Understanding management fees charged to a connected business

Many businesses have encountered trading problems during the coronavirus crisis, but others have prospered. For example, many businesses that sell goods or services online have enjoyed record sales and profits. In the case of associated businesses, where one business has prospered and the other has suffered difficult trading conditions, it might be tempting to share profits by making an inter-company management charge, reducing the profits in one business and the losses in the other. But there are important VAT issues to consider before going down this route.

Management services are standard rated

VAT is charged on a supply of goods or services in the UK, made in the course or furtherance of a business. If a business does not supply any goods or services, then no VAT is due. It is accepted that management and administration services supplied from one UK business to another are standard rated by statute, irrespective of how they are described on a sales invoice. But if a VAT-registered company raises a sales invoice for £x plus 20% VAT to its profitable associated company, and the invoice is shown as being for ‘management services’, does this always produce an easy VAT outcome, (ie, one business accounts for output tax and the other claims input tax)? The answer is ‘no’.

What is the supply?

If both businesses are VAT registered and the recipient of the services can fully claim input tax (partial exemption is not an issue), you might think that HMRC will not be interested in the management services issue: it is output tax on one VAT return, cancelled out as input tax on the return of the other business. But HMRC might seek to disallow the input tax claimed by the receiving business, if it concludes that it has not received any taxable goods or services, so VAT has been wrongly charged by the other company. HMRC has the power to go back four years and raise an assessment for errors made on previous returns.

Key issues to consider

The first challenge is to consider whether the supplier has provided any actual services to support the management charge. Here are the three key questions considered by HMRC (see HMRC’s VAT Supply and Consideration Manual VATSC06512):

• Do the supplies exist and does the amount charged represent any actual supplies made, or is it just a book figure?
• Who is making the supply and what supply is being made?
• What is the value of the supply and how is it costed – in other words, does the value have any relation to the supply being made?

In the recent case of Jupiter Asset Management Group Ltd [2021] UKFTT 96 (TC), the court agreed with HMRC that management supplies to an associated business had been understated, and the principle of HMRC raising an open market value assessment based on costs incurred in making the supply was correct. This power is given by Sch 6, VATA 1994.

EXAMPLE

United Ltd does not employ any staff, only two directors. The company has no business premises or assets and there is no visible documentary evidence of supplies being made to its associated company City Ltd, other than the sales invoice(s) being raised for ‘management services’ and/or bookkeeping entries being made (eg, an accounting journal entered in the accounts of both companies). Both companies are registered for VAT. The directors are unable to specify what supplies are covered by the charge.

HMRC would conclude that there is no VATable supply of goods or services taking place – United should not charge for management services because there aren’t any! 

Holding companies

The main function of many holding companies is to own shares and receive dividends from subsidiary companies. However, they will sometimes be registered for VAT and make management charges to the subsidiary companies, and employ staff in support functions such as finance and administration.

As long as the management services are genuine supplies, the holding company will be able to register for VAT in its own right – it is making taxable supplies and can also claim input tax on its related costs. However, it is quite common for the holding company to be a member of a VAT group, where no VAT is charged on supplies between group members.

An important issue, likely to be checked by HMRC, is whether the holding company has evidence to support any management charge made to a subsidiary. Is there evidence of purchase invoices being processed through the accounts (eg, a group purchasing arrangement might be in place for certain overheads). This type of arrangement would then add credibility to a charge for management services.

As a separate question, does the management charge have a proper basis of calculation – for example, a cost-incurred basis plus a percentage mark-up based on the number of labour hours provided by the holding company to its subsidiaries?

Case law

To show how VAT can produce an own goal, the case of Stirling Investments [2010] UKFTT 61 (TC) provides some important lessons. The disputed issue related to a management charge made by a VAT-registered husband-and-wife partnership to a company they controlled as equal shareholders and directors called Stirling Investments Ltd. The latter was partially exempt as a property development company, so had an input tax restriction on its expenses.

The partnership charged VAT on the invoice, as a way of extracting profit from the company on a lucrative property deal. HMRC correctly disallowed input tax claimed by the company as it related to an exempt project, so the partnership shrewdly reclassified the payment as a dividend, issuing a credit note to cancel the original invoice and VAT charged for management services. Needless to say, HMRC didn’t like the credit note adjustment and issued an output tax assessment against the partnership.

However, the tribunal agreed with the taxpayer that a dividend was the correct outcome because there were no actual management services being provided by the partnership and only an extraction of profits for the shareholders. The Stirlings escaped a VAT problem by a whisker!

Charity tip

What is the situation if two connected entities have no taxable supplies, apart from one of them charging management services to the other, perhaps to recover costs and services provided on its behalf? This would be common if, for example, a charity wants to recharge its trading subsidiary for costs, or vice versa. If the fees are below the annual VAT registration threshold of £85,000, there is no VAT problem lurking in the background. But the good news is that there is no problem forming a VAT group in this situation, even though there will be no taxable supplies to third party customers (ie, output tax on VAT returns will always be zero). And because there are no taxable outputs outside the VAT group, input tax will be nil as well.

Note: to form a VAT group, the usual control conditions would need to be met, not an issue in the case of a charity controlling its trading subsidiary.

EXAMPLE

Good Causes Ltd is a registered charity that owns a trading subsidiary called Good Causes Trading Ltd. Neither company is registered for VAT because their supplies are either outside the scope of VAT or exempt from VAT.

However, Good Causes Ltd incurs costs on behalf of Good Causes Trading Ltd, and wants to make a management charge of £100,000 per annum (ie, exceeding the VAT registration threshold). To avoid Good Causes Trading Ltd having an irrecoverable VAT charge of £20,000 each year, the two companies could register for VAT as a group and submit nil returns each period (see VAT Notice 700/2, para 2.5).

Conclusion

If money or profit moved between associated companies is not relevant to a supply of VATable management services, you will need to work with your clients to establish what it is instead. Is it a dividend, as in the Stirling case, or just a loan to provide working capital (ie, which will be a debtor and creditor outcome in their respective balance sheets)? But the priority is to ensure that VAT is considered before any charges are made, rather than after the horse has bolted from its stable. 

About the author

Neil Warren, CTA (Fellow), ATT, an independent VAT consultant and author who worked for Customs and Excise for 14 years until 1997