After almost 20 years of discussion – where are we now? This article explains what the new HMRC guidance says, some remaining uncertainties and what best practice now looks like.
Input VAT recovery in respect of deal-related costs has been an area of intense interest to HMRC for many years, following a number of landmark legal cases. HMRC finally published its latest guidance earlier this year in VAT Manual VIT40600, which sets out what it now considers to be the criteria for input tax deduction by HoldCos (holding companies).
In order for a HoldCo to be in a position to deduct VAT incurred on deal fee costs, HMRC states that it needs to satisfy the following two main conditions:
1. It must be the recipient of the supply, i.e. it has contracted for the supply (including by novation), it has made use of the supply, and has been invoiced and paid for the supply; and
2. The costs on which VAT is incurred must have a direct and immediate link to taxable supplies conducted by the HoldCo (or the VAT group that the HoldCo is a member of).
Importantly, the HoldCo must be undertaking an economic activity in order to have any possibility of recovering the VAT it incurs, even if it is a member of a fully taxable VAT group. In order to demonstrate the necessary direct and immediate link for VAT recovery, the costs incurred may relate to:
So far, so good – we now have a clear set of principles issued by HMRC that, to be deductible, input VAT must be incurred by a taxable person in the course of an economic activity and have a direct and immediate link to taxable supplies made by that person. Where these conditions are not met (e.g. because the HoldCo is not the recipient or it has no economic activity), the HoldCo cannot recover any VAT on the deal costs.
The difficulty that many HoldCos have is being able to show that the VAT incurred relates to an economic activity – as often a HoldCos’ activities tend to be more “passive” in nature (e.g. holding of shares, receiving dividends, etc.). It was accepted back in 1993 (Polysar) that the mere acquisition and holding of shares is not an economic activity for VAT purposes.
HMRC accepts this “economic activity” condition will be met where evidence exists to show that a HoldCo makes, or intends to make, supplies of management services for a consideration to its subsidiaries.
However, following the ECJ decision in Larentia + Minerva (C-108/14), HMRC consider that the holding of shares (a non-economic activity) can only be disregarded in relation to those subsidiaries to which taxable management services are supplied. Therefore, where a HoldCo only makes supplies to some of its subsidiaries, the holding company will be undertaking a mixture of economic and non-economic activities, and an apportionment of VAT recovery will be appropriate between these two activities. On this basis, full VAT recovery would only be an option for HoldCos that make supplies to all of their subsidiaries. HMRC’s guidance does not consider the VAT implications where the subsidiary receiving the supply does not undertake any economic activity.
HMRC’s guidance states that for VAT to be recoverable, a direct and immediate link is required between the deal costs and the management services carried out.
This was an unexpected surprise. HMRC states that where a shareholding is acquired as a direct, continuous and necessary extension of a taxable activity of the HoldCo, a separate activity (e.g. management services) is not required to facilitate VAT recovery on associated costs. This is thought to have come as a result of the UKFTT case of Heating Plumbing Services Ltd – in which the Tribunal found that where the purpose of an activity is to further strengthen the business, the VAT on associated costs is recoverable – without the need for a specific MSA to be put in place – as they relate to the existing economic activity of the business.
However, it appears that HMRC may only seek to allow this approach in limited circumstances and as advisors we think it more likely that this test would apply to a steady-state corporate acquisition rather than a finance-backed acquisition where the SPV set up to acquire the target joins the target’s VAT group upon acquisition.
HMRC provide an example in their guidance of where a business acquires a direct competitor or a similar/complimentary business with a view of increasing its own market share and achieving efficiencies through greater integration of its supply chain as being a direct, continuous and necessary extension of a taxable activity of the holding company.
By contrast, a company which purchases a business as a free standing enterprise with a view to making money on dividends or an eventual sale does not have a direct, continuous and necessary link as there is there is no direct link between the acquisition and the existing business.
This is also good news - HMRC’s confirmation that the VAT incurred on the costs by the target of an acquisition – vendor due diligence costs for example – may also be recoverable where it can be shown the target is the true recipient of the supplies in question, and the supplies were received for the purposes of the business carried on by the target.
HMRC had previously argued the target could never have received the services since it was not the entity making the supply. Happily, HMRC have changed their view in this regard.
Again, this is where the guidance (and its former versions) arguably departs from conventional legislative interpretation of a VAT group as a single taxable person.
HMRC says that joining/forming a VAT group does not automatically give rise to an entitlement to a HoldCo to recover VAT. It does, however, if the VAT relates to “stewardship costs” – costs described by HMRC as being received by the HoldCo for the purpose of the VAT group as a whole (e.g. audit fees, regulatory compliance fees, brand defence, bid defence, group legal costs, etc.). But it does not if the costs relate to an M&A-type transaction. In these circumstances, HMRC state that joining a VAT group does not, in of itself, change a non-economic (passive shareholding activities) into an economic activity; nor does it create the necessary direct and immediate link to the taxable outputs of the group as a whole.
Deals do abort. The ability to recover VAT is not restricted simply because a deal aborts, as decided back in 1998 in the CJEU decision in Ghent Coal. In these circumstances, VAT can still be recovered subject to the normal rules and conditions for input tax recovery, that is to say:
Where a deal aborts, it is the intention to have an economic activity (and ability to demonstrate this) which supports VAT recovery.
There are a number of practical steps business can take to put HoldCos in the strongest possible position to facilitate recovery of input VAT on deal costs. These would include, but are not limited to:
UK VAT principles stem from European VAT legislation and case law. As such, there is uncertainty as to what the UK’s departure from the EU will mean for UK VAT rules, but a reasonable expectation as regards input VAT recovery on deal costs is that HMRC will not look to reverse its latest position. HMRC have spent many years litigating and refining their position and are unlikely to want to go through many more years of the same. This should mean that the best practice principles set out here are expected to remain relevant post-Brexit, though close monitoring of future developments will of course be essential.
Notwithstanding some remaining uncertainties, it is clear from this guidance, that with some early planning, it should be possible for a HoldCo to minimise the level of otherwise irrecoverable VAT.
For more information please contact:
Tim Jones - Partner
Sarah Reynolds Senior Manager
Ian Mullen - Assistant Manager