Local authority leisure services and the agency model: What is the impact two years on?

Two years after HMRC changed VAT rules affecting local authority-run leisure services, Craig Elder, partner at UK and Ireland law firm Browne Jacobson, and Simon Molden, director at The Sports Consultancy, explain the opportunities and risks for councils. 

The position for local authority leisure services used to be clear. Where those services were provided directly by a local authority, they were regarded as “business” and subject to VAT chargeable on the end users. 

There were, of course, ways that local authorities could mitigate this; most commonly, a local leisure trust could be set up, or an existing leisure trust could contract with the local authority, thus taking advantage of its VAT exempt status.

This all changed in March 2023. New HMRC policy meant that such in-house leisure services would be treated as “non-business”, allowing local authorities to provide services without charging VAT, and to recover all their input VAT paid in connection with the services. This represented the biggest change in local authority leisure management since the arrival of the leisure trusts in the late 1990s.

VAT changes lead to new agency model in leisure management

However, as around three-quarters of local authorities have some form of outsourcing arrangement in place, the leisure operator market – perhaps mindful that this new approach might lead some authorities to consider insourcing – turned its attention to how the new policy could benefit them and, ultimately, their public sector clients. 

Their answer was to propose a new agency model approach to leisure management, “flowing down” the benefit of local authorities’ new non-business status to their contracts by enabling them to charge no VAT to customers and recover input VAT on their expenditure. The local authority would, in addition, be able to recover all the VAT payable by it on any management or service fee charged by the agent.

It was initially estimated the benefit of the agency model arrangement, relative to a traditional outsourcing, could be a six-figure sum for a local authority. 

Emerging evidence from live contracts has confirmed this, with the financial uplift being in the region of £80,000 to £100,000 for a typical wet and dry leisure centre. 

Clearly, the more facilities a local authority has, the greater the potential financial upside and it is something any local authority seeking to generate additional revenue and reduce costs in a time of financial constraints would find difficult to ignore. For those authorities also considering investment in their facilities or the development of new centres, the financial benefit would potentially offer the opportunity to close funding gaps at a time when capital cost inflation has been significant.

Converting contracts to principal-agent models 

Therefore, the solution seemed clear – “convert” existing contracts into principal-agent models, and share savings across the industry. 

The catch is that HMRC would have to accept the substance of these arrangements, rather than the title, was a genuine principal-agent model. Moreover, would the council risk a breach of the procurement regime in making these changes without a fresh procurement? 

For new or “in-flight” procurements, introducing the possibility of an agency model also raised some uncertainties. For example, how easily could “traditional” and agency models be evaluated fairly against each other? What was the perceived risk, and potential financial and practical implications, of the agency model being challenged at some point in the future?

This led to understandable hesitancy on the part of procuring authorities, and some operators, to dive into these new forms. But more than two years on, what have we seen in practice?

The absence of any response from HMRC, the fact there has been no known procurement challenge, and the continued (and significant) financial benefits of the agency model have led to an increasing number of both:

• New leisure procurements that bake-in the possibility of an agency model – either as a “variant” bid or through negotiations as part of the procurement process.
• Variations to existing contracts to translate operating contracts into principal-agent models.  

Are there any risks to local authorities? 

The risk, although it has perhaps decreased over time as the new position beds in, is not zero. 

To mitigate the residual risk that will continue to exist, we have worked with local authorities on agency model arrangements in the following ways:

• Where a change to an existing arrangement is introduced, variations to the documents can be drafted to represent (as far as possible) a genuine agency arrangement under which the local authority is delivering the services through the agent, and under which the agent acts on behalf of the local authority. For example, passing income from the leisure activities directly to the local authority.
• Ensuring the new model, or newly procured model, allocates financial and operational risk between the parties on the same basis as that set out under the original contract (or which would have been tendered under a standard operating contract). The agency model should not be seen as an opportunity for an operator to pass risk or operational responsibilities back to the local authority, thereby denuding it of some of the benefits of the arrangements.
• Accounting for any increased risks arising from the property arrangements. There has been some suggestion that, although not fatal to an agency arrangement, a lease (rather than a licence to occupy) might be more carefully scrutinised by HMRC as part of any purported agency model.
• Ensuring any new tender processes that allow agency models to be compared against standard bids do so on a transparent basis, which incentivises the best bids and reduces the prospects of procurement challenge.

Looking ahead

It is likely that, in the absence of a challenge or other statement from HMRC, the agency model will become increasingly common and quite possibly standard in the market, particularly if ongoing constraints on local authority finances persist. 

Latest thinking from taxation advisers seems to be that, despite market misgivings that the arrangements could be viewed as a sham, HMRC is now unlikely to seek to tackle these arrangements, despite the fact that they deprive government of many millions of pounds of VAT income.