VAT deductions for private equity investors under the microscope

While the decision clarified certain principles, it is also problematic, imposing a strict burden of proof on companies regarding the allocation of costs. A particular risk for private equity investors is that transaction costs could be allocated to them retroactively, with no right to deduct VAT due to the nature of their business. In the absence of more precise guidance, companies cannot be certain they will have the right to deduct VAT without seeking a preliminary ruling, and retrospective adjustment carries a significant risk of tax penalties.

Past practice

Earlier tax practice has already made it clear that if services purchased in connection with a transaction only benefit the acquiring company indirectly, that company cannot deduct the VAT on the services. Instead, the costs should be allocated to the company that directly benefits from the services. Examples of such services provided in the interest of investors include shareholders’ agreements concerning the owners of the acquiring company and planning services for the upper-tier acquisition structure.

Three deduction categories and allocation of costs

The SAC decision classifies professional services into three categories based on deductibility: fully deductible, partially deductible and non-deductible. This means that some professional services may be only partially deductible for the acquiring company, and the rest should be allocated to, for example, investors higher up in the acquisition structure. According to the SAC, such partially deductible costs – i.e. costs related to services that partially benefit investors – may include, for example, due diligence costs. The SAC did not take a more detailed position on how the costs should be allocated between the companies.

Lack of guidance

For the time being, the Tax Administration has not provided detailed guidance on the allocation of costs, which means that companies must make their own assessments based on the general principles set out by the SAC. This is a challenging situation, as the allocation can create a substantial administrative burden for taxpayers and require significant manual work. Especially in the case of larger transactions, it is advisable to discuss the cost allocation in advance with the Tax Administration and apply for a preliminary ruling when necessary. In a panel discussion on the subject held in December, the Tax Administration indicated that it would cooperate with taxpayers on the matter and was open to more informal discussions to find solutions.

Documentation

Going forward, documenting costs will be particularly important, and companies will also need to ensure that the content of the services can be verified retrospectively. This is necessary to determine who benefitted from the services purchased in connection with the transaction – or in other words, who has the right to deduct VAT on these purchases. The company must be able to justify the allocation used for tax deductions. In the individual case now decided by the SAC, for example, the provisions in the shareholders’ agreement regarding costs took on unexpected significance, indicating that such provisions should be drafted with particular care. With clearer documentation, the outcome of the decision could have been more straightforward and perhaps even different to some extent.

The situation may not be as problematic as initially feared after the SAC issued its decision. With careful documentation, companies and investors can prepare for any upcoming Tax Administration investigations already when structuring the transaction. Our discussions with the Tax Administration indicate that they are open to dialogue with companies and their advisors.

– Mikko Alakare

Key considerations for private equity investors

• Correct allocation: Ensure that costs are allocated and, if necessary, recharged to the company to whose business they are directly and immediately related. The acquiring company may not be entitled to fully deduct VAT on professional services charged in connection with the transaction.
• Sufficient documentation: Be prepared to clarify and prove that the costs were allocated to the correct company. Make sure that the documentation is clear enough to be understood even a few years later, and require advisors to provide detailed invoice itemisation for their work.

C&S experts have advised clients on a number of assignments related to transaction cost VAT deductions even before the latest SAC precedent. We are available to assist you with any investigations and processes on the subject.