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Introduction

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The term Mergers and Acquisitions refers to the activity of two or more companies combining to form one entity or one company acquiring the assets or shares of another company. 

 

The are a number of VAT issues associated with Mergers and Acquisitions some of which are listed below:  

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The Recovery of VAT on Deal Costs

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The recovery of VAT on deal costs largely depends on whether the costs are incurred to acquire or create a business that will be used to make taxable supplies going forward (direct attribution). In other words the costs incurred must have a direct and immediate link to taxable supplies that will be made by the business being acquired.  In such cases, the VAT is recoverable from HMRC on cost such as those listed below;

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• Legal Fees

• Consultancy Fees

• Accountancy Fees

• Project Management Fees 

• SPA Drafting Fees

• Corporate Finance Advisory Fees

• Due Diligence Fees

• Tax Advice

• Post Completion Structuring

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If on the other hand the target business was only making exempt supplies and this was going to continue post acquisition, then the VAT on the deal costs would be irrecoverable.

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​However with many M&A deals the target is often acquired  by purchasing shares which in itself is an exempt activity and as such means the associated deal costs can be irrecoverable. 

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When a shareholding is used as part of an economic activity

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VAT may only be recovered if incurred in the course of an economic activity.

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Simply holding shares in order to receive dividends and perhaps to sell them for a capital gain is an investment activity and not an economic activity for VAT purposes. Therefore the VAT on the costs of acquiring and holding shares for either of these purposes is not recoverable. For the VAT to be potentially recoverable the entity acquiring the shares must do so, for some other purpose which is economic.

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For example

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Shares may be acquired and held temporarily as part of an activity of trading in securities. Trading in securities differs from investment in securities because the aim is to profit from short term movements in the price rather than the long term growth. A profit can be made regardless of whether the shares are increasing or decreasing in price. Trading in securities is an economic activity.

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A company may acquire and hold shares in subsidiaries to which it intends to provide management services for consideration. The provision of services for consideration is an economic activity.

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Following the CJEU decision in the joint cases Larentia +Minerva and Marenave (L+M) HMRC reviewed its existing policy in respect of holding companies and deduction of VAT incurred on acquisition costs. Prior to L+M our policy was that VAT incurred on costs of acquiring shares by a holding company was only deductible where it was directly attributable to the provision of taxable management or technical services. VAT incurred had to be apportioned between non-economic activity of shareholdings and economic activity. Additionally, VAT on costs incurred by a holding company was only recoverable if the intention was to recoup the expenditure from the income resulting from taxable services provided to subsidiaries within a reasonable time.

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In L+M the CJEU held that VAT incurred by a holding company on the costs of acquiring shareholdings in subsidiaries, to which it also intends to provide taxable management services, must be regarded as belonging to the Holding company’s general expenditure and is deductible subject to any Partial Exemption restriction in place.

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In order to be able to deduct VAT incurred on costs of acquiring shareholdings in subsidiaries the following conditions must be satisfied:

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• the holding company making the claim must be the recipient of the supply

• the holding company must be undertaking economic activity for VAT purposes

• that economic activity must involve the making of taxable supplies.

• If the holding company is VAT grouped with its subsidiaries, it makes taxable supplies or loans for which it earns interest and the loans support the making of taxable supplies by the VAT group.

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If the holding company is not the recipient of the supply, or is not undertaking economic activity, it will not be able to recover VAT.

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Is the Holding Company the recipient of the supply

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HMRC consider that a holding company is the recipient of the supply where it has contracted for the supply, including by novation and it has made use of the supply, been invoiced and paid for the supply.

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Is the Holding Company undertaking economic activity for VAT Purposes

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In addition to an activity which any other business may undertake (supplies of goods and services more generally), the holding company is undertaking economic activity for VAT purposes where it makes or intends to make supplies of management services for consideration, to its subsidiaries.

It is important to note that the management services must be genuine and provided for consideration which is more than nominal.

Where the Holding company is passive with no economic activity of its own, any VAT incurred on the costs of acquiring subsidiaries is not recoverable, and this will still be the case if the holding company joins a VAT group with the acquired companies.

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For VAT to be recoverable, the costs on which it is incurred (including acquisition costs) must have a direct and immediate link to taxable supplies conducted as part of the economic activity. VAT will only be recoverable to the extent that those costs are used for the taxable activity. For more on the meaning of the term direct and immediate link see VIT21000

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If a holding company provides taxable management services, to all its subsidiaries, then any VAT incurred on acquisition costs relating to the holding in those subsidiaries will be deductible. The receipt of dividends does not affect the deduction.

