I’ve seen a number of queries on various business forums over the years about the VAT reverse charge procedure. Either way, it seems to cause a lot of confusion so I thought I’d try “demystifying the reverse charge”, to explain WHY and HOW the procedure works, to help you understand the principles. Once you understand the principles, the VAT accounting procedure will make sense.
The procedure applies to imported services as well as certain sales of goods and services within the UK. Reverse charge VAT accounting now also applies to a limited range of “specified goods” made within the UK, including mobile phones and computer chips. I’ll explain the principle behind this later.
Why is it called the “reverse charge”?
The reverse charge is where VAT is levied on most imported services by UK VAT registered businesses. It’s called the “reverse charge” because the customer pays the VAT to HMRC, not the vendor/supplier. It’s also referred to as the “tax shift” mechanism, because it shifts the liability to pay VAT from the supplier to the customer.
The best way to understand the principle of the reverse charge on imported services is to compare it to the way that VAT is applied to imported goods.
VAT on imported goods
Suppose you import goods from China. Before you can bring the goods into the UK, you have to declare the goods to HMRC. Your import declaration includes the classification of the goods for customs purposes, which defines how much customs duty you have to pay.
- VAT is then charged on the duty paid value of the goods. This means that VAT is levied on imported goods at the same rate as though the goods are bought from a UK supplier.
- For example: the goods were machine parts, costing £10,000 (including freight and insurance). The duty rate is 6%, so the duty paid is £600.
VAT @ 20% is therefore: £10,600 x 20% = £2,120
- You claim the import VAT as input tax on your VAT return, subject to the normal VAT recovery rules. So if you use the goods to make taxable supplies, then you can claim back all of the import VAT. If you’re partly exempt and can only recover – say 30% of the VAT – then you claim 30% of the VAT.
The VAT recovery is exactly the same depending on whether the goods are imported or purchased from a UK supplier. The only difference is that instead of paying the VAT on purchase to a UK manufacturer supplier, you’ve paid VAT to HMRC on importation.
VAT on imported services
So how does HMRC collect VAT on imported services? It’s not as though the services or even the invoices physically go through Customs in the same way as goods.
That’s what the reverse charge does.
- Suppose instead of buying £10,000 worth of goods, you paid a solicitor in America £10,000 for legal advice.
- Instead of paying the VAT to HMRC at the port of entry, you pay the VAT at 20% to HMRC; i.e. £2,000, by including it as output tax on your VAT return, as though you’d charged £2,000 VAT on £10,000 worth of sales.
- You can claim the reverse charge VAT as input tax on your VAT return, subject to the normal VAT recovery rules. If you use the services to make taxable supplies, then you can claim back all of the import VAT. If you’re partly exempt and can only recover- say 30% of the VAT – then you claim 30% of the VAT.
The VAT recovery is exactly the same whether your solicitor is based in the UK and charges UK VAT, or you import the services VAT free from an overseas supplier The only difference is that instead of paying VAT to a UK solicitor, you pay the VAT to HMRC by including it as output tax on your VAT return.
It’s exactly the same as paying VAT on imported goods – except that you pay the VAT on your VAT return instead of at the port of entry.
HMRC’s guidance about VAT on imported services is in VAT Notice 741: Place of supply of services, section 18. Notice 741 is the most important guide to dealing with VAT on international supplies of services, including the general rules for B2B and B2C transactions; and when the reverse charge applies. It is a long and detailed notice but if you start by understanding the general rule and how the reverse charge works in practice, it will make your life a lot easier.
Other uses for the reverse charge
The reverse charge is also used for certain sales of goods and services in the UK, in most cases as an anti-avoidance measure.
It includes the sale of computer chips, mobile phones and emissions allowances.
Reverse charge accounting was introduced for UK sales of computer chips and mobile phones (normally transactions of £5,000 or more) between VAT registered businesses to prevent VAT evasion. The high value and ready availability of the goods had cost HMRC a lot of VAT, because some traders concerned charged VAT on sales and promptly disappeared. Shifting the liability to the customers prevented this. The customers simply paid the VAT on their purchase as output tax on their VAT return and claimed the VAT as input tax under the normal rules.
There’s more information about this in VAT Notice 735: VAT reverse charge on specified goods and services.