Preventing unnecessary VAT leakage in a private capital setting

This is an updated version of our previous article that discusses ways to mitigate unnecessary VAT leakage in a private capital setting, focussing on the following areas:

• VAT savings in a typical UK/Luxembourg structure;
• The interaction between UK fund structures, VAT groups and partial exemption methods; and
• VAT recovery in respect of transaction costs.

VAT savings in a typical UK manager/Luxembourg fund structure

What's the position?

Luxembourg is a well-established jurisdiction for establishing alternative investment funds (AIFs) as its legal and regulatory status for investment funds is well-established and familiar to investors. There are also VAT benefits that arise due to a difference between the VAT laws of Luxembourg and those of the UK.

To explain, services of managing a special investment fund (SIF) are exempt from VAT. However, the UK and EU member states have their own definitions of what comprises a SIF. Under UK legislation, an AIF is generally not a SIF, whereas under Luxembourg law an AIF does constitute a SIF for VAT purposes (in the EU there is a general shift towards member states recognising AIFs as SIFs). As a result, in a typical UK-Luxembourg structure, with a UK investment/portfolio manager or adviser (referred to below as the investment manager) and a Luxembourg AIF, the VAT treatment of the supplies that take place would usually be as follows:

• the UK investment manager does not charge UK VAT on its services (they are usually received in Luxembourg and so outside the scope of UK VAT);
• the UK investment manager is entitled to recover VAT incurred on costs attributable to the management of the Luxembourg AIF (as, under the UK rules, the investment manager's services would be taxable if they fell within the scope of UK VAT); and
• the Luxembourg AIF or AIFM is not required to self-account for Luxembourg VAT on the UK investment manager's services because the services are VAT-exempt in Luxembourg.

This position is well-established. However, in our experience, sometimes structures involving Luxembourg funds do not make full use of this favourable VAT position, generally due to a lack of awareness or foresight when it comes to implementing the necessary arrangements.

This arises in particular where services such as those of accountants and lawyers which could properly be invoiced to the UK investment manager are instead invoiced directly to the Luxembourg fund. The receipt by the fund of invoices from such suppliers situated outside Luxembourg will usually require the fund to register for Luxembourg VAT and to self-account for Luxembourg VAT on those services. In many cases the fund will not be entitled to recover this VAT.

Establishment costs and transaction fees

The situation described above arises most commonly with fund establishment costs and costs related to aborted transactions. In practice, these costs are usually for services which are received and used by the UK investment manager, in which case it follows that they should be invoiced to the investment manager.

If so, the investment manager should be entitled to recover UK VAT incurred on those costs and to reflect the value of the costs in the investment management fees it charges to the Luxembourg fund or AIFM (i.e. by way of increase to the management fee that is charged). The investment management fees are exempt from Luxembourg VAT and therefore no VAT cost arises in relation to the costs in question.

However, there are a few practical points to be mindful of.

The parties should take care when considering where VAT invoices are sent, ensuring that the investment manager is not invoiced for services that are supplied directly by third parties to the fund, as this could lead to the fund and the investment manager being penalised by the Luxembourg tax authorities and HMRC respectively.

It is also important that all agreements and other documentation reflect the intended commercial position, for example to allow for the third-party supplies to be received and paid for by the UK investment manager, and for the costs of those supplies to be recovered as part of the investment management fee. Invoices issued by the investment manager should make it clear that all amounts charged to the fund or AIFM represent fees in respect of its investment management services (rather than, for example, a recharge of legal fees).

More generally, obtaining the full benefit of the Luxembourg VAT exemption in this context requires the investment manager to have suitable procedures in place at the point of establishing a new fund, engaging with service providers and invoicing for investment management fees. It is also important that individuals involved in these activities are aware of the VAT issues arising in relation to them.

VAT groups and partial exemption for UK funds

Use of VAT groups

Where a UK investment manager is managing a UK fund, it is common to include the investment manager and general partner of the fund in a VAT group. This prevents VAT leakage on the fund management fees as they are disregarded for VAT purposes, rather than VAT being charged and being largely (if not wholly) irrecoverable by the fund.

However, including a general partner in a VAT group has the effect of bringing the fund’s activities into the VAT group. It is likely that input VAT will not be recoverable in respect of at least part of the fund's activities, so in most cases a VAT group of this type will only be entitled to partial VAT recovery (or will be "partially exempt").

