We know that the VAT registration threshold will remain at £85,000 until at least 2020 and there are hints that it may do so for many years to come. Therefore, it is likely that the age old question about splitting a business into two parts, under different legal entities will be raised by clients – the plan being that each entity will trade below the VAT threshold and neither will have to register. Where businesses are dealing with the general public business splitting is an issue of pricing and profitability and not merely inconvenience.
Let us consider a small guest house, which has bed and breakfast income and a small bar on the lower ground floor with an alcohol licence. It is run by Mr & Mrs Smith as a partnership and trades just below the VAT registration threshold. They would like to increase their prices but it is likely that will involve them exceeding the threshold.
Business splitting options
The Smiths have asked about dividing the business into its constituent parts, for example:
- Would it be possible for the bar activity to be organised by their daughter Miss Smith as a sole trader?
- What if guests pay a ‘room only’ fee to the partnership and then a separate payment if they wanted breakfast? The breakfast service would be run by Mrs Smith as a sole trader.
- The partnership use a self-employed cleaner to service the rooms. How about if the cleaner invoices each guest £5 a day for cleaning services? The partnership can then reduce its charges to the guests by £5 each day
HMRC has powers to treat separated businesses as one legal entity. The key challenge is for HMRC to be able to prove that the two businesses have “financial, economic and organisational links.” The key word is “and” - all three links have to be proved rather than one or two of them. These links are considered below.
The main outcome of a direction from HMRC on dis-aggregation (business splitting) is that the combined businesses will need to register for VAT as a single entity moving forward - it does NOT have a retrospective effect. It is tempting therefore to assume that you may as well give it a go? Even if you fall foul of HMRC’s view that you have artificially split a single business, you will have benefited.
Of course, it is not that simple. If HMRC decide there never were two separate businesses, this will become a late registration rather than a dis-aggregation issue. And, whereas there is no retrospective effect of a disaggregation direction, HMRC have the power to go back up to 20 years to correct a late registration.
What are the links?
What do these three links (financial, economic and organisational), mean in practice? There is some guidance in Statement of Practice 4 issued by HMRC on 1 April 1983, which still seems to be relevant to today’s maze of business splitting issues. This statement describes attributes of the three links as follows:
- Financial support given by one part to another part. One part would not be financially viable without support from another part
- Common financial interest in the proceeds of the business
- Seeking to realise the same economic objective
- The activities of one part benefit the other part
- Supplying the same circle of customers
- Common management
- Common employees
- Common premises
- Common equipment
Tips on business splitting
To create a successful business split it’s important to consider the following issues:
- Separate bank accounts and business records should be in place;
- Any charges of goods or services between the separated entities must be made on an arms-length basis for (say) shared overheads, assets or staff;
- Customers must be clear that they are dealing with two separate businesses – in other words there is transparency of trading;
- The two entities must have separate suppliers who deal with each business separately; and
- Separate tax returns should be submitted for each part of the business.
Going back to the Smiths, which of their suggestions are possible solutions to the VAT registration problem? The answer is that there are potential risks with all of them although the separate invoicing by the cleaner is really a non-starter because the cleaner is clearly providing services to the business and not the guests.
A successful business split is often very hard to achieve when family members are involved. This is because there is less incentive to do things on an arms-length basis as the money all belongs to the same family pot. Also, customers perceive just ‘one business’ to be in place. It might be worth finding a third party who is completely independent from the family tree. That person may even pay something for the business goodwill to take over a part of the business, such as the bar at the guest house.
Whatever else you do, when considering business splitting seek financial advice first.
For advice on whether you should split your business contact email@example.com.