Non-economic activity – VAT’s the problem?
Non-economic activity – VAT’s the problem?
Preparing for an inspection by HMRC and dealing with its aftermath can often leave taxpayers with a headache. We give you a quick guide to getting VAT on acquisition costs right.
Preparing for an inspection by HMRC and dealing with its aftermath can often leave taxpayers with a headache. It is not just exempt supplies that can leave businesses with a Value Added Tax (VAT) cost. Non-economic activity can too. This can be of particular relevance in the context of corporate acquisitions.
The developments in case law illustrate the need for taxpayers to take practical steps at each stage to ensure they mitigate potential irrecoverable VAT on acquisition costs. Where taxpayers undertake a mixture of economic and non-economic activity, they are encouraged to identify, objectively, the purpose behind relevant costs incurred and, where possible, seek to look through any related non-economic activity and attribute VAT on related costs to taxable supplies. An objective approach and a focus on getting the right evidence in place at the right time is the key line of defence in a period of uncertainty around holding company VAT costs.
From a VAT perspective, the main questions have been clear for some time:
- Is the entity the recipient of the supply?
- Is the recipient a taxable person?
- To what extent does the VAT relate to taxable supplies provided as part of an economic activity?
Unfortunately, VAT recovery in relation to the costs of corporate acquisitions has been a challenging issue across the EU for many years. In particular, what constitutes an economic activity is not always straightforward.
As a basic principle, VAT incurred in relation to “non-economic activity” is irrecoverable. Passive investment characterised by an intention to simply receive an investment return (e.g. dividends) with no involvement in the management of the relevant subsidiary would be the paradigm example of such non-economic activity. Performing services without remuneration would also be seen to fall into this category (e.g. management services provided with no charge). Related VAT incurred would be blocked but the context is key.
The findings of The European Court of Justice (CJEU), in Securenta (Case C-437/06) -(Case C-437/06 Securenta Göttinger Immobilienanlagen und Vermögensmanagement AG  EU:C:2008:166), have shown us that even entities of a purely commercial nature can be considered as carrying out some “non-economic” activities with a consequential hit to VAT recovery. As seen in Vereniging Noordelijke Land-en Tuinbouw Organisatie (VNLTO) (Case C-515/07) - (Case C-515/07 Vereniging Noordelijke Land- en Tuinbouw Organisatie  EU:C:2009:88) business activity does not necessarily equate to economic activity. It is possible to have non-economic business activity. In other words non-economic activity (which is something not involving the making of supplies for consideration) but still something the taxable person was set up to do which falls within their wider ‘corporate purpose’. This is a key source of confusion to businesses leading to the position that something done for wholly business purposes in an entity which makes no VAT exempt supplies could still give rise to a VAT cost.
So where are businesses at risk?
As VAT in relation to non-economic activities is irrecoverable, it is important to recognise situations where non-economic activity might arise, and plan accordingly.
This is of particular relevance in the context of M&A deals, where corporate vehicles such as holding and bidding companies or other Special Purpose Vehicles (‘SPV’) may be involved. These entities’ basic functions may include acquiring and holding shares in subsidiaries (from which they may receive dividends), defence against takeovers, implementing loan financing structures or to make disposals – where the activities may inadvertently lead to a sticking irrecoverable VAT cost.
With this in mind, whilst implementing a post-completion step plan may sometimes feel somewhat arduous, a failure to do so and to consider the VAT aspects from the point of engaging the relevant service providers may well see the business needing to dispute VAT recovery with HMRC for many months and even years later with significant cashflow implications for the deal.
In light of the recent case of University of Cambridge (Case C-316/18)  - (Case C-316/18 Masters and Scholars of the University of Cambridge EU:C:2019:559) and the developing guidance and continuing challenges from HMRC as well other EU tax authorities, there is an increasing need for clarity as to the treatment of VAT incurred by corporations in relation to non-economic activity and when a VAT restriction is appropriate.
So what has Case Law told us?
VAT case law around this issue suggests outcomes that may not be so straightforward to predict. But what have the precedents told us?
In what many consider a landmark decision, Polysar (Case C-60/90)  - (Case C-60/90 Polysar Investments Netherlands BV EU:C:1991:268), the CJEU held that the acquisition, holding and sale of shares do not constitute economic activities in themselves, effectively meaning that associated VAT recovery is restricted. Instead, active involvement in managed subsidiaries is needed. So what else do we need?
Roll the clock on further and a myriad of holding company and other sector-agnostic VAT case law develops to draw the lines of VAT recovery, from Kretztechnik (Case C-465/03)  - (Case C-465/03 Kretztechnik AG EU:C:2005:320) to Iberdrola (Case C-132/16).
The issues surrounding non-economic activity were perhaps best brought to light in Sveda (Case C-126/14)  - (Case C-126/14 Sveda UAB EU:C:2015:712). A grant funded nature trail with free admission was built by the taxpayer with an objective intention that visitors would ultimately buy food and souvenirs. The Courts held the fact that the subsidisation agreement did not permit the recreational path to be made available in return for consideration did not prevent the taxpayer from carrying out economic activities. In addition, the investment expenditure incurred by the taxpayer for the construction of the path was covered, at least in part, by income from the delicious and taxable café treats. Thus there appeared to be a direct and immediate link between the expenditure incurred by the taxpayer and its planned economic activities as a whole. Planned economic activity is therefore a matter to determine on the basis of objective evidence and, as such, input VAT recovery may be allowed.
