VAT in the Construction Industry
Chelco VAT Ltd
27 July, 2018
Article 11B of the Cyprus VAT Laws that governs the reverse charge on construction services has been around for 6 years. Recently there has been discussions whether it should be abandoned.
What is article 11B? Why was there a need to introduce it? And why it should not be abolished?
The mechanics of article 11B
When there is a supply of construction services from one Taxable Person (TP) to another, then the VAT is discharged by the recipient of the services under the reverse charge mechanism. Where the recipient has the full right of deduction there is no VAT payable/refundable and it is just a matter of accounting entries. The supplier does not charge VAT on its invoices and notes 'Reverse charge – article 11B' on them.
The need for introducing article 11B
On 9th March 2012, law ?.16(?)/2012 was published in the Cyprus Gazette, introducing article 11B to the Cyprus VAT Law ?.95(?)/2000. The reasoning report introducing the legislation noted the following as to why the introduction of article 11B was necessary:
- Support of economic growth and liquidity support for developer companies, and
- Tackling tax avoidance and evasion.
Support of economic growth and liquidity support for developer companies
Prior to article 11B, the developer paid VAT on the invoices received by constructors. Even if the developer had a full right of deduction of input VAT, there was a timing difference from the time it paid the VAT to the time it recovered it either by set off with output VAT on sales or as refund from the Tax Department (TD). This created a need for the developer to finance the VAT which increased the financing cost of projects at a time when financing was already a problem.
With the introduction of article11B the developer no longer pays VAT to the constructor. The VAT is self-charged and has a neutral impact when recovered in full thus avoiding the need for financing.
Tackling tax avoidance and evasion
Application of the reverse charge mechanism for such transactions is allowed as an option to Member States under article 199(1)(a) of the VAT Directive as a measure of tackling tax evasion. The problem faced by the TD in Cyprus was that constructors would register for VAT and issue invoices with VAT to clients. Without paying that VAT to the TD they would then disappear. At the same time, their clients having paid for the services and with a legal invoice at hand would recover the input VAT accordingly. This meant that the TD was forced to refund input VAT which it never received as output VAT. Considering the magnitude of transactions in the construction industry one may realise that the tax evasion resulted to significant losses of public revenue.
By introducing article 11B there is no need for funds to change hands for VAT purposes as the VAT is discharged by the recipient under reverse charge and not paid to the provider. Thus, with a very simple solution it was possible overnight to tackle this fraud and plug a big hole for public revenues.
Should we keep or abandon article 11B?
The part of the property market which targets foreign investors for passport purposes seems to have gone in an overdrive showing the first signs of a property bubble ready to burst. On the other hand, the property market for the Cypriot population, albeit being dragged higher by the foreign investors, does not show the same signs. Fewer properties than demand are being built targeting the local market and this is evident from the rent prices which keep rising to unprecedented levels.
The effects of article 11B are not really a factor affecting the market. This is especially true now that the banks have once again started funding both developers and buyers eliminating the small difference of the effects of article 11B and VAT financing.
Most importantly, the introduction of article 11B has been a determinant factor in tackling tax evasion in the construction industry which created huge losses for the TD. Abandoning article 11B will bring back the legal 'window' which allowed for fraudsters to operate. Other methods used by Tax Authorities in other Member States have not been as effective and have always led to higher administrative costs as it equates to more stringent audits by the Authorities.
Admittedly the 'cost' of article 11B has been pushed down the chain to the constructors who now purchase with VAT but sell without VAT. This creates VAT refundable amounts for them causing a timing difference and potentially a liquidity problem.
In recognition of this drawback of the law, the TD has proceeded to audit such entities in due time. Where the TP has been found to be in compliance with their obligations they have since been receiving refunds within 4-5 months from submitting a request. At the same time VAT refunds might be set off against other taxes the TP might have payable. Thus, if a TP who bears the 'cost' of article 11B is up to date with its tax compliance obligations, it has tools available to help them eliminate this 'cost'.
To this end, it is concluded that abandonment of article 11B at a time when the market has started to understand it and learned how correctly to implement it, would be a mistake. The deeper effects, especially those of tax evasion, of such an action would need to be considered and understood before a final decision is taken. At a time when the European Commission is discussing a universal application of the reverse charge mechanism, discussions of abandoning article 11B in Cyprus are simply without merit especially when it has been proven that it significantly helped combat tax evasion.
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