Lifecycle of a transaction: managing VAT risk

*This article was originally published in the Tax Journal, September 2025 and is reproduced with permission from the publisher.

 

Speed Read

Purchasers of UK real estate investments faced with the alternative of buying the property or the vehicle in which the property is held, must assess the SDLT, direct tax and VAT implications of each option. Continuing our series of the lifecycle of a transaction, this article examines the VAT implications of both buying the property directly and acquiring the shares of the property-owning company, covering international aspects, explaining the traps and the areas where particular focus and due diligence are required. Opportunities for avoiding VAT leakage are also explained.

 

Case study recap

Fundco, a fund solely based in Luxembourg, which holds property rental assets via local SPVs, is looking to expand into the UK market for the first time and acquire a mixed-use investment in Leeds, known as Property A. The acquisition could take the form of an asset purchase or the purchase of the property-owning Jersey incorporated but UK tax resident company (SPV) which owns Property A. Fundco has found out that the SPV has opted to tax and wishes to discuss what VAT issues it should take into account when deciding upon the structure and managing the investment going forward, and what actions it should take to maximise VAT efficiency.

We discuss below the VAT issues involved in buying Property A and the shares in SPV.

 

Fundco Buys the shares in SPV

If Fundco buys the shares in SPV, it will avoid stamp duty land tax on the share purchase. The historic capital gains base cost of Property A will be inherited.

The sale of the shares will be outside the scope of VAT if the Seller holds the shares in SPV passively. If the Seller has been carrying on an economic activity, the sale would be an exempt financial services supply but treated as outside the scope of UK VAT with Fundco established in Luxembourg. Either way Fundco will not incur any VAT on the share purchase. For the Seller, if it has held the shares in the course of an economic activity, its sale to Fundco should give rise to input tax recovery on deal fees under VATA 1994 s 26(2)(c) and the VAT Input Tax (Specified Supplies) Order, SI 1999/3121.

The fact that SPV is incorporated in Jersey has no bearing for VAT purposes if it has its management and operations run from the UK and therefore its business establishment is in the UK. Further, with no human or technical resources in Jersey, it has no fixed establishment there.

 

Checking SPV’s option to tax

It is important for Fundco to ensure the validity of SPV’s option to tax as Fundco will be inheriting that option when it buys SPV together with any historic errors. Warranties should be inserted into the SPA to protect Fundco. For example:

• SPV’s option to tax may be invalid if SPV purported to opt to tax retrospectively. If there is evidence that the option was correctly made, but was only notified to HMRC after the 30 days permitted by law, HMRC have discretion to accept it, see paragraph 4.2.1 of Notice 742A. But an option to tax that was not made at all, cannot be validated retrospectively.
• SPV’s option to tax may be invalid if prior permission to opt to tax was required by law but not sought (e.g. because the SPV had been making exempt supplies, and claimed pre-option input tax, falling outside the automatic permission authorisations in paragraph 5 of Notice 742A). HMRC may accept that option if no tax is at risk and reasonable endeavours were made to comply with the law.
• SPV’s option to tax may have been disapplied in relation to specific leases. Enquiries as part of due diligence are prudent to test the possibility. Under VATA 1994 Sch 10 para 12, a property owner’s option to tax can be disapplied in certain circumstances – irrespective of avoidance motive. Alarm bells should ring if the owner or a connected person occupies the property for a business which is at least 80% exempt, or if an unconnected tenant is in occupation for 80% exempt purposes and has provided finance (as widely defined) to the landlord who has opted to tax. If the option to tax is disapplied, the implications in terms of irrecoverable VAT and correcting the past supplies can be severe.

