas from having to process high value overseas VAT refund claims if services are subject to local VAT rather than reverse charge VAT;
• by having a reverse charge system the tax authorities are able to pursue a local established business in the event of non payment of VAT which would not be as simple if if they were to make the overseas suppliers VAT register and account for the VAT instead

The EU extended the scope of the reverse charge mechanism significantly in 2010 partly for some of the reasons outlined above.

NB the reverse charge does not necessarily apply to land related services so care should be taken if your business is involved in providing services that have a connection to a specific piece of land or property.

How is Reverse Charge VAT declared?

Where the business has purchased service subject to the reverse charge, output tax and input tax should be accounted for on the VAT return, the impact being that the business has declared VAT on a sale and purchase so there is nil net VAT impact (subject to the business’ VAT recovery profile).  On the UK VAT return the VAT amount is declared in box 1 (sales VAT) and box 4 (purchase VAT) and the net amount in box 6 (net sales) and box 7 (net purchases).  Similar principles exist worldwide although the format of the VAT returns varies.

What Types of Service does the Reverse Charge apply to?

To answer this question it is easier to turn it on its head and state which services reverse charge VAT typically does not apply to in the first instance.  In the UK/EU this includes the following:

• land and property related services such as construction, architects, demolition
• restaurants and hotels
• cultural services such as theatre, cinema entrance
• event entrance fees
• exempt services such as financial services, insurance
• outside the scope services (such as paymaster arrangements)

Why is Reverse Charge VAT important?

Accounting for reverse charge VAT when required is important as otherwise a purchase would be untaxed which would not be correct.  Where the VAT rules mean that the overseas supplier is not required to charge their local VAT, the customer is required to account for their local VAT under the reverse charge as set out above.  It would be easy to consider that accounting for reverse charge VAT is not important if the VAT in question is fully recoverable by the business as there is nil net impact/nil tax overall due to the tax authorities.  However it is important as you could make the same argument about VAT generally, where suppliers charge VAT to business customers and they fully reclaim it, so nil net tax is due to the tax authorities overall.  Some countries levy penalties if the reverse charge is not the accounted for when it should be, even if it would be fully recoverable.  Accounting for reverse charge accurately is critical if the businesses is partly exempt – in this case the reverse charge VAT may not be fully recoverable and so there is an amount of VAT due to the tax authorities.  If overlooked, this may lead to significant historic liabilities.

High Risk Transactions

We regularly encounter issues with clients where the following high risk transactions have been overlooked and reverse charge VAT has not been correctly accounted for.  As above, this is particularly problematic for businesses unable to fully recover the reverse charge VAT due to their VAT recovery profile:

• intercompany transactions, especially those booked on the intercompany account rather than being invoiced. Watch out for ‘cost allocations’ which have the same impact.  Agreeing the allocation of a cost charged by an overseas group entity (eg by signing off the accounts) means that a tax point has crystalised for VAT reporting (assuming a VAT invoice has not been raised by this point or payment made).  Any reverse charge VAT would therefore need to be accounted for.  There is also a mandatory 31 December tax point created for reverse charge services where a tax point has not otherwise been created by the above;
• transactions with advertising and marketing service providers such as Google and Linkedin – the contracting party is often located in Ireland and we find that these transactions are often missed, possibly due to the fact that VAT invoices are not necessarily that visible

Reverse Charges in the Accounting System

Ideally the business should use an appropriate tax code in the accounting system so that the transactions are tagged appropriately and the system automatically ensures that VAT flows to the output VAT and input VAT boxes on the VAT return.  If your system doesn’t have this functionality and you cannot implement it, it would be advisable to produce VAT return reports for purchases that show the supplier location so that it is easy to identify transactions on which reverse charge VAT may be due.

Training the AP Team

The AP will typically be in the front line in deciding whether reverse charge VAT applies to a purchase. It is therefore only fair that they have the knowledge to make this determination.  Decision trees are a useful tool for the AP team as these can help them determine whether a particular transaction that they are reviewing should be subject to the reverse charge.  This  should be incorporated into regular (annual) VAT training for the AP team and new joiners should also be encouraged to review the guidance.

Reverse Charge VAT and Sales

If the business provides services B2B and has overseas customers it is likely that it won’t be charging VAT.  If the business is based in the UK it is helpful to show narrative on the invoice stating that the reverse charge applies (within the EU this is mandatory narrative along with the customer by registration number).  From a UK (and EU) VAT perspective the test for not charging VAT cross-border on services is that the customer is in business the best evidence of this status is acknowledged to be the customer VAT registration number.  Ideally this should be shown on the VAT invoice and should be held as part of the customer master data.  Alternative evidence of business status can be obtained for eg business customers that are exempt and are therefore not VAT registered.  However care should be taken with not-for-profit customers – although they may be VAT registered and therefore have a mechanism to account for reverse charge VAT, the true test is that they are purchasing the services for business rather than non business purposes for you to apply the reverse charge to your invoice.

Overseas VAT Registration Liabilities

The following transactions can create overseas by registration liabilities whereas the reverse charge system normally allows your business customer to account for VAT on your behalf so that you don’t need to register.  Care should therefore be taken if you provide such services:

• goods that are imported or acquired by you overseas
• certain land or property related services depending on the customer VAT profile
• supply and installation of goods
• entrance fees to conferences and events

The VAT Consultancy can assist with all of the above so please get in touch if you have any queries.

EU VAT Registration UK Suppliers

If you are a UK business that is registered for VAT in the EU as a result of providing some of the services above, you might find that you are not required to charge overseas VAT to domestic business customers in that country even though you are VAT registered there.  In some countries the  domestic reverse charge applies instead so the tax authorities prefer the local established customer to account for the VAT rather than having you as the overseas supplier charge and account for the VAT. This is different to the construction domestic reverse charge and also the mainstream reverse charge for cross border transactions detailed above.  VAT advice should be taken if you are unsure as to whether this applies to your business.

Reverse Charge on International Business Transactions

The reverse charge is a very useful tool to stop irrecoverable foreign VAT costs arising on cross-border transactions and it also removes the need for multiple overseas VAT registrations.   Care should be taken to ensure that reverse charge is accounted for and that your team is trained in how to manage this and recognise relevant transactions.

The VAT Consultancy is highly experienced and provides relevant and practical advice to help international businesses deal with reverse charge VAT. We provide global VAT and customs duty advice and VAT compliance services.  To discuss how we can help contact us today or call us on +44 203 2806902.