Neil Warren examines whether this is a solution to the freezing of the VAT registration threshold, or if it creates further problems.
In my last article I highlighted some practical issues which will be relevant for clients following the Budget announcement that the VAT registration threshold is to be frozen at £85,000, until at least April 2020. In this article I consider the controversial topic of business splitting.
My personal view is that the VAT registration threshold could remain at £85,000 for many years to come, ie gradually expanding the number of businesses in the VAT club and reducing the ‘cliff edge’ figure in real terms at which businesses trade just below the threshold.
Putting on my Madam Arcati hat (the clairvoyant character in the Noel Coward play Blithe Spirit), I predict that many more clients will ask about the potential for splitting a business into two parts, under different legal entities. Each entity will trade below the VAT threshold, and have plenty of scope to increase prices on an annual basis, without breaching the £85,000 figure.
Case study – seaside guest house
Let us consider a seaside guest house, which has bed and breakfast income and a small bar on the lower ground floor with an alcohol licence. It is run by Terry and June as a partnership. The business trades just below the threshold quite deliberately; Terry and June close the hotel for three months between January and March, and annual turnover is £83,000. They would like to increase their prices in April 2018 by 3% - however, this would produce sales of £85,490 (all things being equal) and a potential VAT problem!
Business splitting options
Terry and June have asked you if any of the following measures can be put into place, so they can increase their prices and avoid a VAT problem. They want to have their cake and eat it so to speak:
- Would it be possible for the bar activity to be organised by Terry or June as a sole trader, ie a separate legal entity to the partnership? This deflects taxable sales from the partnership to another business. Or perhaps their daughter Ruth could operate the bar as a sole trader?
- What if guests pay a ‘room only’ fee to the partnership – and then a separate payment of, say, £6 if they wanted breakfast? The breakfast service would be organised as a separate business to the partnership – say by June as a sole trader.
- Terry and June use a self-employed cleaner called Betty to service the rooms. How about if Betty invoices each guest £5 a day for cleaning services, rather than charging the partnership as she does at the moment? The partnership can then reduce its charges to the guests by £5 each day, ie another case of deflecting sales to another business.
Business splitting legislation
HMRC has powers to treat separated businesses as one legal entity (eg a partnership), given in VATA 1994 Sch 1, paras 1A(1) and 2 (see box). The key challenge is for HMRC to be able to prove that the two businesses have “financial, economic and organisational links.” The key word is “and” ie all three links have to be proved rather than one or two of them. These links are considered below.
The main outcome of a direction from HMRC on disaggregation (business splitting) is that the combined businesses will need to register for VAT as a single entity moving forward, ie not retrospectively.
However, if HMRC decide there never were two separate businesses, this will become a late registration issue. Don’t forget that HMRC have the power to go back up to 20 years to correct a late registration. For guidance on business splitting issues, see HMRC Manual: VAT Single Entity and Disaggregation.
VATA 1994, Sch 1:
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 and organisational links.
What are the links?
What do these three links (financial, economic and organisational), mean in practice? There is some guidance in Statement of Practice 4 issued by HMRC on 1 April 1983, which still seems to be relevant to today’s maze of business splitting issues. This statement describes attributes of the three links as follows:
- 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
- Seeking to realise the same economic objective
- The activities of one part benefit the other part
- Supplying the same circle of customers
- Common management
- Common employees
- Common premises
- Common equipment
Tips on business splitting
To create a successful business split it’s important to consider the following issues:
- Separate bank accounts and business records should be in place
- Any charges of goods or services between the separated entities must be made on an arms-length basis for (say) shared overheads, assets or staff
- Customers must be clear that they are dealing with two separated businesses, ie there is transparency of trading
- The two entities must have separate suppliers who deal with each business separately
- Separate tax returns should be submitted for each part of the business
Going back to Terry and June, which of their suggestions are possible solutions to the VAT registration problem? The answer is that there are potential risks with all of them, although the separate invoicing by the cleaner is really a non-starter because the cleaner is clearly providing services to Terry and June and not the guests.
A successful business split is often very hard to achieve when family members are involved. This is because there is less incentive to do things on an arms-length basis, because the money all belongs to the same family pot. Also, customers perceive just ‘one business’ to be in place.
As a final tip: it might be worth encouraging clients to get a third party involved who is completely independent from the family tree. That person may even pay something for the business goodwill to take over a part of the business, such as the bar at Terry and June’s guest house.
About Neil Warren
Neil Warren is an independent VAT consultant and author who worked for Customs and Excise for 14 years until 1997.