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I act for two associated companies that are both VAT registered and only make taxable sales.
Company A has been charging annual management fees to company B for some years – let’s say £100,000 plus VAT. All of the VAT has been correctly accounted for on both sides.
A recent change of structure has led to these charges being queried and the end result was that it was deemed that the charges should have been treated as employment income for the past two years because the owners of company A were also directors of company B.
All of the PAYE and National Insurance contributions have been settled and in the accounts of company A all of the management charge income has been reversed out.
My questions are as follows:
- Should company A now issue a VAT credit note to company B for the £40,000 of VAT overcharged in the last two years and then repay this amount to company B with both companies adjusting their next VAT return?
- Should both companies disclose the errors to HMRC on form VAT652; in other words, as an error exceeding £10,000, the error correction limit?
- Will interest and penalties apply to the input tax overclaimed by company B in this situation?
Query 19,458 – The Juggler.
Reply by Gardener
If the payments were subject to PAYE, no VAT is due
The question is unclear on who queried the management charges. If it was HMRC, at least it should accept an outcome for VAT that is consistent with the situation for income tax. I doubt whether anyone wants to reopen a freshly healed wound, but it is not inevitable that charges from one company to another, where the subject-matter is the ‘service’ of common directors, should be treated as employment income rather than as consideration for a supply of services.
This was considered recently by the First-tier Tribunal in Computational Structural Mechanics Ltd (TC7033). On the facts, the tribunal held that the sole director of both companies could be ‘supplied’ for VAT purposes by one to the other. There were particular reasons in the case for the existence of the two companies, and it appears that the individual had ‘two hats’ for valid commercial motives.
If it is settled that the payments were properly subject to PAYE, they cannot also be subject to VAT. They are not consideration for a supply of services, because employment is outside the scope of VAT (the deeming of income to be subject to PAYE under IR35 and related legislation aside). So, the VAT has been incorrectly charged and incorrectly deducted. The VAT accounts of both sides must be corrected. The VAT Regulations SI 1995/2518, reg 34 limit for a correction through the VAT account is the higher of £10,000 or 1% of the figure in box 6 for the period in which the correction is made, subject to an overall limit of £50,000 – so an error of £40,000 must be notified separately to HMRC (on form 652 or by letter giving the same information) unless box 6 is at least £4m.
For a substantial error, it is in any case advisable to notify HMRC to obtain protection from penalties. In this case, if the categorisation of the fees was initially raised by HMRC (even if not in a VAT context), it might argue that the disclosure of the VAT correction is ‘prompted’ rather than unprompted. However, this is surely no more than a careless error, not least because there is no net VAT advantage to the two connected companies. Any penalty for error should either be mitigated to zero (as an unprompted disclosure) or suspended (as a prompted one).
It remains HMRC’s long-standing policy not to charge interest if the department has not been deprived of the money because one trader’s error cancels out another’s. This is stated in Notice 700/43/10: Default Interest at 2.2: ‘We would not, for instance, generally charge you interest if you have underdeclared an amount of VAT which would have been immediately reclaimable as input tax by a third party, as this would not represent commercial restitution.’
In the recent case of G4S Corporate Services Ltd and another (TC7081) this was held not to apply to a situation when a taxpayer had not charged VAT to the Home Office – the fact that HMRC had been ‘deprived of the money’ while another arm of government had underpaid by the same amount did not engage the policy. But if both sides of the equation are HMRC, as here, there should be no interest.
Reply by Melanie Lord, director, AVS VAT
A VAT-only credit note could be used to reverse the original charge
It would seem that both parties believed the original VAT treatment was correct and the adjustment now being made follows later information or advice. On that basis, I do not think this is a situation that necessarily needs to be treated as a voluntary disclosure but rather as an accounting adjustment. If so, it should be possible to correct the position by issuing a VAT-only credit note to reverse the original VAT charge.
Although there is normally a choice of whether to adjust VAT on a credit note issued to a customer who can reclaim all the input tax, this situation is different because the VAT was not chargeable in the first place. Any VAT claims are limited to that which was properly chargeable so the usual choice about whether to adjust the original VAT charge would not apply here and a credit note must be issued.
I could argue for not disclosing this to HMRC but, on balance, I think I would encourage both companies to write a mirror image letter enclosing a copy of the original invoice and the adjusting credit note in advance of the return submission. This should focus on the fact that the correct treatment was applied at the time and the adjustment follows new advice. The letters should say that this is really an accounting adjustment, but both parties wanted to keep HMRC informed and safeguard against penalties, which I would expect this action to achieve.