However, if a holding company incurs costs on acquiring shares in subsidiaries intending to make taxable supplies to some of them, but not others, the acquisition of the latter subsidiaries is an investment activity and not an economic activity for VAT Purposes. Accordingly, the VAT incurred should be apportioned between the economic activities and the investment activities.

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Alternatively a holding company may incur costs on acquiring shares in a subsidiary to which it both provides management services and makes a loan in respect of which it earns exempt interest. In those circumstances any VAT incurred on costs relating to the holding must be apportioned between the taxable and exempt supplies in line with the company’s partial exemption method.

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Shareholding acquired as a direct, continuous and necessary extension

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If the shareholding is acquired as a direct, continuous and necessary extension of a taxable economic activity of the holding company, the VAT incurred may also have a direct and immediate link to taxable supplies and be recoverable.

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For example

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• A retail company incurs costs acquiring a subsidiary whose main asset is a property from which the retail company intends to trade. In these circumstances the acquisition of the shares may be an extension of the retail business rather than an investment. If this is the case, the costs of acquisition are likely to be cost components of the retail supplies to be made from the property. The shares were acquired in order to obtain the property for the retail business. The VAT incurred will be recoverable to the extent that the retail supplies are taxable.

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• A business acquires a direct competitor, a similar and complementary business or a key supplier/customer with a view (as the case may be) to increasing market share, achieving economies of scale, or achieving efficiencies through greater integration of its supply chain.

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In the above examples the shareholding is a direct, continuous and necessary extension of the existing business activity. There is no need for a specific supply (e.g. management services provided to the acquired business) to link the VAT costs to the existing economic activity.

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This is to be contrasted with:

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• A company which purchases a business as a free-standing enterprise with a view to making money on dividends or an eventual sale.

In the first two examples the buyer is buying to strengthen its business, but by contrast in the above example there is no direct link between the acquisition and its own business and the acquired business does not itself benefit by being part of a larger, similar operation.

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The VAT on costs incurred by the target of an acquisition, such as vendor due diligence costs, may also be deductible provided it can be shown that the target is the recipient of the supplies in question and those supplies were received for the purposes of the business carried out by the target.

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Intention to make taxable supplies

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If a holding company recovers VAT on acquisition costs because it intends to make taxable supplies to the subsidiary, it should retain evidence to demonstrate that this was the intended business model.

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Where a holding company can evidence a genuine intention to make taxable supplies to its subsidiaries but those services are not actually made then the normal input tax rules regarding intention to make supplies will apply. See VIT22000

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Contingent consideration for management services

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Where a holding company incurs input tax on costs in providing or intending to provide management services to subsidiaries on terms whereby any payment will be contingent upon the profitability of those subsidiaries, then the holding company is not engaged in economic activity. This is because where services are supplied for no consideration or there is no contractual expectation that consideration will be received there is no supply for VAT purposes.

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The supplies in question are not being provided for a consideration because the essential direct link and reciprocity between the obligations on the one hand of the holding company to provide the management services and the obligations on the other of the subsidiaries to make a payment for those services, is absent.

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The issue of what constitutes a supply for a consideration has been the subject of a substantial body of case law. Most recently we have the decision of the Upper Tribunal in the case of Norseman Gold see VIT64050

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Both the FTT and the Upper Tribunal on appeal considered the adequacy for the purpose of making taxable supplies of an intention to charge at some time in the future for services being provided. The FTT concluded that this would be insufficient in the absence of evidence of any agreement about the amount to be charged, the frequency with which invoices would be sent and the details of the services to be provided in exchange for the charge. It decided that it was important that the price or consideration is stipulated rather than there being ‘a rather vague intention to levy an unspecified charge, at some undefined time in the future’.

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The effect of a holding company joining a VAT Group

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Joining a VAT group does not, of itself give rise automatically to an entitlement to recover VAT. It cannot change a non-economic (i.e. out of the scope) activity into an economic activity. Nor does it automatically create a direct and immediate link between all input costs of a holding company and the taxable outputs of other VAT group members unless such a link can be traced through the intra group supplies, or the input costs are such that they are properly and naturally attributable to the VAT group’s taxable outputs.

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VAT grouping has the effect that all supplies are treated for VAT purposes as made to and by the representative member and imposes joint and several liability on all the members. It doesn’t have any other effect. If a member of a VAT group incurs costs which it uses for non-economic activities, then the VAT on those costs still relates to the non-economic activities and VAT grouping does not change that. The supplies are treated as being used by the representative member for non-economic purposes.