Partial exemption methods

In this context, managers of UK-based private equity and credit funds ordinarily operate a partial exemption special method (PESM) which has been agreed by HMRC. Typically, this is a sectorised method, with the two most common sectors being fund activities (resulting in supplies consisting of the disposals of investments and/or granting of loans) and portfolio monitoring (providing advice and support to portfolio companies and directors to sit on the boards of portfolio companies).

Where a significant amount of time has passed since a PESM was agreed with HMRC, the method agreed may no longer be suitable for the VAT group in question. For this reason, the operation of a PESM should be reviewed periodically, not only to mitigate existing VAT risks and minimise unnecessary VAT leakage, but also to potentially improve future VAT recovery. This is especially relevant following events that could impact the PESM, such as the launch of a new fund or the adoption of a new asset holding structure.

Further, HMRC are increasingly challenging the use of previously agreed PESMs that allocate input VAT on overhead costs between sectors based on the time-spent on undertaking fund activities versus portfolio management. Such methods were accepted by HMRC historically and were put forward as a common means of allocation in HMRC’s Control Note V1-37. The control note has now been withdrawn by HMRC and their current view is that such methods do not ordinarily reflect the partial exemption principles of auditability and accuracy. In light of this, we are working with several managers to agree new PESMs with HMRC. There are several potential alternatives to time-spent calculations, but it may be some time before HMRC develop a clear and consistent view on which of the alternatives are generally acceptable to them.

It is also important to understand how the PESM applies to individual costs incurred by members of the VAT group. For example, we are aware of instances where abort costs, as well as fees for fund formation services and/or day-to-day fund services, have been allocated in their entirety to the fund activities sector, when in fact it is appropriate to allocate these costs across both sectors (and in doing so improve the VAT recovery position). This is because such costs are usually incurred to allow for the funds to be established, meet legal and commercial requirements and make investments with funds raised, thus allowing the VAT group to provide taxable monitoring services to portfolio companies as well as to potentially make disposals of those companies to realise profits. The VAT on these costs should therefore be attributed to both the portfolio management and investment disposals sectors.

VAT recovery on transaction costs

Recovery of VAT by Bidcos on deal fees has been, and continues to be, a contentious topic. It has given rise to a significant volume of case law and has been the subject of lengthy discussions between industry bodies and HMRC.

Thankfully, as a result of extensive case law and HMRC setting out their views in detailed guidance, we now have more clarity in respect of buy-side costs than was once the case, although the sell-side position is less clear.

Buy-side costs

The steps required for Bidco to secure VAT recovery are well-tested. However, common pitfalls we see in practice can lead to unnecessary VAT leakage of VAT on buy-side deal fees, including the following.

• Failing to document, at the appropriate time, Bidco's intention to provide services to the target in return for fees can lead to loss of VAT recovery.
• The receipt by Bidco of VAT-exempt loan interest from entities with which it is not VAT-grouped. For example, where debt funding is pushed down via Bidco soon after closing and there is a delay in adding Bidco to the relevant VAT group, the receipt of this income can reduce Bidco's entitlement to VAT recovery.
• Failing to implement the service agreement between Bidco and the target group and, in particular, the failure by Bidco to charge fees to the target group. This may lead to partial or full loss of input VAT recovery.

Therefore, consideration should ideally be given to these points well in advance of closing, and the relevant documentation should be put in place and monitored on an ongoing basis to support VAT recovery.

Sell-side costs

As touched on above, the route to VAT recovery will often be less clear, and will be more fact-dependent, in respect of sell-side transaction costs as the sale of shares to a UK buyer is a VAT-exempt supply that does not usually give entitlement to input VAT recovery.

Recent case law has considered whether in certain circumstances the sale of shares can be viewed as a means of raising funds for the taxable activities of the wider group, so creating a basis for VAT recovery by looking past the sale of the shares. However, the Supreme Court in HMRC v Hotel La Tour Ltd [2025] UKSC 46 has now confirmed that VAT on professional costs incurred in connection with a VAT-exempt share disposal is not recoverable, even where the purpose of the disposal is to raise funds to support a fully taxable business.

The judgment overturns earlier tribunal decisions and brings clarity to an area that has caused long-running uncertainty: whether transaction costs incurred in relation to a share sale can be treated as general overheads of a taxable business rather than being wholly attributed to the share sale itself.

The answer following Hotel La Tour is clear, there is no general “fundraising exception” allowing the taxpayer to look past the share sale and to base VAT recovery on the use of funds generated by the share sale.

A more detailed discussion of the case can be found here: Supreme Court denies VAT recovery on costs relating to sale of a subsidiary company.

If you would like to discuss any of the points raised in this note, please get in touch with Chris Mortimer or Lucy Green.