Simple? Roll the clock even further forward and this feels a suitable point to cite the more recent findings in University of Cambridge (Case C-316/18)  - (Masters and Scholars of the University of Cambridge, supra n. 3). The narrow focus appears to be the decision of the VAT treatment of the investment management services. Here the Courts decided that the management costs of an endowment fund that makes investments with the aim of financing the whole of the taxpayer’s outputs transactions were not an overhead of the charitable activities of the University (some of which were taxable) but instead were solely referable to the non-economic investment activity. So it followed that no VAT recovery was available.
Sounds familiar? This may appear to have a narrow impact, but the case and others like it has a wider impact as regards, for instance, the key question of how far one may look through to eventual economic activity and taxable supplies and how far VAT cost sticks to non-economic activity.
What might this wider impact look like?
The decision in University of Cambridge (Case C-316/18)  - (Ibid n. 7.) may also have given some taxpayers creative ideas to argue that funds may be ‘not in business’ on the grounds of non-economic activity. While generally the ‘B2B’ general rule for supplies of services is that the supply is made where the customer belongs. Should a UK-based fund argue that a fund is non-business, the general rule for ‘B2C’ supplies of services is that the place of supply is where the supplier belongs and no UK VAT may be due on offshore services supplied to the UK fund.
Any taxpayer seeking to switch the ‘B2B’ and ‘B2C’ place of supply rules to circumvent the payment of VAT should be mindful of HMRC’s new DASVOIT VAT avoidance disclosure scheme. Any such VAT offshore ‘looping’ for the purpose of obtaining a VAT advantage may require disclosure at the risk of penalties.
So what about VAT groups? HMRC’s guidance maintains that where a holding company joins a fully taxable VAT group – this alone should not itself trigger VAT deduction on its costs. Instead a link between costs would need to be traced (via the disregarded VAT group supply chain) to the taxable activities of VAT group members. This position may appear at odds with case law principles on VAT groups as a single taxable person but it is HMRC policy and so should be anticipated as their likely approach when reviewing VAT reclaims.
The recent decisions create a bit of a mess that will take some time to unravel. On reflection, a pattern, however, emerges from HMRC Guidance and preceding case law. Where there is a mixture of economic and non-economic activity, taxpayers should objectively identify the purpose of any non-economic activity and, where possible, seek to attribute the activities to taxable supplies, documenting the position as they go, ideally in contracts and invoices.
What to do now?
So what steps can taxpayers take to assess the potential impact of non-economic activity on their VAT recovery?
Step 1 – Identify non-economic activity:
First of all, a taxpayer should seek to identify what the non-economic activity is. Does an activity generate income but is not a consideration for a supply? Is the service ‘free’ and is not caught by the deeming provisions? This may be particularly difficult for taxpayers to identify where, for example, numerous transactions take place between corporate vehicles within a complex corporate structure.
Step 2 – Look at ‘objective’ purpose:
Notwithstanding HMRC seeking to identify non-economic activities more often than before in commercial contexts, it is clear from case law that an ‘objective’ approach is required. Taxpayers should consider whether the non –economic activities are an aim in themselves or a support for wider economic activities. Do the non –economic activities in question consume VAT in their own right? Is there a direct economic benefit for the recipient deriving from the services in question? Can the VAT ‘look through’ principle be applied to the services in question?
Step 3 – Can the activities in question be linked to taxable supplies?
Where a supply has been received and non-economic activity has been identified, taxpayers should seek to identify if there is a direct and immediate link between the supply received and a taxable supply made. Further, taxpayers should consider – if the non-economic activity generates income, what will that income be used for – will it support taxable activities?
What else could we be doing?
In view of University of Cambridge (Case C-316/18)  - (Ibid n. 7) and recent industry challenges from HMRC, it is recommended that taxpayers pro-actively consider many questions to avoid receiving a very unwanted Easter present from HMRC. So what might an in-house Finance team’s non-economic activity ‘wish list’ look like? Taxpayers should ask themselves:
Have suppliers correctly applied VAT in the first place?
- Has the intention to use the costs to make taxable supplies been appropriately documented at the time VAT had been incurred?
- Have in-house tax departments reviewed HMRC’s latest guidance?
Do the contracts and documentation reflect the economic and commercial reality of the transactions?
- A novation will not re-write VAT history once VAT supplies have been invoiced and paid for. Are engagement letters drafted appropriately?
- What about step plans? Have recipient companies been VAT registered before or promptly after the transaction? Has the timing of invoices and registrations been aligned where necessary?
- What about those that have a mixture of exempt or non-economic activity and taxable supplies, requiring apportionment? Do partial exemption methods require updating?
The recent developments confirm the need for taxpayers to take practical pro-active steps from the outset to ensure they mitigate potential VAT costs on acquisitions.
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