 

Ensure the SPV’s option to tax is valid and properly notified, or risk inheriting costly errors

VAT on Fundco’s deal costs in purchasing the SPV

A careful VAT analysis of each service is required to avoid costly mistakes. The professional services provided by UK businesses involved in Fundco’s acquisition of the shares will not attract UK VAT because the services will not relate to UK land, and will be treated as received in Luxembourg where Fundco is established. Assuming that Fundco is a special investment fund (i.e. the management of which is exempt under Luxembourg VAT law), it will be viewed as a VAT taxable person in Luxembourg, and the services will be subject to Luxembourg VAT under the reverse charge at 17%. Unless already registered, Fundco will have to register for VAT in Luxembourg in so far as the services received do not qualify for a VAT exemption in Luxembourg. Financial services may qualify for exemption and if Fundco is a special investment vehicle, some of the professional services may qualify for VAT exemption in Luxembourg under article 135(g) of the Principal VAT Directive which covers the management of special investment funds and which Luxembourg applies generously in practice.

Strategies for Fundco to recover Luxemburg VAT on deal costs and pitfalls

If Fundco holds the shares in SPV with a view to a future capital gain and to receive dividends from SPV, this will not constitute a taxable activity for VAT purposes. Accordingly, if Fundco incurs VAT in Luxembourg in connection with the purchase it will not be able to recover the VAT, unless it agrees to provide management and/or administrative services to the SPV for consideration (Larentia and Minerva (Case C-108/14)). Such services would be treated as a taxable supply and give rise to a reverse charge in the UK for SPV. However, because SPV is making mixed supplies of exempt residential and taxable commercial lettings, it will not be able to recover the VAT in full. Depending on the ratio of SPV’s taxable and exempt supplies, over time the irrecoverable VAT on the reverse charge may exceed the irrecoverable VAT on the deal costs in Fundco. SPV may therefore incur less VAT leakage if it employs its own manager and does not receive taxable services from Fundco.

If, however, the ratio of SPV’s taxable and exempt supplies makes it worthwhile for Fundco to provide management services to SPV, the next question is how to value those supplies. This issue was recently addressed by the Advocate General in  (Case C-808/23). The context is that where taxable supplies are made to a connected company which is partially exempt, HMRC has the power to direct that those supplies should be treated as taking place at open market value for VAT purposes, in accordance with VATA 1994 Sch 6 para 1. This provision is designed to ensure that the value of goods and services is not artificially deflated to reduce irrecoverable input VAT and the Principal VAT Directive contains an equivalent provision. The Advocate General opined on the criteria to consider when assessing the open market value. He emphasised that each component of the services must be reviewed individually and if possible comparable arm’s length pricing should be obtained. Costs incurred by Fundco which are irrelevant to the services supplied to the SPV and costs which did not bear any VAT do not have to be taken into account. Capital costs incurred by Fundco can be amortised and charged to SPV as part of the management charges. Although UK courts are no longer bound to take account of CJEU judgments, they remain persuasive.

Fundco buying Property A

Since Property A is let and income producing, and assuming Fundco wishes to carry on that business, the purchase of Property A should qualify as a transfer of SPV’s (letting) business as a going concern within Article 5 of the VAT (Special Provisions) Order, SI 1995 /1268. The supply of the Property should therefore fall outside the scope of VAT. The provisions are mandatory. In fact, although the TOGC rules are today regarded as a relief, they began life as an anti-avoidance provision to prevent sellers from retiring after selling their business and running-off with the VAT.

The TOGC rules are subject to conditions, and we explain below the most relevant here:

• If the SPV is registered for VAT, Fundco must also be a taxable person for UK VAT purposes as of the date of completion. This means that Fundco must either be UK registered before completion as a non-UK established person in accordance with VATA schedule 1A or liable to be so registered.
• Fundco must intend to carry on the letting business at Property A as a going concern in the same way as SPV and not sell it on. In practice, Fundco should carry on the letting business for at least three months (although no time frame is stipulated in legislation).
• Since SPV has opted to tax, Fundco’s directors must also opt to tax and notify the option to tax to HMRC before completion (or where the deposit is held by SPV’s solicitors as agent for SPV or paid to SPV outright, Fundco must opt to tax and notify its option to tax before exchange of contracts).

