VAT Recovery: Getting Transaction Costs Right

A general market practice has developed in recent years to ensure that a newly established Bidco has a documented intention to make actual supplies of management services (for real consideration) to the target group, thus establishing economic activity for VAT purposes. HMRC considers that holding (or intending to hold) shares in a company is not enough to establish economic activity, even if that entity is part of a wider VAT group. A management services agreement (MSA) helps to evidence that Bidco is carrying on an economic activity for VAT purposes and thereby enables Bidco to recover input tax on its acquisition costs.

It is imperative that the intention to make such taxable supplies is present at the time the costs (and VAT on those costs) is invoiced. Accordingly, the intention to enter into an MSA should be documented in advance of the acquisition, and by way of a formal MSA from acquisition.

Documents without substance are not sufficient. As set out in CJEU (Case C–85/11): Commission v Ireland, the following would suggest that no real supply has taken place (even if an MSA has notionally been entered into):

• Bidco has no employees;
  
  
• the directors are common to both Bidco and the recipient of the services;
  
  
• Bidco has no business premises or assets;
  
  
• there is no documentary evidence of supplies other than the invoice and/or book-keeping entry;
  
  
• Bidco is unable to specify what supplies are covered by the charge.

As is demonstrated in Commission v Ireland, the entity providing management services must have sufficient substance to provide the services, including having directors with the relevant knowledge and expertise. The services should be clearly set out e.g. in an MSA together with the fee.

Advisor engagement letters should be addressed to Bidco or, if that entity is not incorporated at the time of engaging advisors, be novated as soon as is possible after incorporation. Further, any advisor invoices should be issued (to the extent possible) only once the MSA is in place. This is to align the time of supply of the services received with the VAT position of Bidco.

Another approach is for Bidco to join the Target's VAT group following acquisition and argue that the input VAT incurred is a general overhead of the wider VAT group. However, as was illustrated in the Court of Appeal judgment in BAA, joining a VAT group alone is unlikely to be the answer in itself to allow for VAT recovery; the taxable person (being Bidco) must still meet the normal conditions for input tax recovery:

1. input tax must be incurred by a taxable person in the course of business activity – on the facts in BAA, at the time of acquisition, Bidco was not carrying on an economic activity and could produce no evidence of an intention to do so. (It was also noted that no application was made for Bidco to join the target's VAT group until several months after the acquisition, which in the court's view again illustrated a lack of intention); and
   
   
2. the inbound supplies must have a direct and immediate link with taxable supplies made by that person, or made by the Target solely to the extent the subsidiary uses the supplies from Bidco to make taxable supplies. In BAA, at the time the costs were incurred, the supplies were only in connection with the act of taking over the Target, so there was no link with any supplies made by BAA or the wider VAT group.

It should be noted that HMRC also has the power to refuse an application to join a VAT Group within 90 days of it being made "for the protection of the revenue" (s.43B(5) VAT Act 1994) which was not really a point on advisers radars until it was considered in a recent Upper Tribunal decision (Barclays Services Corporation & Anor v HMRC [2026] UKUT 211 (TCC)) which concerned a branch of a non-UK entity: Unfixed establishments: Barclays Services Corporation, fixed establishments, and VAT grouping  

Therefore, care should be taken where there is no documented intention for Bidco to make supplies to the Target.

The Supreme Court judgment in Hotel La Tour (HLT) seems to have settled the VAT position on sell side costs. The facts of HLT were as follows. HLT was a holding company that provided management services (for a fee) to its wholly-owned subsidiary (which it was VAT grouped with), which operated a hotel in Birmingham. HLT sold the subsidiary by way of a share sale in order to part-fund the development of a new hotel in Milton Keynes. Certain professional fees were incurred in connection with that share sale.

The key question was whether input tax on those fees could be recovered, given that the underlying transaction was a share sale to a UK purchaser (which, generally, is either exempt from VAT or outside the scope entirely). VAT recovery on deal costs restricted

The Supreme Court held that the advisory costs were directly and immediately linked to an exempt supply, the share sale, and that, therefore, the VAT input on those costs was irrecoverable, regardless of the wider commercial purposes that the sale proceeds financed. The ruling reinforces a restrictive approach to input VAT recovery in respect of sell side costs: a direct and immediate link between the professional costs and a share disposal will necessarily block any consideration of a business’ wider operations and commercial purposes when entering the sale transaction.

It is worth noting that there are cases where sell side costs are recoverable.  One example is where shares are sold to a non-UK purchaser. In that situation the Value Added Tax (Input Tax) (Specified Supplies) Order 1999 provides that such a sale is a "Specified Supply" such that input tax is recoverable in respect of it under section 26 VATA.  Another situation is where the sale is an asset sale – either the sale may constitute taxable supplies itself (if VAT attaches to the consideration) or the transfer of going concern (TOGC) rules could treat the sale as out of scope of VAT, thereby allowing for input tax on costs related to that disposal to be attributable to the seller's general business overheads and therefore potentially recoverable.

The recent changes to UK transfer pricing rules, removing certain domestic arrangements from scope, mean that connected parties can no longer rely on arm's length transfer pricing documentation prepared for transfer pricing purposes to support the VAT valuation of management charges and intra-group supplies. Pursuant to VAT legislation the pricing for such supplies must satisfy the open market value standard. Groups should therefore review and maintain evidence capable of demonstrating open market value for those supplies, particularly given that parties (including HMRC) have historically leaned on transfer pricing documentation in this area and HMRC's response to the new landscape remains to be seen.