This is an edited version of an article first published on LinkedIn Pulse on 8 June 2018. There has been a lot of debate in the health service and national press recently about the increasing number of NHS Trusts setting up wholly owned subsidiaries. To date I have not read anything that accurately describes the commercial model for these companies, as much of the published literature is from a particular political ideology or from NHS Providers communicating the message ‘nothing to see here’. Much of the controversy surrounding wholly owned subsidiaries is the ability to make VAT savings and the potential to remunerate staff on less favorable terms and conditions. There have also been accusations of privatisation via the back door. Having recently supported a NHS Foundation Trust in the south of England to set up a wholly owned subsidiary to deliver fully managed healthcare facilities, in this article I explain from an unbiased perspective the issues to consider and the typical commercial model. As explained by NHS Providers, NHS wholly owned subsidiary companies (hereafter referred to as SubCo’s) are nothing new. They have been used for some time for outpatient pharmacy dispensing, although outsourcing to private pharmacies is a more common model. However, pharmacy SubCo’s (and outsourced pharmacy providers) have a very different commercial model to the facilities and estate SubCo’s we are now seeing set up. For Pharmacy SubCo’s, VAT recovery occurs at the SubCo level as the supply of goods and services is zero rated, but for facilities and estate SubCo’s the supply of services is standard rated and the VAT recovery occurs at the NHS organisation level through a contracted out direction.
The contracted out service rules are in section 41(3) of the VAT Act 1994. They allow the Treasury to issue a Direction, commonly known as a ‘Contracted Out Direction’ which lists the government bodies able to claim refunds of VAT and the services on which VAT can be refunded. The rules were introduced to avoid a disincentive for government bodies to contract out services. Initially contracted out service directions were used to contract out services such as cleaning, catering and portering. Without a contracted out direction, the 20% VAT charged by the contracted out services provider would make the services nonviable, as the VAT would be an additional cost to the commissioning organisation. The contracted out service direction allows the recovery of this VAT by the commissioning organisation, thereby creating a level playing field between in house and contracted out services. Any remaining difference in cost is due to efficiency. The assertion by NHS Provider’s Chris Hopson (available here), and Saffron Cordery (available here), that NHS wholly owned SubCo’s are not private companies and are still part of the NHS family is a little disingenuous. Most NHS wholly owned SubCo’s are set up as private limited companies, and therefore by definition, are private companies. The term ‘part of the NHS family’ is nebulous with no real meaning. Most GP practices are private companies but the public generally consider them to be part of the NHS, so in a similar way, perhaps NHS owned SubCo’s could be considered part of the NHS family. Increasingly, wholly owned SubCo’s are being used to contract out the management of healthcare facilities. The model involves the transfer of assets to the SubCo, and the transfer of staff that support, manage and maintain the assets, such as maintenance and procurement staff. The SubCo then provides fully managed healthcare facilities back to the NHS parent company, or TopCo. The NHS TopCo then recovers VAT using contracted out service (COS) heading 45, which covers the ‘operation of hospitals, healthcare establishments and healthcare facilities and the provision of any related services’. This is the same COS heading used for VAT recovery for private finance initiative (PFI) deals. In effect, the deal between the TopCo and SubCo needs to mimic a PFI deal, but with the private partner being a wholly owned subsidiary rather than a third party company. To make the model robust it is important that the SubCo has substance i.e. owns assets, employs staff, holds third party contracts, plans to make a profit and has an independent board of directors. The more circular arrangements that exist, whereby services are provided to the SubCo by the NHS TopCo, just for the SubCo to subsume into its supply of fully managed healthcare facilities charged back to the TopCo, the greater the risk that HMRC will consider the arrangement contrived or artificial and not allow the recovery of VAT. This has the potential to add cost, since the supply of fully managed healthcare facilities will include VAT on costs where the NHS is not currently paying VAT e.g. staff costs. The assets are usually transferred into the SubCo at net book value via a loan from the NHS parent TopCo. To prevent unlawful state aid, it is important that the loan is charged at market rates, known as the market economy investor principle. I have explained the importance of this in a previous article, available here. At the point of asset transfer, it is common to impair down the value of the assets, since their eventual replacement via the SubCo will no longer incur VAT. This leads to a reduced depreciation charge in the SubCo’s accounts, which leads to a lower service charge to the NHS TopCo. This is a second area of significant savings. It is important to use the depreciation element of the service charge to pay off the loan, so that the loan