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Tolley's Practical VAT by Neil Warren

Neil Warren looks at Customs' approach to dealing with the artificial separation of business activities and the potential problems that tax advisers should consider.If you were asked to give a definition of the word ‘artificial’, then a suitable explanation may be to say: ‘something that is not real.’ In a nutshell, this is one of the key questions a VAT adviser should ask when discussing the separation of business activities with a client: ‘Is it a genuine arrangement made for commercial reasons and with commercial motives – or is it an artificial measure designed to avoid paying VAT?’

Let me give a famous example of ‘disaggregation’ which was well publicised in the early 1990s – and illustrates both the motives and benefits of separating business activities. Basically, a laundrette proprietor traded in twelve different towns, all under different limited companies, and all under different trading names. The reason for such an arrangement was clear – all of the individual shops traded below the VAT registration threshold and therefore no VAT was paid by any of the shops.

The situation above was a nightmare for Customs, not least because they probably received a lot of complaints from other laundrettes about unfair competition!

However, their power to deal with such situations was greatly strengthened in the 1997 Budget, when a new paragraph 1A was inserted into the legislation as an amendment to VATA 1994 Sch 1 . The new paragraph gave extra weight to paragraph 2 – with the following words:

‘1A(1) Paragraph 2 below is for the purpose of preventing the maintenance or creation of any artificial separation of business activities carried on by two or more persons from resulting in an avoidance of VAT.

‘2 – In determining for the purposes of subparagraph 1A above whether any separation of business activities is artificial, regard shall be had to the extent to which the different persons carrying on those activities are closely bound to one another by financial, economic or organisational links.’

Customs' approach

With this legislation firmly in place, Customs thought they had this aspect of tax avoidance well and truly secured. They issued Notice 700/61 in June 1997 (since withdrawn), a concise leaflet entitled ‘Artificial separation of business activities: Statement of practice’. However, the last seven years have shown that although they have won many cases at Tribunals, there are still cases they lose, and I will give the reasons why in this article.

The approach taken by Customs when they visit a trader and identify what they consider to be an artificial separation is to use their powers to issue a direction to all persons involved in the business. See Example 1.

Example 1

Mr A provides accountancy services from his office in the High Street. Mr. B trades from the same premises, offering a service of completing tax returns. Neither of the two businesses is VAT registered as they each have turnover of £40,000.

They receive a visit from Customs, who decide that there is only one combined business. They issue a direction to Mr A and Mr B stating that for the purposes of VAT, their combined supplies need to be taken into account when determining VAT registration. As this figure is £80,000 (exceeding current registration limit of £56,000) then the direction states they must be registered from today’s date.

Key issues to determine separation

The next question to consider is the issues that are taken into account by Customs when making their decision that only one business exists – in other words, why Mr A and Mr B cannot trade independently.

In reality, the decision as to whether one or more businesses exists is a bit like the Revenue approach to determining whether someone is employed or self-employed. A whole series of different conditions are considered, and an overall conclusion is reached based on the facts for each case.

Overall, however, Customs address three key questions:

Is the separation artificial?

Does the separation result in an avoidance of VAT?
Are the parties involved closely bound by financial, economic and organisational links?
See Example 2.

Example 2 (continuing from Example 1)

Mr A and Mr B have asked a VAT adviser if Customs were correct to issue the direction that they must register for VAT as one entity. During the meeting with the adviser, the following facts are established:

Mr A and Mr B use the same computers for their work;

They have many common clients, where Mr. A produces the accounts and Mr. B completes the tax returns;

Mr B employs a receptionist who spends a lot of time doing work for Mr A as well as Mr B;
Mr A employs a secretary who spends a lot of time doing work for both Mr A and Mr B; and
They have a joint advert in the local newspaper –promoting a service of ‘preparing accounts and completing tax returns’.

Looking at the overall circumstances, the two businesses have economic links (the same supply of customers) and organisation links (common equipment, common premises, common employees). They even promote themselves as one business through the joint advert. It would be very difficult to convince a tribunal that there were two genuine business activities.

Normal commercial arrangements

One of the main changes in VAT thinking in recent years has been for Tribunal and high courts to consider an issue based on what the customer perceives to be happening – or what he perceives to be buying with his money. For example, when he walks in to the office of Mr A and Mr B above, does he identify that he is clearly dealing with two different businesses – or only one?

Another key question is to look at the common links between the two businesses, and ask the question: Are these links based on standard commercial arrangements?

For example, in the case of the employee above, a normal arrangement when an employee carries out work for another business is for the employee to record the time spent on each activity, an hourly rate for these services to be agreed between the two parties and an invoice raised to reflect the work done. However, where this formal charging structure is not carried out, this is a clear indication to Customs that the separation is artificial.

