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VAT: How to test whether a business is viable

Making hay while the sun shines is fine, but to be a recognised business you have to sell something. Neil Warren explains why Babylon Farm had three years of input tax disallowed due to lack of sales.

22nd Oct 2019
Independent VAT Consultant
Columnist
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Imagine if your client spent nearly £100,000 plus VAT on building a barn and installing equipment, the purpose of which was to store their own hay, which is zero-rated for VAT purposes.

This could have been a perfect VAT situation: zero-rated income means input tax recovery on related expenses and no output tax liability – a VAT winner.

However, in the case of Babylon Farm Ltd (TC07356), the downside was the absence of any decent level of sales.

The facts

The company registered for VAT in 2014 and claimed input tax of £19,765 in the three years up to 2017, but with no outputs or output tax declared in this period.

The only income earned by the company, apart from an exempt property sale (a capital disposal) was about £500 for selling hay to a connected business. An invoice for this income was only raised when HMRC queried the lack of sales.

HMRC disallowed all input tax on the basis that there was no proper business in place and activities were “not conducted on sound and recognisable business principles.” The tribunal agreed.

Five learning points

The odds were always against the taxpayer in this case but there are some important lessons to be learned. Here are my five top tips.

1. Refer to the Lord Fisher tests

The tribunal considered the six business tests established in the landmark case Lord Fisher 1981 STC238 and agreed with HMRC that the company was “not predominantly concerned with the making of taxable supplies for consideration.” It is great to see that this case has stood the test of time, which considered whether fees from shoots on a country estate constituted business income (see VAT Business/Non-Business Manual VBN22000).

2. Always consider the bigger picture

Babylon passed some of the Lord Fisher tests but the key fact was that no rational business owner would spend £100,000 in return for an annual income of less than £500. This is a 200-year payback period and clearly failed the third Fisher test: does the business have a certain measure of substance in terms of the quarterly or annual value of taxable sales made?

3. Beware of trading with connected parties

The company’s only customer was the director, which meant there was little incentive to raises sales invoices on a regular arms-length basis at commercial rates. It is important that clients treat each business as a separate commercial entity in its own right, and raise sales invoices to associated businesses where necessary.

4. Establish length of intending trader status

It is common for a business to register for VAT as an intending trader, and there may be a lengthy delay before sales are made.

Think of a new company building a hotel on bare land that might take 18 months to two years to complete. Input tax can be claimed on the expenses as they are incurred, producing a large number of repayment returns.

However, it is important for advisers to have some idea about when a project will be completed and when sales will be made. It is equally important to know how the costs are being financed in the meantime. Any HMRC query can then be easily defended.

5. Consider deregistration option

Babylon would probably have had a better outcome if it had deregistered voluntarily, perhaps after 18 months, on the basis that it had initial business intentions but these plans were aborted because of other projects. There would have been an output tax liability on the stock and assets on hand (eg equipment) but the building work on the new barn would fall under the capital goods scheme threshold so there would have been no input tax problems there (VAT Notice 706/2, para 3).

Replies (3)

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By mwalker
23rd Oct 2019 13:05

So what would happen in the case of a new business being specifically set up to produce, market and sell 12yr old Scotch Whisky. In theory, there would be a fair bit of initial capital expenditure, plus a little over 12yrs worth of ongoing regular outgoings before the first sale could reasonably be made.

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Replying to mwalker:
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By flightdeck
27th Oct 2019 17:05

Good example! However HMRC must look at each business individually. Start-ups will often take years before they make sales. Therefore I think what they are looking at is less "is this a proper business?" and more "are they deliberately abusing VAT?". Your whiskey business should be able to show investment in brewing facilities, brewing know-how, inventory in barrels and in the later years investment in marketing etc so I think it would pass muster as a business despite the long lag to sales.

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By fawltybasil2575
28th Oct 2019 18:02

@ mwalker.

It is crucially the “intending trader” concept which one has to prove to exist, in the event of a challenge by HMRC to an Input Tax claim, which holds the key.

In the Babylon case, the Tribunal decided that there was no legitimate “intention to trade”, hence the unsuccessful appeal.

Frankly, in the case of whisky production, there should normally be no difficulty in rebutting any HMRC challenge.

In addition to the aspects rightly indicated by "flightdeck", one would in any event have to comply with (and would thus be able to produce, to the VAT office, paperwork to evidence the trading intention) other “official” requirements, since the production of whisky quite rightly requires one to obtain a formal licence, per the following link:-

https://www.gov.uk/government/publications/excise-notice-39-spirits-prod...

For the above reason, IMHO a genuinely intending whisky producer should not experience any difficulty.

Basil.

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