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April 7, 2010

In the past few months, there have been developments in the European VAT courts that could have significant implications for businesses involved in M&A activity, as well as corporate groups in general. 

This month’s Tax Advisor Update covers the potential effects of these developments on holding companies and dormant companies in VAT groups, the recovery of VAT on deal costs and the ability to recover VAT on certain sales of shares. 

VAT Groups
For those not versed in the complexities of VAT legislation, the EU VAT Directives are the basis for the local VAT legislation for all EU Member States. These Directives contain both mandatory and discretionary clauses. If a Member State is found to incorrectly implement a mandatory clause, the European Commission (the authority responsible for ensuring compliance with EU law) can institute infringement proceedings. 

Toward the end of last year, the Commission announced that it was commencing infringement proceedings against the UK, the Netherlands, Ireland, Spain, Finland, Sweden, Denmark and the Czech Republic related to the VAT group legislation applied in each of these countries. The proceedings against Sweden are due to its limitation of VAT groups to entities in the financial and insurance sectors. The grievance against the other seven countries is that they allow non-taxable persons to be included in VAT groups.

These proceedings could have wide-ranging implications; if the Commission succeeds, VAT group membership will need to be reviewed.  Pure holding companies, dormant companies and, possibly, new companies incurring costs in advance of making taxable supplies (sometimes known as intending traders) may need to be removed from VAT groups. This will add to the complexities in VAT accounting, but may also increase VAT costs. In some cases, the cost can be significant.

VAT groups are currently used for various reasons, including: 

  • Reducing administration costs and labour by completing just one return for all group members;
  • Avoiding VAT charges on intra-VAT group supplies;
  • Enabling recovery of VAT on invoices incorrectly addressed to another member of the group (possibly following a restructuring);
  • Allowing such restructurings to take place VAT free; and
  • Allowing holding companies to recover VAT on costs associated with holding their interest in subsidiaries.

One of the largest potential implications, particularly in the UK, will be for holding companies. HM Revenue & Customs (HMRC) has, for some time, accepted that holding companies can join VAT groups with taxable subsidiaries, and that this enables them to recover VAT on acquisition costs and costs incurred in defending takeover bids, etc.  However, this does not cover every scenario, and the UK Tax authorities are beginning to challenge the recovery of VAT incurred by a holding company. (See the BAA case referred to below).

Many groups are able to simplify the restructuring of their businesses by leaving dormant companies in VAT groups. This enables continued recovery of VAT while the suppliers adjust their systems to reflect the new customer details. In addition, any simplifications that are in place to bring goods into the EU under duty deferment numbers can continue to exist even if the deferment number is held by a now dormant member of a VAT group.

If groups are no longer able to put holding companies (which do not generate taxable supplies) and dormant companies in VAT groups (because they are not taxable persons), any VAT expenses these companies incur will be an additional cost. 

Another point that will need to be considered by the Member States concerned in the infringement proceedings is how they define a “taxable person.”  Many mandatory conditions of the European legislation are translated into local legislation with a different meaning.

The EU legislation defines a taxable person as “any person who, independently, carries out in any place any economic activity, whatever the purpose or results of that activity.” This is a broad definition that has been narrowed considerably in UK legislation, when a person is a taxable person while they are required to be registered for VAT. Registration for VAT is dependent upon whether or not the person is generating taxable supplies in the UK, and / or if making supplies elsewhere would be taxable if made in the UK. Under EU definition, pure holding companies (e.g., ones that passively invest in subsidiaries for the purpose of receiving dividends) do not qualify as taxable persons. This follows the cases of Kretztechnik AG ([2005] STC 1118) and Polysar Investments Netherlands BV case ([1993] STC 222), which determined that the mere acquisition and holding of shares in a company could not be regarded as an economic activity and, consequently, the entity holding the shares could not be regarded as a taxable person.

In the UK, companies making only exempt supplies (e.g., those with Treasury functions that lend to other group companies) would be unable to register for VAT and, therefore, would be unable to recover VAT incurred on costs unless they register in a VAT group. This is because they do not make taxable supplies, only exempt supplies. If the infraction proceedings result in non-taxable persons being removed from VAT groups, these companies, under the current UK definition, would be unable to register for UK VAT. However, if they continue to carry out similar economic activities, they will be able to qualify as taxable persons under the EU Directive and, consequently, should be able to remain members of a VAT group under the EU definition.

It will be some time before the proceedings are concluded and all areas of concern are resolved. In the meantime, groups should be considering what they will do to reduce any impact on current VAT group registrations. For example, could any proposed group restructurings be brought forward, would it be possible for a holding company to make a management charge to its subsidiaries? Some VAT groups have hundreds of companies. If any are removed from the VAT group and cannot register for VAT, a review of VAT group companies and an estimate of the increased VAT cost would be worthwhile to enable potential mitigation if the costs prove significant.

