11th January 2018 VAT and Pension Scheme Expenses for Defined Benefit Schemes

There have been recent changes to the rules regarding VAT charged on pension scheme management that can be reclaimed by trustees. What are the new rules and how will the recovery process work?

It is three and a half years since HM Revenue and Customs (“HMRC”) announced a change in their practice in relation to recoverability of VAT on pension scheme expenses. The reform allowed employers to recover VAT on investment, including administrative expenses associated with their defined benefit pension schemes. However, working out how to achieve this in the highly regulated world of pensions has proved to be a challenge for HMRC. It left employers unclear about how to achieve full recovery of VAT on investment expenses, which are normally one of the highest of the charges incurred by pension schemes.

Following HMRC’s guidance in its internal Input Tax Manual, updated on November 1, 2017, employers should now be able to sit down and consider with their advisers how to achieve the most appropriate and efficient means of recovering VAT on the expenses associated with their defined benefit (“DB”) pension scheme.

Recovery of VAT in Relation to Pension Schemes in U.K

To understand the implications of these changes and how to address them, it is probably helpful to rehearse some of the facts around recovery of VAT in relation to pension schemes in the U.K. VAT is a compulsory EU tax. Its purpose is to harmonize turnover taxes to prevent distortion in competition in different jurisdictions. It is a consumption tax on the sale of goods and services, and is added at each step in a production process, creating revenue for the jurisdiction where the value is added at the tax rates applicable. Only the recipient of the supply can deduct VAT charged on the supply.

While it is rare for a pension scheme to be registered for VAT purposes—they charge no VAT on outputs, there has been nothing to deduct input VAT from—a few of the larger schemes are registered for VAT purposes. Historically, this did not matter because HMRC treated running a pension as part of the employer’s business, i.e., setting up and then the ongoing administration of their DB scheme. This included the expenses of professional advisers, so that employers could recover 100 percent of any VAT on administration costs.

The 30/70 Rule

However, HMRC viewed investment expenses differently from administration expenses. HMRC had a practice of allowing only an element of expenses to be recoverable where an invoice was then issued which covered both investment management and administration. This was on the basis that elements of any expenses were associated with administration of the DB pension scheme’s investments and therefore should be recoverable for VAT purposes. This was the so­called 30/70 rule; 30 percent of the invoice would be treated as administration costs.

However, HMRC recognized that the 30/70 rule may need to change following a case heard in the Court of Justice of the European Union (“CJEU”) in 2013. The CJEU held in the PPG case (C­26/12, http://src.bna.com/uSW) that the sponsor of a DB scheme could recover VAT paid on all services incurred in running a scheme. This included investment expenses, if there was a “direct and immediate link” between

those services and their own taxable supplies. It seems sensible that such a link should exist if you consider the nature of a DB pension scheme where employers are, in effect, payers of last resort.

Following this case, HMRC issued a briefing that confirmed, subject to a transitional period (due to end on December 31, 2017), the 30/70 rule would be discontinued, meaning that employers would be able to recover VAT on any type of costs incurred in the management of the pension scheme so long as the employer could demonstrate it was the recipient of the supply (the direct and immediate link).

However, working out how to achieve that has proven to be a significant challenge for HMRC when, in reality, it is the trustees who have the contractual relationship with the suppliers of the services to pension schemes generally, and the added challenge that pension schemes operate in a highly regulated universe. HMRC have, for the last three and a half years, been grappling with how some of these options, particularly the suggested tripartite arrangement, might impact an employer’s corporation tax position. HMRC have been trying to address concerns in relation to joint and several liabilities for VAT under the grouping option (corporate trustee in the same group as the employer). In this highly complex world they have been faced with the challenge of Brexit and its future implications. It seems highly unlikely that Brexit will disturb HMRC’s approved options, even though VAT is EU­driven. While in theory Parliament could abolish VAT, it is a highly unlikely move, politically or economically.

On November 1, 2017, two months before the current transitional arrangement was due to run out, HMRC announced that the 30/70 rule can continue indefinitely: all the other options described above are also available to employers.

