VAT – arguably the most complex area of taxation and the bane of most accountant’s existence – gets particularly complicated when there are three parties involved in a transaction. But not everyone is aware of the dangers, and the penalties of missing the point can be severe.

Three party transactions most often occur in agency situations where one party is arranging for the supply of goods or services in return for a commission. Most (but not all) people are aware of this and will watch for the dangers and try to get the VAT points right. But it's not always straightforward: the key to the correct VAT treatment is to understand which role each party plays – principal or customer.

If the roles of the parties are confused, the wrong person may reclaim the VAT or the VAT liability may be missed by all parties. More dangerous though, is the fact that three-party issues can arise in other circumstances which are not so easy to recognise, and this is where businesses, and their accountants, can blindly run into problems. The consequence? Potential penalties, interest on the late paid VAT when the error is discovered, as well as what happens if there is a contradiction between the commercial reality of a transaction and what the contracts say.

So what is the solution? And how can you avoid falling foul of VAT’s complexities?

As every accountant adept in this area of taxation knows, the key to the correct VAT treatment is to understand which role each party plays: principal, agent or customer.

In order to identify which party is the principal within the relationship, the contract and the customer’s perception should be considered. Which party does the contract point towards? Does it make it clear who the principal is? It may be necessary to delve deeper, by asking questions such as who would a customer complain too if they had a problem? Customer perception is key; from their point of view, which party do they think they are dealing with? This will be the principle. If the transaction is online, the terms and conditions can often point towards this. It is worth bearing in mind that despite the above, HMRC will always take the view of the underlying ‘commercial reality’ of the transaction, which can override what a contract might state.

Rules can become more complex for agents. An agent sells on behalf of the principal. In this scenario, there are two supplies. One being the purchase of goods/services from the principal, the other being the sales commission received. In some cases a business may think it is an agent where in reality it is not, for example a car dealer, who actually just buys and sells vehicles. As an agent you won’t be the owner of any of the goods or be able to use any of the services that you buy or sell for the principal. The criteria of an agent would not be met if the nature or value of the supplies made between the principal and the customer were altered.

A landmark case was Airtours Holidays Transport Ltd and its bank and accountancy firm. Airtours was in financial difficulties and in order to assess its financial viability and to satisfy banks, from which it had borrowed money, engaged an accountancy firm to provide a report. Invoices from the accountancy firm has been addressed to Airtours, to which Airtours paid and reclaimed input tax. The Supreme Court decided that the supply was to the bank because it was the bank who had ordered the work to be carried out and specified details of the review. The VAT claimed by Airtours was disallowed.

When a service provider supplies services to customers who cannot claim VAT, it is important to establish whether an agency arrangement exists; for example a taxi firm. If, based on the guidelines set out above, it is decided that the taxi firm is the principal and the taxi driver is the agent, VAT must be charged on the entire fare if the firm’s income exceeds the VAT registration thresholds (£85,000 in 17/18). However if it is decided that the taxi driver was the principal and the taxi firm the Agent supplying support services to the driver, the fare would be free from VAT provided that the taxi driver earned less than the VAT registration threshold per year.

It is possible for an agent to act in their own name, so that the supplier and customer do not know each other. If this is for the supply of goods, VAT is charged on the full output value of the sale and the agent must account to HMRC for the full VAT charged.

For those looking to keep on the right side of VAT compliance, it is key to assess the facts to determine whether the business is operating as an agent or a principal. I advise you to look at the contractual terms between the company and the customer and who the customer would perceive to be the supplier to make your case. After all, the VAT consequences for both could have very different outcomes and any confusion should be avoided.

Ellen Bright is a manager at Oury Clark.

Originally published in Economia on 31 May 2018.