WHICH hits the floor first after a big deal – the Champagne cork or the advisers’ invoices? Whichever it is, one thing for sure is that the first questions asked of tax advisers shortly afterwards are “can we reclaim the VAT?” and “how much can we treat as tax deductible?”. These are important questions because for every £100,000 of gross professional fees, around £40,000 of VAT and tax relief is at stake.

In the past, it was only the selling of shares that created VAT recovery problems in deal situations. European case law sorted out the problem as far as new shares were concerned but selling a subsidiary, for example, remains a VAT exempt transaction with probably no right to reclaim VAT on the related professional fees.

Where matters have got considerably worse is in the case of the buying of companies. In the last couple of years HMRC has begun closely unpicking the different ways in which such acquisitions are structured and has been aggressively challenging the right of buyers to reclaim VAT incurred by special vehicle companies, even if those special vehicle companies are in the main trading VAT group.

Private equity funded transactions are particularly vulnerable to challenge because HMRC are trying to pin the acquisition costs on the PE houses (who cannot usually reclaim VAT) instead of on the acquired or acquiring companies (who usually can reclaim VAT). Over the course of the next year these challenges from HMRC will find themselves being argued at a high level before the courts. Seeing clients at the difficult end of an argument has equipped us with the knowledge and experience of the weaknesses that HMRC seeks to exploit. We advise our clients to pay very close attention in advance to their arrangements with professional advisers including the parties to, and the wording of, engagement letters; and the roles and responsibilities of any newly created vehicle companies.

If you thought the recovery of VAT was difficult, then obtaining a corporate tax deduction for acquisition costs is at least as complex. Generally in an acquisition of an entity there will be the costs associated with an initial evaluation of potential targets, costs of acquiring the target business, and the costs associated with raising debt finance. The rule of thumb is that a tax deduction won’t be available for the costs of acquiring shares, should be available for the costs of raising finance, and may be available for early stage evaluation of investment opportunities. You also have to throw into the mix the accounting for these costs because if they are capitalised as part of the investment cost then no deduction would be available.

In some cases it will be obvious where the deal fees will fall – for example, stamp duty (acquisition cost) or bank arrangements fees (debt raising costs) – but for the vast majority it may be less clear (for example, due diligence) as they could apply to all three categories. Having invoices clearly worded before they are submitted does help with the allocation process and securing agreement with HMRC. The alternative is for the taxpayer to derive a methodology and hope for the best that HMRC accepts it without challenge.

Dealing with both the VAT and corporate tax issues in advance of the exciting stages of deal activity, and certainly before a champagne bottle is even in sight, will help prevent you choking twice on the champagne served at your completion meeting: the first time on receiving deal cost bills and secondly on discovering there are tax issues which could have been avoided with early planning.

:: David Ward is senior manager in tax at PwC in the North East, tel: 0191 269 3267 or email: david.ward@uk.pwc.com