The notification to HMRC of the option to tax is done on form VAT1614 A. SPV will insist on seeing evidence of Fundco’s notification of option to tax. The option to tax cannot be made on only part of a building. It is made on the whole building even though it only takes effect on the supplies of the non-residential lettings.

Assuming the TOGC rules apply, Fundco will inherit SPV’S position as regards the input VAT recovered on the Property A and certain works under the capital goods adjustment rules in reg 112 of the VAT Regulations (SI 1995/1268).

 

TOGC treatment applies automatically when conditions are met, and VAT must not be charged on the property transfer

Fundco will therefore need to do extensive due diligence on the capital goods adjustments made by SPV. These rules could give rise to more of the VAT paid by SPV being reclaimed by Fundco or becoming irrecoverable, on a year-by-year basis, if use of the Property changes during the remainder of the 10-year period of adjustment period which applies to land and buildings.

Recovering the VAT on related costs and fees

Fundco will incur professional fees in connection with the purchase of Property A. Care needs to be taken to apply the place of supply rules correctly to avoid costly mistakes. The UK based surveyors, property agents and real estate solicitors will all charge UK VAT on their services because their services are closely related to a specific piece of UK land, either as being land related advice or facilitating a legal or contractual change in the land, and so the services are treated as taking place in the UK. Certain other services will not involve land related work (for example, negotiating a facility agreement) and such services will have their place of supply in Luxembourg where Fundco has its sole establishment. It is important for Fundco not to pay VAT if it is not due or in the wrong jurisdiction as it will not be recoverable as input tax.

Fundco must take care to ensure that the appropriate amount of input VAT is recovered both in Luxembourg and in UK. Under the standard method of VAT recovery, the following principles will apply:

• VAT on general overhead expenses of Fundco, which are not directly related to Property A, should be billed by UK service providers to Fundco in Luxembourg and VAT will be accounted for under the reverse charge and recovered in accordance with the rules applicable in Luxembourg.
• VAT on expenses which relate specifically to the commercial lettings of Property A should be recoverable in full under Fundco’s UK VAT registration.
• VAT on expenses which relate specifically to the residential lettings is wholly irrecoverable.
• VAT on expenses which relate to Property A generally, both the commercial and residential parts, is recoverable based on the ratio of taxable supplies to total supplies at Property A. This is in accordance with the standard method of input tax recovery for partially exempt businesses.

If Fundco acquires the SPV, due diligence should be undertaken on the methodology of SPV’s input tax recovery to ensure it has been done correctly, and that no errors will be discovered in an enquiry. Suitable warranties regarding its partial exemption method should be sought.

Following completion, any extension or refurbishment project on Property A exceeding £250k (expected to become £600k in accordance with government plans) will be treated as a separate item pursuant to the capital goods scheme adjustment rules. This would result in an initial input tax deduction, in accordance with the principles above, subject to later year-by-year adjustments in accordance with changes of use over a 10-year period. Refurbishments split into phases under separate contracts will constitute different capital items with different starting and end dates.

 

Review partial exemption methods and capital goods scheme adjustments carefully

Due diligence on the leases

Fundco must verify as part of the lease due diligence, irrespective of whether it buys Property A directly, or acquires the shares in SPV, that the form of leases of the non-residential parts of Property A expressly allows VAT to be added to the rents and service charge. Otherwise, the rents could be deemed to be inclusive of VAT. This is a particular issue for SPV if it opted to tax the Property before a particular lease was granted, and so would be unable to rely on the option to tax constituting a change of law pursuant to VATA 1994 s 89(3).

Conclusion

Unless there is a fundamental problem with the SPV’s option to tax, or the VAT provisions in the leases are defective, VAT will rarely be the decisive factor in whether a transaction proceeds or how it is structured, but there are a myriad of VAT issues which need careful management and which, if ignored, can cause significant cost and time and potential delays in the transaction.