What happens if HMRC disagrees with 5% VAT?

I usually write RenovateMe blogs from the perspective of the property owner, but this blog is about the contractor and what happens if the contractor has charged 5% VAT but HMRC disagrees.

Let’s assume I’m a contractor and I did a renovation project for £100,000 net. I charged 5% VAT, £105,000 in total. Unfortunately, a VAT officer comes to inspect my records a couple of years later and says that the work was liable to 20% VAT.

So what happens next?

The assessment, review and appeals process

The process is long and tedious.  This is how it works:

  • The officer sends me a bill – or “issues an assessment” to use the technical phrase – for the under-declared VAT.
  • I have 30 days to ask HMRC to review the assessment or to appeal to the First Tier Tax Tribunal.
  • I ask HMRC to review the appeal, providing as much evidence as possible to prove that my decision to charge 5% was correct. The review is carried out by a review officer who has no previous knowledge of the case.
  • If the reviewing officer upholds the assessment,  I then have 45 days to decide whether to appeal to the First Tier Tax Tribunal.
  • In the meantime, I have to pay the assessment, unless I can prove to the Tribunal that paying cause financial hardship.
  • If I win the appeal at the Tribunal, HMRC can appeal to the High Court against the Tribunal decision, which could take several months.
  • If I lose at the Tribunal, I could appeal to the High Court against the Tribunal decision, which could take several months.
  • In certain circumstances, further appeals can be made by either party to the Court of Appeal, the House of Lords and/or the European Court of Justice, which could take several months or even years.

Whether or not I ultimately “win” the case, I have to pay my own costs.

This is a very long and tedious and, more importantly, expensive process.

And in practice, even if HMRC’s assessment was wrong, I either have to pay the VAT or let myself in for a long and potentially protracted appeals process.  I have to decide whether to pay the incorrectly charged VAT  or whether it’s worth the cost given the financial cost, but also the hassle and managerial time that would be involved, never mind my stress level!


And I also have to ask the client if they are willing to pay the additional VAT.

What if the client refuses to pay the additional VAT?

In this situation, the first thing I’d do would be to check the contract to find out what the contract says about VAT.    Unless the contract specifically says that the client is liable to pay any under-charged VAT, the contractor will almost certainly end up having to foot the bill.

That’s why it’s particularly important for contractors to include some protection for themselves when the contract is drawn up so that the client is liable for VAT if HMRC issues an assessment. Alternatively, the contract could include some arrangement for the contractor and the client to share the VAT cost, or whether to share the costs of an appeal against the assessment.
But I know that this isn’t always possible in the real world.  Clients often won’t appoint a contractor if they think that they might have to pay additional VAT at a later time, so this issue could be an important factor when trying to win business.

The VERY SMALL silver lining……

There is one very small benefit in this situation is that, if the client doesn’t pay any more money, the amount of “under-declared” VAT will be reduced.

This is because HMRC can only charge VAT based on the total payment that I’ve received from my client, on the basis that this is VAT-INCLUSIVE.

What does this mean?

On a normal £100,000 contract at 20% VAT, I’d charge £20,000 VAT and the client would pay £120,000, because the £100,000 net cost is VAT exclusive.  So you’d assume that HMRC’s assessment would be for £15,000; the difference between VAT @20% and VAT@5%.

However if I’ve only received £105,000 and can’t recover any more VAT from the client, then HMRC can only assess me for £12,500. This is because the cash amount I’ve received is treated as including VAT, so HMRC must calculate their assessment using the “VAT fraction” as follows:

£105,000 x 20/120 = £17,500 VAT (i.e. on VAT inclusive amount) less £5,000 VAT already paid = £12,500.

But whether it’s £12,500 or £15,000, it’s still a lot of money.

So if you are a contractor, I’d strongly recommend that, if it’s at all possible, you ensure that the client has to pay any additional VAT charged by HMRC, or at least shares the costs equally, whether or not you think that HMRC’s decision is correct.