5% reduced VAT rate
I recently received an email from a developer whose contractor was refusing to charge the 5% reduced VAT rate unless the developer had a letter from HMRC confirming that the 5% rate was correct. The developer asked, quite reasonably, how he could get such a letter.
Unfortunately, that’s not how it works, because HMRC do not routinely issue letters to confirm the VAT liability of construction work. As I’ll explain below, every VAT registered business has to assess its’ own VAT liabilities and this means that they have to decide the correct rate of VAT.
VAT: the original self-assessed tax
VAT is a self-assessed tax which means that VAT registered businesses have to charge the correct rate of VAT to their customers and pay the correct amount to HMRC. Unlike income tax, there is no routine review of VAT returns. The businesses collect the tax and pay the money to HMRC every three months. And this self-assessment has been in place since VAT was introduced in 1973.
It means that the business has to decide whether their sales of goods and/or services are liable to 20% VAT, or qualify for the 5% or zero-rate, or even exemption from VAT. It’s their liability to get it right.
So what does this have to do with getting the 5% rate for your conversion or renovation?
It means that contractors have to decide whether their work qualifies for either the zero-rate or the 5% rates, as explained in VAT Notice 708: Buildings and construction. And this is where the problems start.
Most experienced contractors understand the basic principles; new build is usually zero-rated, some conversions and refurbishments are at 5% and everything else is at 20%. If you’re unsure, you probably want to charge 20% so that you don’t owe HMRC any money, even if you think that the 5% rate might apply.
This isn’t unusual: a lot of businesses pay TOO MUCH VAT for the simple reason that they’d rather pay too much now than end up with an assessment later for under-declared VAT.
HMRC often talk about business who don’t pay enough VAT – but they rarely acknowledge the many thousands of businesses who routinely overpay because they are frightened of getting it wrong.
Let’s look at some figures
Take our contractor and suppose he has a contract that he has costed at £5,000 net of VAT. The difference between VAT at 5% and VAT at 20% is quite significant:
- £5,000 x 5% = £250.
- £5,000 x 20% = £1,000
The difference of £750 is a significant amount of money. I can certainly understand that a customer would be keen to take advantage of the reduced rate where possible.
Now, let’s suppose that our contractor charges 5% VAT so the total bill is £5,250. HMRC reviews the return and tells the contractor that the job was liable to 20% VAT. The customer refuses to pay the additional £750.
This is where the calculations become a bit confusing. HMRC treat the £5250 as VAT inclusive, so to calculate 20% VAT included, they apply the “VAT fraction” and calculate the VAT as follows:
£5,250 x1/6 = £875.
The contractor paid £250 on his original VAT return, so he has to pay the difference:
£875 – £250 = £625
The £625 comes straight out of the contractor’s pocket and probably means he loses money on the job.
It’s easy to understand why contractors are careful about charging the reduced VAT rate of 5% or zero-rate.
So what DO you do if the contractor asks for a letter?
There are a number of things you can do:
- Refer the contractor to the relevant section of Notice 708; section 7 about conversions and section 8 about renovations/refurbishments to make sure that he can see the information clearly explained by HMRC.
- Ask if the contractor will agree if you get a letter/email from a VAT consultant giving an opinion about whether the 5% applies. You will almost certainly have to pay for this but it will probably still be less than 20% VAT on the contractor’s fee.
- Deal with the issue in the contract; for example that you will pay the difference if HMRC rules that the 5% rate is wrong, or that you’ll split the difference, or maybe decide to appeal against HMRC’s decision.
At the end of the day, if all else fails, you can find a contractor who is willing to charge 5%. You may be able to contract some of the labour to a self-employed contractor who isn’t registered for VAT. You’re the customer; it’s your decision.
And finally: why not just pay in cash to avoid VAT altogether?
If you ask a contractor to do any work for cash to avoid paying VAT, you are asking the contractor to commit fraud by knowingly under declaring VAT. You would be jeopardising the contractor’s business simply to save yourself a bit of cash. Of course, some contractors might agree, but then just ask yourself: if they’re willing to cheat the VAT man, are they also cheating you as well?