The issue of input VAT recovery in respect of deal related costs has been an area of intense interest to HMRC for a number of years. HMRC have revised their policy a number of times over the years following landmark case law decisions. Currently we are aware that HMRC are reviewing their latest published policy and associated guidance notes in view of recent cases such as Larentia + Minerva. We are expecting the latest guidance to set out what HMRC will now consider to be the criteria for input tax deduction in an acquisition vehicle and clearly this is keenly awaited by business and advisors alike.
This article sets out the suggested best practice approach in respect of input VAT recovery on deal costs incurred by an acquisition vehicle (“BidCo”) on the purchase of a Target Group, and provides practical guidance on how to implement what is required.
In order to be in as strong a position as possible (until HMRC publish their guidance) to facilitate recovery of input VAT on deal costs, we advise that Bidco should:
a. be registered for VAT at the time of incurring costs (i.e. when the invoice is issued);
b. receives the relevant transaction related supplies (and can clearly evidence commis-sioning the supplies). Typically this means ensuring that Bidco has a contractual agreement with the supplier or has formally assumed a contractual relationship and receives VAT invoices in its name;
c. undertakes a genuine, demonstrable taxable economic activity (for example management services) which have been documented. Bidco should also document its intention to carry out this taxable economic activity as soon as practicable after its creation;
d. enter into a VAT group with the Target Group as soon as possible. Note that the entering into a VAT group itself will not give Bidco the right to recover input VAT on deal costs and separate taxable economic activity by Bidco will be required (see point c. above);
e. have executed management services agreements prior to the receipt of any invoices or otherwise has such agreements in place as soon as possible after it is incorporated;
f. charge management services to the Target Group;
g. charge management services at an arm’s length value, including an appropriate margin on costs, and should look to recoup the value of the relevant acquisition fees from the Target Group over a reasonable period of, say, 5 to 10 years; and
h. not have entirely wholly common directors as the entities to which management services are being charged.
HMRC take the view that a direct and immediate link is required between the deal costs and the management services carried out for VAT to be recoverable on the deal costs.
HMRC appear to accept that there is such a link between the typical deal costs an acquisition vehicle incurs and the typical management services the acquisition vehicle would provide to its subsidiaries. This position has been confirmed by the ECJ in the Cibo case .
Following the decision of the ECJ in Larentia + Minerva , the European Court held that deal costs do not necessarily need to be a cost component of onward taxable supplies made by an acquisition vehicle for those taxable supplies to give rise to a right to recover input VAT on relevant deal costs. This position is a departure from HMRC’s traditional view where deal costs had to be a cost component of taxable supplies made by an acquisition vehicle. Final updated guidance from HMRC is anticipated on this point as noted above.
Despite this, it would still be advisable for deal costs to be a cost component of the relevant management services provided by Bidco, in the interim period whilst we await final updated HMRC guidance. This position if ultimately confirmed, would allow for welcomed flexibility in the calculation of management services (see below), for example deal costs can be included as a cost component of management services fees where a higher management services fee value is required, but can be excluded where a lower management services fee is favoured for commercial or non-VAT related tax reasons.
Following comments of the Court of Justice of the European Union in Larentia + Minerva, careful thought should be given to the extent to which management services should be provided to the subsidiaries within the Target group by the acquisition vehicle if this vehicle is to obtain a right to recover 100% of input VAT on deal costs incurred. The rationale of the Court of Justice of the European Union suggests that if an acquisition vehicle actively manages only some of its subsidiaries, it will be making taxable supplies but will also be carrying out non-business activities, in the form of the passive holding of investments (of subsidiaries it does not manage). As a result, the acquisition vehicle’s right to recover input VAT on general expenditure (such as deal costs) may need to be pro-rated to reflect the taxable versus non-business activities carried out.
The above can be practically problematic where the Target group has large numbers of subsidiaries, and it would become administratively burdensome to document, provide and invoice for management services to all entities. However, the effect of the above requirement can often be manageable because excluding subsidiaries which contribute little to overall group turnover or EBITDA from receiving management services will consequently have an immaterial or very limited effect on an input VAT pro-rata recovery calculation. The administrative burden can also be managed by invoicing once a year only. It will be interesting to see how HMRC intend to address the comments of the Court of Justice of the European Union in their revised guidance..