Taking the case of Mr A and Mr B a stage further, if both businesses had been VAT registered in their own right, then disaggregation would not have been an issue. Going back to paragraph 1(A) above, the issue only applies when actions are taken ‘resulting in an avoidance of VAT.’ If they are both VAT registered anyway, then Customs are getting their share of the cake and will be quite happy.

In reality, a large proportion of disaggregation cases won by Customs occur when members of the same family are involved. The reason for this is simple: when family members are involved, there is less incentive to keep arrangements on a strictly commercial level – and this gives Customs a field day when it comes to proving an artificial separation.

The classic case of an artificial arrangement is the husband and wife running a pub with the wife organising the catering and the husband running the bar – see Example 3 .

Example 3

Married couple Fred and Ethel lease the White Horse pub in the village of St Mary Mead (Agatha Christie fans will remember this village as the home of the legendary Miss Marple). They decide that Fred will run the bar as a sole trader, and Ethel will organiser the catering side of the business also as a sole trader. The catering activity will generate income of £1,000 per week – below the VAT registration threshold. The bar activity will generate income of £150,000 per year, so Fred will register for VAT in the normal way. The pub lease with the brewery will be registered in Fred’s name, and he will pay all rent through the bar activity as this is the main source of income.

Fred and Ethel decide to make the separation as legitimate as possible – they have separate bank accounts and invoices issued to customers by Ethel have her own name shown, with no VAT number. A common till is used for the two businesses.

What is your conclusion on this one if you were a Customs officer – or a VAT adviser working for Fred and Ethel?

In reality, there is one major problem that would almost certainly lead to a direction from Customs that there was only one business. Basically, Ethel is running the catering part of the business using the pub’s kitchen equipment, table and chairs where customers sit, gas and electricity and the use of the till – but making no payment to Fred as a rental contribution. Would this be the case if Fred and Ethel were not married? Unlikely, as Fred would want to make some profit (or at least cover costs) on any arrangements of this nature. So even though Fred and Ethel have tried hard to give the impression that the two parts of the business are separate, the facts indicate otherwise.

Cases won by the taxpayer

At this stage, readers may be thinking that Customs are well on top of their game on this issue, and are unlikely to lose many cases. So I will now look at a few situations where they did lose at Tribunal – and the reasons why. This will then enable a clear course of action to be established to ensure the rules are not broken.

One of my favourite Tribunals is a father and son case, Skelton Waste Disposal (17351). In this case, the key point was that Dean Langton (son of Maurice) was very ambitious and keen to branch off with a separate business of his own. He formed Skelton Mini Skips, and claimed successfully that this was a different business from Skelton Waste Disposal (in which he was a partner with his father).

The key point with the above case is that the motivation for the arrangement was not to avoid VAT – but for Dean Langton to trade independently and develop profit and business in his own right. All of the arrangements were based on normal commercial terms, and the fact that both businesses had the name ‘Skelton’ within the trading name was not considered the key issue overall.

Looking at a husband and wife situation, a case that Customs must have been very disappointed to lose involved D and M Townsend (17081). The Townsends ran separate pottery businesses – Mrs Townsend painted and decorated pottery blanks, and Mr Townsend made studio pieces. The Tribunal considered that the arrangements for the two businesses were made on normal commercial terms, and that they were operated at arms length to each other. These factors were considered more important than the fact that the couple were married and involved in a similar trade.

An example of a pub case that went against Customs involved Robert Wallace trading as Inn House (17109). Mr Wallace owned the Kings Head pub and was VAT registered. His partner Mrs Greenland, who lived with him, carried on the catering side of the business at the pub. She was not VAT registered.

The key point in this case was that although Mrs Greenland had exclusive use of the kitchen, and hired and fired her own staff, she paid Mr Wallace for all of the gas she used – and paid him for other costs as well. She produced her own accounts, and recorded the profits on the self-employment section of her tax return. In other words, normal commercial arrangements were clearly evident.

A final case I will refer to where the taxpayer was victorious involved S and AJ Trippitt (17340). The circumstances were similar to the Wallace case above, but instead of running the catering part of the business, Mrs Trippitt ran the bed and breakfast activity. The key point that convinced the tribunal was that she paid Mr Trippitt a rent based on 35% of her takings – again showing the commercial reality of the situation.

Cases won by Customs

To balance the above cases, it will be useful to have a look at a few cases won by Customs. In virtually all cases they win, it is because they can clearly illustrate that the arrangement was a scheme to avoid paying VAT – not one based on normal commercial arrangements.