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If the holding company provides management services or loans in respect of which it earns interest (see VIT64050 EDM C-77/01) to the companies acquired in the VAT group and these can be seen to support the making of taxable supplies by the VAT group (identifiable by ‘looking through’ the supply chain within the group), the related VAT will be recoverable to the extent that the costs support taxable supplies made. This is the case whether the transactions within the group would be taxable or exempt supplies, were they not disregarded because of the VAT grouping.

It is use that determines whether input tax is deductible and the existence of a direct and immediate link between the cost and the taxable supply. The question to ask is ‘has the VAT group incurred the costs for use in its economic activity?’

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The Sale of Shares In a Subsidiary to Fund Business Expansion

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As illustrated in the case HMRC vs Hotel la tour, it is possible to recover input VAT on costs related to the sale of shares in a subsidiary which will be used to fund expansion of a taxable business.

 

 Basically the VAT was recoverable because:

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• The costs were incurred to fund the businesses expansion providing taxable supplies and as such the associated VAT was recoverable

• The costs were not incorporated into a component of the share price 

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Sale and Purchase Agreement (SPA's)

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The sale or acquisition of a business will normally involve the drafting of a SPA which will set out the responsibility of each party under the agreement including the price of the deal,  the assets and liabilities (Including Tax and VAT).  Its important from a VAT perspective to ensure that all VAT receivable and payable is clearly identified and included in the SPA as an asset and liability respectively.  Both of these elements will affect the final agreed deal price.  Getting these amounts wrong can lead to future problems and disputes so its also important that the VAT clauses within the SPA cover how to resolve such issues when they arise.

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For example 

 

The VAT receivable maybe based on invoices from suppliers which include VAT but have not been recovered from HMRC yet. If the invoices are issued to the existing business owner under its VAT registration, then the new owners will not be entitled to VAT recovery under a new VAT registration number for the newly purchased entity. The VAT on such invoices will normally have to be recovered by the former owners of the business by submitting an Error Correction Notice (ECN) to HMRC.

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Acquisitions that Straddle VAT Return Periods.

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It is often the case that the date of acquisition occurs on a day that is in between the usual VAT reporting period of the business being sold or acquired.  Where this happens, it can present a number of issues that need to be addressed to ensure accurate reporting of VAT to HMRC.  Some examples are listed below:

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• Output VAT payable and Input VAT recoverable reporting will need to align to the date up to the sale date

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• Data extracted from systems used to provide information for the VAT return will need to be changed to reflect the new cut off date.

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• Accounts Payable and Receivable teams will need to be informed of the deal date so invoices are issued and paid within the appropriate period.

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• VAT payable and receivable post deal date will need to be settled by the new owners or transferred across from the existing owners respectively.  The mechanism to effect this will need to be included in the VAT clauses of the SPA.

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VAT Recovery Forecasts

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Some businesses being sold maybe partially exempt and as such can only recover a percentage of the VAT they incur on their costs. VAT recovery will either be based on using the standard partial exemption method or by using a HMRC Agreed Special Method.  In any case, where the business uses the gross method of VAT accounting by posting the cost and VAT to P&L based on invoices received from suppliers, it may forecast its VAT recovery credit on a monthly basis and annual basis.  VAT recovery can have a significant impact on profitability especially for large businesses where irrecoverable VAT can be high.  

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It is therefore important that the current owners of the business being sold ensure that VAT recovery forecasts are amended to reflect the shorter period of VAT / Financial Reporting.

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Due Diligence for VAT Risks  

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Due diligence is the process that is carried out by a prospective buyer of a business to understand the business and assess any inherent and future risks to the business.  It ​also involves a review and appraisal of the business to identify its assets and liabilities and evaluate its commercial viability as a going concern.

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There are many areas and aspects of the business that a potential buyer will want to review and assess before going ahead with the purchase or to ensure that any material issues identified are reflected in the final purchase price.

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Some of the main due diligence areas for review from a VAT perspective are listed below:

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• Intercompany recharging agreements and recharges to identify any VAT liabilities including reverse charges applicable

• Controls in existence around intercompany invoicing and recharging

• The VAT accounting process and any existing input VAT receivables and output VAT payables

• The systems used to prepare the VAT returns including billing and accounts payable systems

• VAT registration periods are these monthly or quarterly / mixture of both

• Entities where payments on account are made to HMRC and the scheduled payment dates

• Systems used to extract values data, transaction counts, sales credits for Partial Exemption calculations

• External third party systems used to prepare the VAT returns and partial exemption calculations such as VAT consolidation systems, e filers, VAT allocation and analysis systems.

