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Steve Allen of VAT Advisers Ltd looks at the practice of 'business splitting' for VAT purposes.

Introduction

The impending 20% rate of VAT from 1 January 2011 has raised concerns amongst small VAT-registered businesses about their pricing structure and how to remain competitive. So much so, that some are considering the idea of splitting their business into two or more parts, so that at least one part would not be VAT-registered, and be able to charge less than their VAT-registered competitors, or charge the same price and earn more profit. Clearly, taking such a step can have considerable VAT implications, and in this article, we outline the risks associated with such a move, along with a summary of HMRC’s policy and powers.

The Law

The legislation covering artificial separation is in VATA 1994 Sch 1 paras 1A(1) and 1A(2) as follows: 

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.

1A(2)  In determining for the purposes of sub-paragraph (1) 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 and organisational links.

HMRC Policy

HMRC’s policy towards 'disaggregation' is centred around the phrase ‘resulting in an avoidance of VAT’ within para 1A(1), which indicates that the law is concerned primarily with the effect of the separation rather than the intention (although intention is still a factor as we will see later in this article). Prior to FA 1997, the law contained an extra condition (para 2(2)(d)), which required HMRC to show that the structure was specifically intended to avoid VAT. Clearly, the 1997 repeal of this condition has since made HMRC’s life a little easier in trying to prove cases of disaggregation.

Despite the fact that the law refers to outcome rather than intention, in practice, HMRC’s case will still be significantly weaker where there is non-VAT justification for splitting the business. Examples of this could be where one area of the business has specific regulatory requirements, or a highly speculative venture where the costs need to be ring fenced in case the venture ultimately fails. Sometimes, there are issues associated with the lending or funding of the activity which require it to be kept separate. 

HMRC’s internal guidance (in Registration Volume V1-28) says that when they examine a possible case of disaggregation, there are three possible outcomes as follows: 

1. There has always been a single legal entity, and if not already registered, action should be taken immediately to register that entity  (a failure to register rather than disaggregation)
2. The existence of a number of separate legal entities is accepted, but there is only one business which has been artificially separated to avoid VAT registration (this is disaggregation, which requires a Notice of Direction to be issued to register the business from a current date)
3. There are a number of genuinely separate legal entities (this is not disaggregation – no action)

Is There A Single Entity?

HMRC’s internal guidance says that before Officers can consider treating a separated business as a single entity, they need to establish the taxpayers’ intention when organising the business. It says that Tribunals have given a lot of weight to this, and that where it is evident that their intention was to operate as separate entities, and a genuine attempt is made to separate the business activities, it usually decides in favour of the taxpayers. As such, if the reason given by the taxpayer would be difficult to argue before a Tribunal, the Officer should accept that more than one legal entity exists. However, the guidance goes on to say that, in these circumstances, they are still entitled to consider whether the separation is artificial, and as such, whether a Notice of Direction should still be issued.

Are the Entities ‘Closely Bound’?

In determining artificiality, HMRC must follow the requirement of para 1A(2) that the entities are ‘closely bound to one another by financial, economic and organisation links’. On the back of this wording, HMRC have produced a Statement of Practice in section 13 of Public Notice 700/1 ‘Should I be registered for VAT?’ which expands on the three ‘financial’, ‘economic’ and ‘organisational’ conditions as follows:

‘Financial Links’

• financial support given by one part to another part
• one part would not be financially viable without support from another part
• common financial interest in the proceeds of the business.

‘Economic Links’

• seeking to realise the same economic objective
• the activities of one part benefit the other part
• supplying the same 'circle' of customers.

‘Organisational Links’

• common management
• common employees

As a practical rule of thumb, HMRC are normally looking to get at least one ‘hit’ under each of the three conditions in order for a potential challenge to be made. Usually, anything short of this is likely to be a weak case, especially at Tribunal. Notice 700/1 gives examples of what HMRC see as obvious disaggregation structures, such as splitting a business between registered and unregistered customers, splitting integral activities such as accommodation and food in a B&B, or drinks and catering in a pub/hotel. Other examples are the treatment of multiple locations as individual businesses (e.g., a chain of shops), and sharing the same equipment and premises.

Are the Entities Sufficiently 'Separate'?

Coming back to the issue of ‘intention’, HMRC will obviously be looking to prove that the intention of the separation was to avoid VAT, but as mentioned above, the Tribunal still tends go with the taxpayer if a total separation was intended from the outset. This means that if the separation is done "sufficiently well", HMRC will struggle to win the case, even if the separation is likely to result in a VAT saving.  Clearly, the extent of separation needed to succeed will depend on the circumstances of each case, but generally speaking, having the following things in place prior to a challenge can only serve to strengthen your position.

• Separate annual accounts and bank accounts
• Separate employees
• Separate telephone numbers, fax numbers, signage, trading styles, websites
• Separate premises – where not possible, use of separate floorspace and business assets/equipment 
• Separate customers (but not VAT registered/unregistered) and separate suppliers

• Goods, services or floorspace provided by one entity to another should be at open market value

Should I Do This?

We have had this question put to us a few times of late. In summary, whilst  we would always advise people not to 'disaggregate' their business artificially - it is a form of tax avoidance after all - it is fair to say that, if done properly, and it is commercially justified, it can be very difficult for HMRC to challenge the structure. If HMRC disagrees with treating the business activities separately, and issues a Direction requiring aggregation from a current date, then additional VAT will not be due on previous periods. 

One last thought - it should be remembered that where a professional person is seen to be acting in a manner which HMRC considers to be deliberately non-compliant or just plain dishonest, the consequences can be far more serious than for ‘normal’ taxpayers. HMRC take the view that such persons should ‘know better’, so business advisers who are contemplating splitting their own businesses should think long and hard before doing so.