Splitting a business: avoiding a HMRC headache

Legal entities

The VAT system works on the basis of legal entities having to register for the tax, rather than a particular business. The main legal entities are sole traders, partnerships, limited companies, LLPs, as well as clubs, trusts, charities and associations. The opening challenge for our trader is to ensure that his son sets up his business with a proper legal entity that is different from his own. A legal entity does not have to register for VAT until its taxable sales in the last twelve months have exceeded £85,000 or are expected to exceed this figure in the next 30 days.

Not being VAT registered is a benefit to a business if it sells goods or services to customers who cannot claim input tax. That will almost certainly be the case for this car valeting business.

The chosen legal entity of the new business should be consistent for all aspects of trading, e.g. name on the business bank account; supplier accounts; sales invoices issued to customers; website advertising, etc.

Arms-length trading

Our trader, John, and his son will need to be disciplined with their new trading arrangement to avoid HMRC successfully arguing that there is only one VAT-registered business rather than two (one of which is unregistered). They must ensure that any shared expenses or benefits are properly charged between the two entities based on open market values. It’s important to set up clear trading terms as soon as you start an arrangement.

Example. John has agreed to buy the materials for his son’s business through his own supplier accounts, in order to take advantage of favourable discount terms. This is fine but John should raise regular sales invoices (say monthly) to his son for these materials. The recharge should be at cost price or greater, and will be subject to 20% VAT.

Tip. You must ensure that all inter-trading arrangements with family members and friends are dealt with on a commercial basis. For example, John might buy some valeting equipment through his own business and lease it to his son. John can claim input tax on the purchase, as long as the leasing charges to his son are made on a commercial basis and he charges VAT.

If John undercharges his son, the legislation gives power for HMRC to assess extra VAT based on the market value.

HMRC powers

If John and his son set up the new business as explained above, then any HMRC challenge about VAT can only be for current and future sales, rather than retrospectively. The legislation gives HMRC the power to treat two separate entities as a single business moving forward if they are closely connected by “economic, financial and organisational links”. The separated entities will be treated as a single VAT-registered partnership, with all income being subject to VAT.

Note the word “and” in the sentence about links. HMRC needs to prove all three links before issuing a direction, not just one or two.