I’ve had a number of queries recently about splitting up small businesses to avoid being registering for VAT and whether or not HMRC will challenge such arrangements. So I thought it would be useful to explain how the law works and how HMRC respond when they come across something they regard as “artificial separation”.
What is “artificial separation?” for VAT purposes?
I think that most of you will be familiar with the concept – a typical example is where a couple run a pub and do B & B. The husband owns the pub and registers for VAT but the wife runs the B & B business and as this income is below the VAT registration limit, she doesn’t register, thus saving the VAT that would otherwise be paid on the income.
Now if you ask the man on the street, I suspect that he would not think that this was tax avoidance and think it completely acceptable. But let’s take it one step further, what about if the husband set up seven different companies each running the pub one day of the week. If the annual turnover of each company is below the registration limit, then the companies would not in theory be required to register for VAT, avoiding VAT on all of the pub’s takings.
Most of us would recognise a difference in degree here and agree that the owner of the pub should be registered for VAT as its’ total annual turnover exceeds the registration limit. But what about our B & B scenario?
Is it avoidance?
The simple answer is yes. The VAT law enables HMRC to consider the purpose for any such separation. So in the case of our B & B business, HMRC would look for evidence that the reason for the separation was to avoid VAT and take steps to recover lost VAT. They most certainly regard such separation as VAT avoidance and they have the means within the law to deal with such situations. They are known in the VAT world as the “Disaggregation rules”.
Now like many of you, I have seen much more extreme and highly sophisticated arrangements that have cost HMRC millions of pounds worth of tax and have lead to the introduction of new anti-avoidance legislation in recent years. In comparison to these, the Disaggregation rules do seem like a very large sledgehammer to crack a lot of extremely small nuts. After all the amount of tax loss from our B & B might only be £2,000 or £3,000 a year, not the millions of pounds in cases that make the headlines.
The point is, of course, that the vast majority of the VAT registered population is made up of businesses whose turnover is well under £1 million per annum, many hovering just on or around the VAT registration limit, which is currently £67,000. If say 10,000 of those businesses split off parts of their business like our B & B, this would cost HMRC £20 million a year in lost revenue. I have no idea of the real figures, but it does add up.
On the other side of the argument is the fact that thousands and thousands of small business owners work long hours to make a living and to treat them in the same way as the huge multinationals with anti-avoidance rules does seem to be out of perspective.
So is it avoidance or just common sense? What do you think?
How do the “Disaggregation Rules” work?
The legislation allows HMRC to look at the purpose of the arrangements and not just the effects in order to decide whether avoidance has occurred.
Let’s assume that our pub owner has been trading for a couple of years and gets a phone call from the VAT office setting up a routine VAT inspection. The officer comes along and finds out about the B & B business run by the wife. He looks at the various records and asks a lot of questions about how the two businesses are operated on a day to day basis.
The officer doesn’t accept that the two businesses are separate and that the motive for the separation or one of the motives is to avoid paying VAT on the B & B income.
He has two ways of dealing with the situation.
The first is that he believes that in practice, there is a single “legal entity” of a partnership between the husband and wife which has been trading as a pub and B & B since the business started. He can cancel the existing registration of the husband and replace it with a registration for the partnership from day one. He can then assess for the underpaid VAT from the B & B during that time. The VAT return in future must cover all of the activities of the partnership, ie pub and B & B. There will also be interest to pay and possibly penalties on top.
The alternative is that the officer can issue a Direction from a current date that the existing registration covers both activities. At least in this scenario there is no assessment for underpaid VAT in the past.
So can you successfully separate business activities?
Well the simple answer is yes. There have been a number of cases that have gone to the VAT Tribunal about this issue and some have ruled in favour of the taxpayer. But you might have to be prepared to spend a lot of time arguing the point.
You have to show that VAT was not the motive or even one of the motives, but simply a side effect. And the practical arrangements have to support your argument.
In the case of our pub and B & B, there are a number of factors to consider. If our husband and wife are arguing that there are separate legal entities or separate businesses, they would have to show that each is operated independently.
• They would have to retain separate books and records for each business and have separate bank accounts.
• If the property is owned by both parties, ie husband and wife, then there should be separate charges for the use of the property and the utilities to the husband for the pub and the wife for the B & B.
• If the telephone number is listed as the husbands and used to advertise the pub, then the wife should either have her own telephone line or pay him a third party amount for the use of his line.
• There should be commercially set cross charges for the use of each other’s staff.
• How is the wife taxed? Does she get paid by her husband and pay PAYE? Does she do separate tax returns as a sole proprietor for the B & B?
One further factor is whether the couple have a proven history of running separate businesses and can thus show that the arrangement is following previous practice. For example, if the wife had always run her own business in the past, then this would be a good indication that the arrangement was not to avoid paying VAT.
This does seem like a lot of hassle to save a bit of VAT and for that reason a lot of businesses don’t set things up properly and end up having to pay the VAT anyway. And of course, that’s what HMRC are hoping.
So what would I recommend?
Quite simply don’t do it unless there are compelling reasons for keeping businesses separate apart from VAT.
There are certain separation arrangements that HMRC accept as being valid – for example hairdressers operating certain “rent a chair” arrangements. But these are the exception rather than the rule and only work if they satisfy specific criteria that apply to that type of business. For most businesses, it is a matter of fact that the law treats such arrangements as avoidance.
But if it takes such a heavy handed approach to prevent such avoidance, why don’t HMRC consider alternative approaches for businesses operating on or below the registration limit?
For example, in some EC countries, every business has to register for VAT, regardless of their income, but there are schemes to minimise their VAT bills. These include lower rates of VAT for small businesses with labour intensive supplies, such as B & B, domestic cleaning, beauticians. I can’t help thinking that if HMRC introduced such rules, they would find that they had fewer VAT avoidance cases with small businesses and could spend their time much more effectively.
We already have a 5% rate of VAT for certain supplies, so why not use this for such small businesses? That way our husband and wife could have a single VAT registration, perhaps with the pub paying VAT at the normal rate, which is currently 15% and the wife at 5%.
I know that such proposals have been made to HMRC in the past and to date they haven’t taken them on board. But otherwise small business owners have to go to an awful lot of hassle to demonstrate that businesses are separate and that time and effort could be put to so much more productive use.