VAT due diligence: common issues for buyers and sellers

VAT due diligence can have a material effect on the economics of a sale, acquisition or refinancing. Exposures identified during the process may lead to purchase price adjustments, specific indemnities, additional warranties, or a reduction in the funding available.

Despite this, VAT does not always receive the same attention as other taxes and may even be removed from the scope of a due diligence review. This can leave sellers exposed to issues they have not identified and buyers uncertain whether forecasts accurately reflect the potential VAT cost. The risk is particularly significant for businesses that sell to consumers or operate in sectors such as financial services, insurance, healthcare and education, where VAT can represent a direct cost.

Businesses that regularly review their VAT position, retain appropriate evidence and seek advice on complex transactions are generally better prepared when they engage with potential buyers, investors or funders. While every transaction is different, the following issues frequently arise during VAT due diligence.

Historic VAT underpayments

The normal time limit for correcting VAT errors is four years. However, different and potentially longer assessment rules can apply where an error is deliberate. Historic underpayments may also attract late payment interest and, depending on the circumstances and the care taken by the business, penalties.

Interest can arise even where another business would have been able to recover the VAT. Where the recipient is not VAT registered or cannot recover VAT in full, the VAT itself may also become a real cost. Businesses should therefore review areas involving significant judgement and confirm that historic positions remain supportable before a transaction begins.

VAT risks in property transactions

Property transactions regularly create unexpected and material VAT exposures, particularly for businesses outside the real estate sector. The correct treatment may depend on the type and age of the property, whether an option to tax has been exercised, the intended use of the property, the status of the parties and whether the transfer of a business as a going concern rules apply.

Given the value of the underlying assets, an error can produce a significant liability or cash-flow cost. Property-related transactions should therefore be reviewed carefully even where property is not part of the business’s core activity.

Intercompany charges and recharges

Management charges, cost recharges and other transactions between separate legal entities may represent supplies for VAT purposes, even where they are recorded only through intercompany accounts. The absence of a cash payment or formal invoice does not necessarily mean that there is no VAT consequence.

Transfers made free of charge or for a nominal amount also require review. In certain circumstances, where the parties are connected and the recipient cannot recover VAT in full, HM Revenue & Customs (HMRC) may direct that a supply is valued at its open market value. If one group entity incurs costs that are used by another entity without an appropriate recharge, HMRC may also challenge the first entity’s input VAT recovery.

Businesses should periodically review their agreements, invoicing, allocation methods, VAT-group status and audit trails. This is particularly important where the recipient is partly exempt and VAT on intercompany charges may be irrecoverable.

Overseas VAT registration risks

A UK establishment does not mean that a business will have VAT obligations only in the UK. Cross-border sales can create local registration and reporting requirements, depending on the country, the nature of the supply, the location and status of the customer and any relevant thresholds or simplification schemes.

Where these obligations have been missed, exposure may include historic VAT, penalties and interest. Local registration dates can sometimes extend back several years. The commercial impact can be greater for business-to-consumer (B2C) sales because it may be impractical to collect additional VAT from customers after the transaction.

Overseas VAT compliance should therefore form part of a periodic review for any business selling internationally.

Incorrect VAT treatment of income

This risk is particularly relevant where VAT exemptions are interpreted narrowly, including in financial services, insurance, education, healthcare and certain non-profit activities. Each exemption has specific conditions, which must be considered against the contracts and the services supplied in practice.

If a business incorrectly treats taxable income as exempt, it may have to account for VAT retrospectively. Where VAT cannot be collected from customers, the cost falls directly on the business, together with any interest and penalties. Some associated input VAT may become recoverable, subject to the normal rules, but this will not necessarily offset the VAT due on revenue.

Input VAT recovery and evidence

A VAT-registered business can generally recover VAT on costs to the extent that they are used to make taxable supplies or other qualifying supplies carrying a right to deduct. Recovery remains subject to the normal conditions, including business use, correct attribution, any blocked-input-tax rules and appropriate evidence.