For example, in the husband and wife case of J and A Smith trading as Gwyn Hotel (17406), Mrs Smith ran the catering business, but the only payment she made to her husband towards the facilities she enjoyed was to provide free sandwiches to pub customers on a Thursday night! It was argued by the Smiths that this was her way of paying for the kitchen and equipment facilities she enjoyed within the premises.

However, the reality of the situation is that no person in business would sublet such a large part of his premises and allow gas and electric supplies to be freely used in return for a weekly plate of sandwiches!

In the case of A and S Essex (15072), a married couple provided computer programming services via a partnership and computer hardware via a limited company. However, the lack of an arm's length arrangement worked against them and in favour of Customs.

Another of my favourite cases illustrates the importance of not scoring an own goal in any arrangement that is created. In the case of JNE and SA Ashcroft (17476), Mrs Ashcroft ran the catering part of the pub, but she was so successful that the level of business soon exceeded the VAT registration limit. Once this happened, the Ashcrofts merged the two parts of the business into the partnership anyway. This proved that the reason for the initial separation was to avoid VAT – making it easy for Customs to show this was not a genuine commercial arrangement.

The Tribunal also noted that during the period of Mrs Ashcroft’s independence, there was no effort made by her husband to charge her for the share of the overheads and assets she enjoyed.

Approach to adopt

Having considered the relevant issues on this subject, I will now produce a checklist of five key questions that I hope will be useful for advisers dealing with specific cases on this subject:

1) What is the key motive for separating the businesses?

Just because two parties are married or living together does not mean that they cannot run separate businesses. The human rights legislation has been well publicised in recent years, and one of these rights is the opportunity to trade in business for a profit.

The key point is to be satisfied that VAT avoidance is not the main motive for separating a business.

2) Do normal commercial relationships exist for all issues affecting the businesses?

As a matter of course, most businesses use assets and incur overheads. It is therefore important that if each of the two businesses are to be considered genuine trading entities, they must pay for any assets used or overheads incurred. Equally importantly, these assets and overheads must be paid for at reasonable levels ie open market rates. As the case of the Gwyn Hotel proved, a plate of sandwiches was not deemed adequate payment for the use of kitchen facilities and gas charges!

3) What do the customers perceive to be happening?

A recent case I was asked to advise on concerned two ladies trading from the same premises, one selling dietary supplements and vitamin pills, the other selling health foods. The accountant was worried that Customs might see the entities as one concern.

The key point in this situation was that if a customer came into the shop to complain about the goods they had purchased, this complaint could only be dealt with by the lady running her own part of the business.

Neither of the ladies knew anything about the products sold by the other – there was total independence as far as trading names, invoicing, suppliers, bank accounts, profit margins and product range were concerned. In other words, from the customers’ viewpoint, there is no overlap between the two ladies, they just happen to be sharing the premises as an arrangement convenient to both parties.

4) Does one of the parties have a controlling influence over the other party?

Going back to the laundrette example at the beginning of this article, one of the main features of this case was that one director and shareholder had control of all twelve of the different limited companies. In effect, this is displaying both common financial, economic and organisational links.

With regard to the pub examples I have considered, a separation would fail if, for example, it was agreed that the husband retained all of the profit made by the wife’s catering profit in order to pay the overhead costs. In this situation, the wife would no longer be in business on her own account if the extraction of profit went to her husband.

5) How will the arrangement look in the eyes of a Customs officer?

Although effective tax planning is the right of any taxpayer, there is sometimes a thin line between avoidance and evasion. I therefore feel it is important to stand back and look at every prospective separation as it would look to a Customs officer. Ask the question: is there any blatant limitation in this arrangement that would make it look like a VAT evasion scheme rather than a genuine business arrangement.

It is important to remember that just because the arrangement may pass the test on a number of issues – for example, separate bank account and invoicing arrangements – it is the overall picture that is important. A bit like the Gwyn Hotel case and the sandwich arrangement.

Conclusion

As with many aspects of VAT, a wide range of issues need to be considered before reaching a decision as to whether an arrangement produces one or two businesses from a VAT point of view. It is often not a clear-cut situation, and the lost Tribunal cases show that Customs are not always correct in their interpretation of the law. But planning in advance is the key – rather than waiting for the dreaded knock at the door by the VAT man!

NEIL WARREN

Neil Warren is VAT consultant for Keens Shay Keens Ltd (Chartered Accountants and Tax Advisers) in Luton. He is also a part-time tax and accounting lecturer at Barnfield College in Luton.

This article was first published in 'Tolley's Practical VAT' on 1 April 2004, and is reproduced with the kind permission of Lexis Nexis.