Also, management charges made by holding companies could serve as an easy VAT solution and should enable continued inclusion of a company in the VAT group; however, there may be other implications to take into account. If suppliers are still issuing invoices to dormant members of a VAT group where the business has been transferred to another company, now would be a good time to ask suppliers to invoice the trading entity.

VAT Recovery on Costs of Acquisitions
The Polysar case, regarding when a holding company has economic activity, was also mentioned in the recent UK case of BAA Limited (LON/2007/1018). The case concerned costs incurred by the consortium, which lodged a successful takeover bid for BAA Limited in 2006. The consortium formed a company, ADIL, to make the offer. Because the bid was ultimately successful, ADIL became the holding company for the BAA group, and ADIL joined the BAA VAT group shortly thereafter. The case arose because HM Revenue & Customs (HMRC) disputed ADIL’s right to recover VAT on the costs paid by ADIL to investment banks, lawyers and advisers, etc., in connection with the takeover.

HMRC took the position that as ADIL had no employees, the company was only set up as a takeover vehicle and that the management of the group would be carried out by other group companies. In addition, ADIL’s advisers’ fees could not be incurred for the purpose of BAA’s business if BAA had its own advisers and was fighting the takeover. There should be a split between pre-acquisition VAT and post-acquisition VAT, and only the latter could constitute “business” activities in respect of which VAT is recoverable.

ADIL argued that the company’s role had always been to manage and operate the airports owned by the BAA group, and not just to acquire and hold the shares. Responsibility for corporate governance and direction was with ADIL and it operated currency hedging for the group. 

The recoverability of the VAT incurred was dependent on whether ADIL had carried out the specific economic activity as defined by the EU Directive. The UK Tribunal determined that, because ADIL had put forward business plans, renegotiated financing and carried out internal reorganisations, the company was carrying out the appropriate economic activity, even if these initiatives did not lead to the making of taxable supplies in its own right. ADIL was “conceived as and operated as the highest level of strategic and financial direction for the UK airports business within the BAA group.” The VAT group was treated as if it was a single entity for VAT purposes with all purchases and sales made to and by the representative member (the entity in whose name the registration is formed). While ADIL did not make taxable supplies in its own right, the Tribunal found that the VAT incurred had a direct and immediate link with the general overhead costs of the representative member of the VAT group. Consequently, the VAT was recoverable.

While this is a UK Tribunal case, it is possible that it will be subject to an appeal, which will move it to the European Court of Justice. The key point for anyone involved in acquisitions is to consider VAT as early as possible and put in place a structure that supports the inclusion of any holding company within a VAT group and allows for recovery of VAT on acquisition costs, when possible.

The impact of the infringement proceedings for VAT groups referred to above may mean that additional planning is required.

VAT Recovery on Costs of Sale
The European Court of Justice (”ECJ”) case of AB SKF (“SKF”) (C-29/08) is also about the recovery of VAT on costs incurred by a holding company and whether the holding company is carrying out an economic activity. In this case, the issue concerns the recovery of VAT incurred in connection with the sale of shares. 

Following the case of BLP Group plc (C-4/94) many years ago, there has been a consistent approach that VAT incurred on the sale of shares to entities in the EU relates wholly to exempt supplies and is irrecoverable.  This was regardless of the reasons for the sale (refinancing), which meant that the corporate group could continue to generate taxable income.  Received wisdom following BLP is that the sale of shares is exempt and if the costs are wholly attributable to that exempt sale, the VAT thereon is an additional cost.

However, the Court in the SKF cases adopted an alternative analysis, finding that SKF played an active role in the management of its subsidiaries for which it charged a management fee. The shares were sold to enable the parent company to restructure the group; this action could be regarded as going beyond a simple sale of shares, as it carries a direct link to the group’s activities and, therefore, is an extension of its taxable activity.

In a fresh view, the Court considered the point that, where the disposal of shares amounted to the transfer of the totality of assets, the transaction could be seen as a transfer of a going concern (TOGC), which would be outside the scope of VAT. VAT incurred in connection with TOGCs may be recoverable and the Court took the view that there would be a breach of fiscal neutrality if there was a difference in the recoverability of the VAT on such a share sale and a TOGC. 

The Court also noted that it was appropriate to deduct VAT on costs incurred in connection with the disposal of shares if there was a direct link with the overall economic activities of the taxable person.

The case has been referred back to the National Court in Sweden for consideration. However, there are some key issues arising from the ECJ’s decision and it is likely to lead to further litigation, at least at National Court level. In the meantime, businesses that have incurred VAT on the sale of subsidiaries within the appropriate local time limits, when they have been actively involved in the management of the companies and when the disposal has been for a wider business purposes (e.g., refinancing  or restructuring) should consider lodging a claim for reimbursement of the VAT with the relevant tax authorities.

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