Employers now need to decide whether to continue with the 30/70 rule or adopt one of the options set out above in order to maximize VAT recovery for them, particularly in relation to investment expenses. This could result in significant savings for them. Trustees of DB pension schemes are likely to go along with the employer’s proposals, provided they do not breach regulatory requirements or expose the DB scheme to any risk of significant claims for unpaid VAT.

HMRC Options for Employers

The options put forward by HMRC for employers to demonstrate that direct and immediate link to the supply of services are as follows:

• tripartite agreements, where the employer is also a party to the contract between the trustees and the supplier of services; or

• the trustee becomes VAT registered and has a contract with the employer to provide services in connection with the scheme; or

• the trustee is or becomes a corporate trustee (which is a subsidiary of the employer) and becomes part of the employer’s VAT group.

Tripartite Agreements

Tripartite agreements appear to have the potential to work best for most employers in regards to recovery of 100 percent of VAT on investment expenses. Recovering VAT using tripartite agreements will be straightforward so long as the agreements meet the guidance which HMRC has issued. In order for these agreements to be satisfactory from HMRC’s point of view and to enable maximum recovery of VAT payable on investment expenses, certain conditions need to be met. Agreements must evidence the supply of services to the employer and the employer must make direct payment for those services. The employer should also receive any reports supplied to the trustees and must have termination rights and be able to pursue the service supplier for breach of contract.

Some investment managers have already reviewed their agreements and updated them to allow the employer to be a party to the agreement, as well as the trustee/s, and to include termination rights. However, some of these clauses are subject to trustee consent, recognizing the statutory requirement for the trustee to appoint the investment manager as well as dismiss them.

HMRC have confirmed in their internal guidance that there will be no deduction for corporation tax purposes on any outlay under these tripartite agreements. This is because only costs recognized in the profit and loss account and contributions to pension schemes may attract a deduction for corporation tax purposes. This ability to recover VAT seems to be accepted, even though the service is in fact provided to the trustee.

Tripartite agreements may not work so well for professional advice where statutory duties of confidentiality and conflicts generally make it more difficult to simply join in the employer scheme. The Scheme Actuary is a personal appointment which is likely to face similar challenges. Also, there would be challenges for lawyers (and possibly other advisers) under their professional rules in accepting liability to a potentially hostile party or restricting the scope so it negates any duty of care.

Trustee Becomes VAT Registered

The trustee becomes VAT registered under this option but this may not deliver 100 percent recovery of VAT on investment expenses for the employer, as some of the investment expenses would be regarded as

referable to the trustee’s own activities and so not recoverable. This may lead a similar outcome to the 30/70 rule.

Trustee Becomes a Corporate Trustee

The trustee becomes a corporate trustee and part of the employer’s VAT group under the third option, but this may be the least popular option with trustees, given the risk of joint and several liabilities from the VAT grouping. HMRC confirm in their briefings that they would not seek to claim VAT for the wider employer group from the trustee (meaning that there is a low risk) but trustees are naturally risk averse.

Although it is not directly relevant, it is worth mentioning that money purchase or defined contribution schemes are treated differently for VAT purposes. HMRC have recognized the ATP case, heard in the CJEU and decided in 2014 (Case C­464/12, http://src.bna.com/uS3) which held that investment management fees would be exempt from VAT if the scheme met the definition of “special investment trust.” This will be the case for most money purchase schemes and if VAT has been paid there could be an opportunity for employers to be repaid.

Going Forward

Now that HMRC have settled their position internally on the recoverability of VAT on DB pension scheme expenses, employers should take tax advice on which option is going to work best for them. This will depend on their tax position: employers need to work with the trustees to implement any changes to their current arrangements regarding pension scheme expenses so that any further savings can be enjoyed as soon as possible.

Kate Payne, Partner

This article was published in Bloomberg BNA

The views in this article are intended for general information purposes only and should not be used as a substitute for professional advice. ARC Pensions Law and the author(s) are not responsible for any direct or indirect result arising from any reliance placed on content, including any loss, and exclude liability to the full extent. Always seek appropriate legal advice from a suitably qualified lawyer before taking, or avoiding taking, any action. If you have any questions on the points raised in the above, please do not hesitate to get in touch.