• Internal VAT preparation procedures and any VAT bibles

• Review and understand any Partial Exemption Special Methods  agreed with HMRC. Is it up to date or due to be reviewed

• Any assessments issued by HMRC, penalties or interest due

• Overall relationship score with HMRC 

• Existing staff and levels in the VAT team and who will be assisting with providing the necessary data to support the business sale

• List of existing VAT reliefs and agreements with HMRC that are in use in preparing the VAT returns

• Review of branch and subsidiary structures to ensure they are compliant from a fixed establishment perspective both locally and overseas. (See Skandia and Danske cases under the VAT News section.

• Any overseas entities and the existing tax authority relationships

• Pending and recent HMRC audits and also overseas tax authority audits

• Recent internal audit outcomes. 

• Barter Transactions and Arrangements - How VAT is accounted for

• Existing property portfolio and who manages the billing for rent and service charges where these are sublet. (External management or internal)

• Options to Tax on properties in place with HMRC

• Level of client entertaining and whether the recovery is being blocked per HMRC rules

• Error Correction Notices (ECN) review for any potential future VAT risk

• Understand the business structure and transaction types

• VAT group members

• Understand the supply chain / product procurement process and existing contracts both local and global

• New product and changes to existing product signoff process by VAT Team

• VAT Coding used for transactions

• Tax Technology support. (Internal / external)

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Completion Accounts

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The acquisition or disposal of a VAT registered business or a business that is part of a VAT group will require a due diligence review of the financial records from both the buyer and sellers perspective.

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As part of that review, a set of completion accounts will be drafted and agreed which will list all the assets and liabilities of the business being sold in order to make adjustments to the initially agreed  purchase / sales price for the business. 

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As part of this exercise, the seller will be required to declare / include all VAT assets (recoverable VAT debtors) and outstanding / pending VAT liabilities in the completion statement.   

 

Failure to do this can result in:     

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• The incorrect valuation of the business leading to under or over consideration payments for the business

• Unexpected liabilities for the buyer

• Irrecoverable input VAT for the buyer 

• Post acquisition disputes / litigation

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As such, it is imperative that clear and specific VAT clauses are included within the sale and purchase agreements (SPA) by the tax / legal team to ensure that where lapses occur within the due diligence process, there are mechanisms to settle any losses and resolve any disputes post sale completion.

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Seller - Pre - Completion Date Responsibilities (List not Exhaustive)

  

• Ensure all recoverable input VAT is Identify and included within the completion statement 

• Ensure all VAT payable amounts are identified and included within the completion statement

• De register the business for VAT or remove from VAT group as at date of completion 

• Include the relevant VAT clauses as agreed with buyer

• Run all the necessary reports required for pre sale VAT reporting prior to the completion date

• Inform HMRC of the sale  and change to the business or VAT group structure

• Amend the partial exemption method calculations and process notes where necessary.

• Inform HMRC of any required changes to the PESM 

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Buyer - Pre - Completion Date Responsibilities (List not Exhaustive)

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• Ensure adequate due diligence is undertaken by tax and legal teams and the necessary VAT clauses are incorporated in the SPA

• Register the acquired business for VAT or as a member of the VAT Group from date of completion 

• Inform HMRC of any required changes to the agreed group partial exemption special method (PESM) 

• Update the internal process notes for the acquired entity's VAT return preparation and compliance

• Ensure there are trained staff to oversee the acquired entities VAT compliance and reporting process

• MTD requirements for acquired entity

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Transitional  Service Agreements (TSA)

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Normally as part of the sale of a business, the buyer and seller will come to an agreement known as a TSA to ensure there is a smooth transition of the business after the deal has been signed.  This will ensure that there is continuity of the business post sale and these TSA's can normally be in place for between 1 to 2 years. 

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They can cover areas such as:

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• Ongoing IT Support by the seller

• Use of Sellers systems for a period 

• Supply of sellers staff to maintain BAU

• Use of Buildings where the leases are still in the name of the seller

• Logistical support

• etc 

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TSA's need to be drafted and operated correctly from a VAT perspective. 

 

Some of the key points are listed below:

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• TSA invoices issued to the new owner need to show the correct VAT liability depending on the service being provided

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• Costs associated with the TSA will normally need to be ringfenced in a specific cost centre to segregate them from the sellers existing BAU costs.

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•  VAT incurred by the seller on costs that have been ringfenced as above will often be fully recoverable as they are directly attributable to the taxable supply of services provided to the buyer.  If the cost and VAT cannot be ringfenced then full recovery of VAT will most likely not be possible.

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Contains public sector information licenced under the open Government Licence v3.0

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