VAT on supplies to connected parties below value

Q: What are the three conditions?

Value below open market value. The consideration must be wholly in money. If any part is non monetary, a direction cannot be made and the supply is valued under section 19(3) instead. A direction can only increase a value; HMRC cannot use it to reduce an inflated price (VATVAL07300). The parties are connected. Connection is decided under section 1122 of the Corporation Tax Act 2010 (paragraph 1(4)). The customer cannot recover all the VAT. For a taxable supply, the recipient must not be entitled to credit for all the VAT under sections 25 and 26. HMRC says this happens in practice where the recipient is unregistered, wholly or partly exempt, or has non business activities. No direction can be issued where the recipient makes only taxable supplies. Paragraph 1(5) excludes supplies covered by paragraph 8A or paragraph 10 of Schedule 6. Paragraph 10 deals with catering and accommodation provided by employers to employees.

Q: Where else does connection change the VAT?

Continuous supplies. Notice 700, paragraph 14.3.1, explains that for continuous supplies of goods or services to a connected person who cannot fully recover the VAT, the law creates an annual tax point where one has not already occurred, with detail at VATTOS2385. VAT groups. VATVAL15700 says that where both parties are in the same VAT group at the time of the supply and any later adjustment, no VAT liability would normally arise. Grouping is covered in VAT group registration. Transfer pricing. VATVAL15700 says a transfer pricing adjustment or balancing payment does not in itself create a supply, but may indicate that the value of an earlier supply was understated and needs reviewing. Intra group recharges are the most common setting; see management charges and VAT for how they are priced and invoiced.

HMRC can direct that a supply between connected parties is valued for VAT at its open market value when three conditions are all met: the price is below open market value, the supplier and customer are connected, and the customer cannot recover all the VAT on the supply. The power is in paragraph 1 of Schedule 6 to the VAT Act 1994; a direction must be given in writing within three years of the supply and can also cover future supplies.

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Why does this rule exist?

When a customer can recover all its input tax, a low price between related businesses costs HMRC nothing: the supplier pays less output tax and the customer reclaims less. The position changes when the customer is exempt, partly exempt or not registered. Then an artificially low price lets the group recover input tax on costs in the supplier while paying little VAT on the onward charge to the customer who cannot reclaim it.

HMRC’s VAT Valuation manual (VATVAL07300) says the paragraph is specifically intended to counter tax avoidance. Its example is an exempt or partly exempt group setting up a fully taxable company outside the group, which buys large quantities of office equipment, recovers the input tax, and makes only a minimal charge to the group for using it.

What are the three conditions?

Value below open market value. The consideration must be wholly in money. If any part is non monetary, a direction cannot be made and the supply is valued under section 19(3) instead. A direction can only increase a value; HMRC cannot use it to reduce an inflated price (VATVAL07300).
The parties are connected. Connection is decided under section 1122 of the Corporation Tax Act 2010 (paragraph 1(4)).
The customer cannot recover all the VAT. For a taxable supply, the recipient must not be entitled to credit for all the VAT under sections 25 and 26. HMRC says this happens in practice where the recipient is unregistered, wholly or partly exempt, or has non business activities. No direction can be issued where the recipient makes only taxable supplies.

Paragraph 1(5) excludes supplies covered by paragraph 8A or paragraph 10 of Schedule 6. Paragraph 10 deals with catering and accommodation provided by employers to employees.

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Who counts as connected?

Section 1122, reproduced in VATVAL07400, treats these as connected:

two companies controlled by the same person, or by a person and people connected with them, or by the same group of people
a company and a person who, alone or with connected persons, controls it
an individual and their spouse or civil partner, their relatives, relatives of their spouse or civil partner, and the spouses or civil partners of those relatives
partners, their spouses or civil partners and relatives, except for acquisitions or disposals of partnership assets under genuine commercial arrangements
trustees and the settlor, people connected with the settlor, and certain companies

VATVAL07300 notes that relative means brother, sister, ancestor or lineal descendant, so nephews, nieces, uncles and aunts are not included, and that following Steele v EVC International NV control means control at the level of general meetings of shareholders. The same test appears across the tax system; see connected persons in UK tax.

How does a direction work in practice?

Paragraph 1(2) requires the direction to be given by notice in writing to the supplier, and no direction may be given more than three years after the time of the supply. Paragraph 1(3) allows it to include supplies made after the notice, or after a later date the notice specifies, where the conditions are still met. VATVAL07300 adds that HMRC cannot issue a notice covering future supplies only; it must relate to at least one past supply.

A direction is discretionary. The manual says that where a supply is made below open market value for a legitimate reason the trader can substantiate and which is unconnected with avoidance, HMRC has discretion not to issue one. Officers must obtain authority from HMRC’s VAT Supply Policy Team before issuing a notice. A direction can also cover exempt supplies, for example where a partly exempt supplier understates the value of exempt supplies to a connected company to improve its partial exemption recovery.

A direction under paragraph 1 of Schedule 6 can be appealed to the tribunal under section 83(1)(v) of the VAT Act; the route is explained in HMRC statutory review and the tax tribunal.

How is open market value measured?

Section 19(5) defines open market value as the value the supply would have if the consideration were what a person standing in no relationship affecting the price would pay. Finding that figure is not always easy, and VATVAL07300 says HMRC’s main concern is that the supply is valued at no less than the cost actually incurred by the supplier, so that input tax overclaimed by the supplier is clawed back. Evidence of what the supplier charges unconnected customers, or what the customer would pay a third party, is the most persuasive answer if HMRC’s figure looks too high.

What does a direction cost?

Illustration only. A company buys £120,000 of equipment plus £24,000 VAT, recovers the £24,000 and rents the equipment to a connected dental practice, which makes exempt supplies, for £6,000 a year plus £1,200 VAT. A comparable rental from an unconnected lessor would be £30,000 a year.

All three conditions are met: the rent is below open market value, the companies are under common control, and the practice cannot recover VAT.
If HMRC directs open market value, output tax becomes £6,000 a year instead of £1,200, an extra £4,800 for each year covered, going back up to three years and continuing into the future if the notice says so.
The practice cannot recover any of the extra VAT, so the cost falls on the group.

Where else does connection change the VAT?

Continuous supplies. Notice 700, paragraph 14.3.1, explains that for continuous supplies of goods or services to a connected person who cannot fully recover the VAT, the law creates an annual tax point where one has not already occurred, with detail at VATTOS2385.
VAT groups. VATVAL15700 says that where both parties are in the same VAT group at the time of the supply and any later adjustment, no VAT liability would normally arise. Grouping is covered in VAT group registration.
Transfer pricing. VATVAL15700 says a transfer pricing adjustment or balancing payment does not in itself create a supply, but may indicate that the value of an earlier supply was understated and needs reviewing.

Intra group recharges are the most common setting; see management charges and VAT for how they are priced and invoiced.

What mistakes come up most often?

Charging a nominal fee to an exempt or charitable connected body while recovering full input tax on the underlying costs.
Assuming a family member who is not a brother, sister, ancestor or descendant is connected, or that one who is cannot be.
Keeping no record of why a price was set, which removes the easiest way to persuade HMRC not to use its discretion.
Forgetting that the three year window runs from each supply, so long running arrangements remain exposed.

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Reviewed by Christine Anderson, Broker, Solar Protect. Last reviewed 24 October 2026. Part of Accountapedia, the Solar Protect guide to UK tax and accounting. This page is general information, not personalised advice.