The BAA Case & VAT on Deal Costs

Why should anyone in the M&A world worry about VAT?  The simple answer is cost: VAT can drive deal costs up by 20%.  The importance of VAT risk is illustrated by decision in BAA Ltd v Revenue and Customs Commissioners. 
 
What happened in the BAA case?
 
A consortium incorporated a special purpose vehicle (“SPV”), ADIL, to make a successful bid for BAA.  After it had acquired the shares ADIL joined the BAA VAT group.  A VAT group is treated as a unity for VAT purposes and all its taxable supplies are deemed to be made by the representative member.  The representative member also claims back the VAT on business costs (“input tax”), regardless of which company made the particular purchase.  Supplies between members of a VAT group are disregarded.
 
ADIL took the view that it was now entitled to claim back the VAT on the fees it paid in connection with the acquisition.  This was claimed through the VAT return put in by BAA, the representative member.  HMRC raised an assessment to disallow £6.7 million of input tax.
 
Earlier this year HMRC won in the Court of Appeal and we are now waiting for the outcome of an application for leave to appeal to the Supreme Court.  But even before the final outcome of this case we can identify some action points for M&A specialists. 
 
The Technical Background
 
To claim VAT on costs the claimant must be in business and in this connection preparatory activity may amount to business activity.  Also, there must be a direct and immediate link between the input tax and actual or intended taxable supplies.  Most business can claim back virtually all the VAT they pay on business costs; the exceptions to this include banking, finance, insurance and healthcare. 
 
Typically in an acquisition the bidder will use an SPV to acquire the shares.  Holding investments is not regarded as a business activity.  Unless it takes some action an SPV that just holds shares cannot claim back VAT, even if the target is able to claim back its input tax.  To be able to claim input tax the SPV needs to be regarded as being in business and it must be able to attribute the input tax to actual or intended taxable supplies, at the time it is incurred.
 
There are two possible ways of getting over the VAT recovery problem.  One way is to ensure that the SPV goes into a VAT group with the target.  A VAT group is regarded as a unity for VAT purposes.  The VAT on the deal costs is then argued to be attributable to the taxable supplies of the group.  The other way is to ensure that the SPV will supply management services to the target after the acquisition.  The VAT on the deal costs is then argued to be attributable to putting the SPV in a position to supply the management services.  This approach did not work for BAA: why?
 
What Went Wrong for BAA?
 
The Court of Appeal said that BAA failed on both of the requirements for VAT recovery.  It said that the only proven intention at the time the VAT was incurred was to take over the shares in BAA.  As we have seen, the mere holding of shares is not a business activity.  At the relevant time therefore it could not be said that ADIL had made, or intended to make, taxable supplies.  The Court also said that at the time it incurred that VAT, ADIL could not establish a direct and immediate link between the services it had bought and the taxable supplies made by BAA.  BAA failed for want of evidence. 
 
How to Reduce the Risk
 
Because the right to deduct input tax arises when it is incurred, the basis for VAT recovery should be in place at that time.  In BAA the Court said that there was no evidence prior to completion that ADIL intended to join the BAA VAT group.  If a bidder wants claims input tax on the basis of an intended inclusion in a VAT group with the target, it may later be called upon to prove its intention.  Care should be taken with documents and correspondence to ensure that there is contemporary evidence of the intention.  This should be kept ready to be sent to HMRC.  For instance, the SPV might evidence its intention in a Board minute.  If professional advice is taken on VAT grouping, the SPV might e-mail the adviser to say it intends to enter a VAT group with the target if the bid is successful.
 
If the VAT recovery is to be based on the intended supply of management services to the target after completion, this too should be evidenced at the time.  Again a Board minute would be helpful, as would the preparation of a draft management services agreement.  It is advisable that the SPV ask its advisers to make explicit in their engagement letters, client care letters etc. those parts of their services that have lasting benefit.  Such services can sensibly be recharged and regarded as supplied to the target after completion.  This will strengthen the case that the SPV intends to supply management services, 
 
I favour the use of both devices to provide the basis for a VAT claim.  There are two reasons for this.  The first relates to the procedure for VAT grouping.  An application to include a company in a VAT group has effect from the date on which it is received, subject to HMRC’s right to opt against grouping within 90 days.  If they do so, the VAT group is deemed never to have come into existence.  The conditions for VAT grouping will not be present until the day the acquisition completes and this means that for a period of 90 days after completion there will be a risk that the VAT group will disappear with effect back to the date of completion.  It is rare for HMRC to exercise this power but if it were to do so it would be advisable to have a management services agreement in place as a back-up.
 
Paying attention to matters of evidence may also help the SPV to register for VAT as an “intending trader”; the cash flow benefits of early registration can be considerable.
 
Conclusion
 
Over the years HMRC have tried various approaches to VAT on deal costs.  They will always be alert when trying to find weaknesses.  This is to be expected, if only because of the magnitude of the figures involved in the larger transactions.  Planning at the outset and paying attention to documents can put bidders in a much stronger position to deal with queries and to prevent queries maturing into challenges.  We cannot be sure that there will be another act in the BAA drama.  The Supreme Court might refuse leave to appeal.  Even if there is a further appeal the decision might be a narrow one based on the facts.  However professional advisers will await the conclusion to see whether it brings about a fundamental change in the general view on VAT recovery.  In the meantime those involved in M&A activity must hope for the best and plan for the worst.
 
Paddy Behan is a director of Behan & Co Ltd, an independent indirect tax consultancy which serves accounting firms and businesses instructing it direct.  It covers the full range of VAT, excise and all types of indirect tax dispute.  Paddy represents clients in Tribunal appeals.  He has extensive experience of advising on the VAT aspects of land and property, social housing projects and corporate finance.  He is a CEDR accredited mediator and was part of the team of advisers in the first tax mediation to complete in the UK.  Paddy is a past National Chairman of the VAT Practitioners’ Group.
 
This article is intended for general information only.  Readers are advised to take appropriate professional advice before taking substantive action.