During due diligence, purchase invoices may be missing, incomplete or addressed to the wrong group entity, and VAT may have been coded incorrectly. If historic claims cannot be substantiated, a buyer may question the reliability of the VAT controls and seek additional contractual protection. Regular reviews of VAT coding, invoices and record-keeping can reduce this risk.

Reverse charge on overseas services

The supplier will usually determine the VAT treatment of a sale. However, the reverse charge can transfer responsibility for accounting for VAT from a non-UK supplier to its UK business customer where the relevant conditions are met.

For a business that is not already VAT registered, the value of business-to-business (B2B) general-rule services received from overseas suppliers must be considered when testing the UK VAT registration threshold. A missed obligation can lead to backdated registration, historic VAT, penalties and interest.

The reverse charge is usually VAT-neutral where the business can recover the corresponding input VAT in full. For a partly exempt business, however, some or all of that VAT may be irrecoverable. Common review areas include software licences, cloud services, professional fees and online advertising purchased from an overseas contracting entity. Businesses should check the contract, invoice and establishment supplying the service rather than relying solely on the provider’s brand name.

Partial exemption calculations

A partly exempt business makes both taxable and exempt supplies and may not be able to recover all the VAT it incurs. It must identify VAT attributable directly to taxable or exempt supplies, apportion residual VAT using the applicable method and complete any required annual adjustment.

Partial exemption calculations may be missed or completed incorrectly following acquisitions, restructurings, changes in activity or changes to the composition of a VAT group. A method that was once appropriate may also stop producing a fair and reasonable result. Errors can extend across several VAT periods and become material in a transaction.

VAT records and supporting documentation

Many VAT issues identified during due diligence arise from weak documentation rather than from the technical treatment alone. A buyer will commonly request evidence supporting significant VAT positions, just as HMRC would during an enquiry.

Relevant evidence may include valid purchase invoices, option-to-tax records, property analyses, customer-location evidence, proof of export, partial exemption calculations and documentation supporting the treatment of intercompany transactions. If records are incomplete or the analysis was not documented at the time, an otherwise reasonable position may be more difficult to defend.

What to do when VAT issues are identified

If a VAT issue is found during a pre-sale or vendor VAT due diligence review, the business should first establish the facts, quantify the potential exposure, identify the affected periods and confirm the available evidence. It can then determine the appropriate correction route and whether an unprompted disclosure to HMRC is required or advisable.

HMRC’s reporting procedure depends on the size and nature of the error. Having the analysis and corrective action under way before buy-side due diligence begins may put the seller in a stronger position. It demonstrates that the issue has been identified, quantified and supported by a clear plan rather than being left for the buyer to uncover.

Key VAT due diligence priorities

Businesses preparing for a sale, acquisition or refinancing should give particular attention to:

• Historic VAT underpayments and the assumptions supporting significant VAT positions
• Property transactions and options to tax
• Intercompany charges, recharges and input VAT allocation
• Overseas VAT registrations and reporting obligations
• The VAT treatment of income
• Input VAT recovery and supporting invoices
• Reverse charge obligations on overseas services
• Partial exemption calculations and annual adjustments
• Record-keeping and evidence for zero-rated, exempt or outside-the-scope supplies

The fact that UK VAT has not been charged does not itself indicate an error. The important question is whether the treatment is correct and supported by appropriate evidence. For example, a zero-rated export of goods requires evidence that the goods left the UK within the relevant conditions and timeframe.

A proactive VAT review before a transaction begins can help preserve value, reduce uncertainty and limit the risk of price adjustments, indemnities or delays during negotiations.

How Blick Rothenberg can help

Blick Rothenberg’s Indirect Tax team can support buy-side and vendor VAT due diligence, pre-sale VAT reviews, the quantification of historic exposure and the correction or disclosure of identified errors. We can also work with the wider Mergers & Acquisitions team to help you understand the VAT implications of the transaction and address them before they affect deal value.

If you are preparing to sell, acquire or refinance a business, an early VAT review can give you greater control over the process and reduce the risk of unexpected issues during negotiations.

Interested in speaking to one of our team? Then contact us.