The economic activity required to give rise to a right to input VAT recovery on deal fees could also take the form of lending (on commercial terms) to non EU subsidiaries (as opposed to management services). Interest on such debt is a service which is exempt from VAT but which explicitly carries the right to recover input VAT as what is known as a “specified supply”. The above best practice guide broadly applies equally where non EU loans are the economic activity being used to generate input VAT recovery. It is important to note that the pairing of the provision of management services with the granting of non EU loans would make the input VAT recovery case even stronger.
Interest on EU loans is a service which is exempt from VAT without the right to recover input VAT. This will mean such loans will likely impact overall input VAT deal recovery on deal costs and should therefore typically be avoided at Bidco level.
Interestingly, however, on the basis that the provision of credit (e.g. loans, advances) also constitutes an economic activity, HMRC may consider that lending to subsidiaries on proper commercial terms, could be supportive in terms of VAT recovery in certain specific circumstances. For example, were Bidco to make loans to its UK subsidiaries, and crucially is part of a VAT group with these subsidiaries, this lending could potentially be sufficient to satisfy the economic activity requirement for input VAT recovery. Loans within a VAT group are outside the scope of VAT rather than exempt supplies, and therefore would not in themselves taint input VAT recovery. If this were to be confirmed by HMRC, it could mean that where a UK Bidco purchases a UK Target group, lends funds to the UK Target group (e.g. to refinance debt) having formed a VAT group with this UK Target group, the UK Bidco could (subject to the other best practice guidelines and normal recovery rules set out above) potentially be able recover input VAT on deal costs without providing management services.
The “leave” vote in the referendum on EU membership has raised numerous questions concerning the UK’s tax rules post Brexit. The UK’s VAT system is currently governed by EU law in the form of the VAT Directive and decisions of the ECJ. However the exit is managed, leaving the EU will mean that UK VAT law will no longer be required to adhere to EU VAT law. At the same time, the current expectation is that historic EU case law will remain very influential in the future as the UK will want its VAT system to be a level playing field with the rest of the EU as far as possible, so as not to act as a disincentive to investment.
It should be kept in mind that the UK will technically be required to continue to implement existing EU case law into UK law through HMRC’s application of its policies until such time as it has formally left the EU. This creates a tension between HMRC’s stated preference for deal costs to be a cost component of taxable supplies made by the acquisition vehicle to allow for input tax recovery and the ECJ’s decision in Larentia + Minerva that downplays the requirement for costs to be a cost component of the onward supply in order to allow for input tax recovery.
It will be interesting for the industry to see what HMRC’s anticipated, updated guidance says when it is finally released. While the natural expectation would be for HMRC to fall into alignment with the ECJ view during the final period of EU membership, if HMRC were to retain its cost component position it remains to be seen how the Commission would react and whether there would be appetite to start infraction proceedings for a departing Member State. While we await HMRC’s latest guidance, the best practice principles outlined here represent a sensible policy to adopt, though close monitoring of future developments will of course be essential.
With early planning and careful adherence to the guidance noted above, it should be possible for Bidco to recover all or at least part of the input VAT it incurs on its deal costs. It should be noted, however, that some risk will always remain that HMRC will challenge VAT recovery on deal costs and impose at least some level of restriction on VAT recovery. Practically, care should be taken when recovering VAT on deal costs as the VAT component on certain deal costs will never be recoverable (for example VAT costs which do not fall to be input VAT), such as where the acquisition vehicle is settling fees for a supply made to another party (e.g. a bank).
Additionally, it should be noted that where a Bidco is a newly registered entity for VAT purposes and submits a repayment VAT return, HMRC are likely to scrutinise such returns closely to ensure they are happy with the VAT recovery position adopted.
1. Participations SA v Directeur Regional des Impots du Nord-Pas-de-Calais (C-16/00)
2. Beteiligungsgesellschaft Larentia + Minerva GmbH & Co. KG and Finanzamt Hamburg-Mitte v Finanzamt Nordenham and Marenave Schiffahrts AG (ECLI:EU:C:2015:496 previous ref C-108/14 and C-109/14)