and net book value of the assets remain the same. This way the loan can immediately be repaid at any point by the transfer of assets. When setting up a SubCo it is worth considering how to avoid getting caught by the thin capitalisation rules i.e funding the SubCo wholly or mainly through debt rather than equity, thereby minimising profit through interest payments back to the TopCo to reduce or avoid corporation tax. As explained below, it is important that the SubCo does plan to make a reasonable profit. A quick review of NHS SubCo’s suggests that a 80% debt / 20% equity ratio is typical. Transactions between the SubCo and TopCo will almost certainly fall within the scope of transfer pricing legislation. This legislation requires that the OECD’s transfer pricing guidelines including the ‘arm’s length principle’ are followed. This requires that prices between the parties are comparable to prices that would be charged if the parties were completely independent i.e. include a reasonable profit margin. One of the aims of this legislation is to prevent prices being set at a level that would artificially reduce taxable profits. Surplus profit can be passed to the NHS TopCo via dividend payments. If the SubCo is set up as a private limited company then corporation tax will be payable on the profit. This can be avoided by making a charitable donation back to the TopCo, although control of the donated funding would be with the trustees of the charity of the TopCo. Another method would be to set up the SubCo as a limited liability partnership (LLP), though by definition the SubCo would not be ‘wholly owned’ since a partner would be required. Members of LLPs are taxed individually, and since the NHS’s non-business activities are not subject to corporation tax, the profit distributed back to the shareholding TopCo would not incur corporation tax, as long as the SubCo was supporting the non-business activities. A third area of savings is regarding capital expenditure for new assets which are purchased via further loan agreements between the NHS TopCo and its SubCo. As VAT can be recovered, the capital budget effectively increases by 20%. The fourth area of savings is critically important to demonstrate that the SubCo has not been set up purely for the purpose of avoiding tax. That is, by having a company solely focused on the management of facilities, there should be efficiencies and improvements in the quality of service provision. As facilities SubCo’s are new there is very little evidence on whether this is achieved in practice. However, the business case for the creation of a SubCo must present a credible plan for achieving these efficiencies and / or pursuing external commercial opportunities. This should avoid accusations of tax avoidance, which HMRC defines as, ‘…. bending the rules of the tax system to gain a tax advantage that parliament never intended. … it often involves contrived, artificial transactions that serve little or no purpose other than to produce this advantage’. Staff whose roles are largely moved to a SubCo have their employment transferred via the Transfer of Undertakings (Protection of Employment) Regulations (TUPE). This ensures that all terms and conditions are protected indefinitely. It is standard practice to obtain a closed direction order allowing continued access to the NHS pension scheme for transferring staff. A wholly owned SubCo will never be able to obtain an open pensions direction, and therefore new staff will not have access to the NHS pension scheme. Since an equivalent pension scheme would be unaffordable (requiring employer contributions of around 35%) it is common to offer new staff a salary that is higher than the NHS equivalent to offset the reduced pension benefits. In some cases, this can be attractive to applicants. Once set up, the NHS TopCo is able to place a contract for fully managed healthcare facilities from the SubCo without any competitive process, using the Teckal exemption in Regulation 12(1) of the Public Contracts Regulations 2015. To qualify for the Teckal exemption, the regulation requires that: · The contracting authority exercises control over the SubCo which is similar to that which it exerts over its own departments; · More than 80% of the work of the SubCo must be for the contracting authority; and, · There must be no direct private capital participation in the controlled SubCo. The control exerted over the SubCo is set out at the point of incorporation in the Articles of Association. This provides the boundaries of what the SubCo can do without referring back to shareholders i.e. the NHS TopCo. Typically in the shareholders’ reserve power there is a catch all phrase allowing the shareholders to direct the board of the SubCo to take or not take a particular course of action. This supports the control required to use the Teckal exemption described above, but it sits uncomfortably with other legislation requiring an arm’s length relationship. Please get in touch if you would like to discuss NHS wholly owned subsidiary companies. Copyright © 2018 Magrath Consulting Limited, all rights reserved
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Mark Magrath MBAI am a management consultant with 12 years experience as an executive director in an NHS Foundation Trust, including 10 years as Deputy Chief Executive. I only write blogs on projects and assignments that I have personally led. My aim is to write amazing content that combines real world experience with insightful advice. Categories
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