The issue is that the insurance company has received a supply of services (software design) from a non-UK supplier. HMRC Public Notice 741A covers the topic of place of supply of services.
The place of supply of this type of service is deemed to be where the customer belongs under what is known as the general rule. Therefore a supply from Israel to UK would see the place of supply being the UK, thus the Israeli supplier need not register for or charge UK VAT.
Paragraph 5.1 of Notice 741A states that if you are a UK recipient of services from a non-UK supplier, you must follow the reverse charge rules. Reverse charge sees the recipient act as both supplier and recipient of the services, thus the £200,000 invoice would see the UK insurer treat the invoice as a sale to itself and account for output tax of £40,000 in Box 1 (and £200,000 in Box 6).
Then on the purchase side, declaring the same £200,000 as a purchase in Box 7 and one would think a corresponding £40,000 of input tax in Box 4. However, in this instance, the insurance business is partially exempt and can only reclaim 15% of any input tax it incurs on its purchases, so the Box 4 figure should have been £6,000. This has the effect on the VAT return of declaring £40,000 output tax in Box 1 but only reclaiming £6,000 in Box 4, leaving a net VAT due to HMRC of £34,000, which is why HMRC raised an assessment. This is explained in para 5.2 and para 5.3 of Notice 741A.
It may seem peculiar, declaring VAT on an invoice which is not subject to VAT, but the reverse charge measure is designed, in part, to stop exempt/partially exempt businesses from purchasing services from outside the UK and thus avoiding a VAT charge.
This reverse charge process also has the effect of counting towards the VAT registration threshold. So if the insurer was not VAT registered (ie, it only made wholly exempt supplies), the £200,000 purchase, because it is treated as a self-supply/sale, would trigger a VAT registration in order to perform the reverse charge process, concluding with a VAT liability of £40,000. So purchasing services from outside the UK would see non-registered traders potentially becoming VAT registered to declare output tax on non-UK received supplies.
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