HM Revenue and Customs have confirmed they will mount a legal challenge to Leeds United chairman Ken Bates's buy-back of the club, after he formed a new company to save the League One side from administration.

The club's creditors narrowly accepted his 1p-in-the-pound offer last month. It was a decision that angered the Inland Revenue, who are owed £7.7 million by the club in unpaid taxes, and had until 4pm today to announce formal action. Their concern was shared by Yorkshire MPs Phil Willis, George Mudie and Colin Burgon, who met with then economic secretary to the Treasury Ed Balls and former Sports Minister Richard Caborn at Westminster to express their concerns at the buy-back deal.

The Yorkshire club raised their offer to the Revenue of £77,000 to £616,000 yesterday in a last-ditch attempt to avoid a legal challenge. With Bates fearing the club could slide into liquidation, the former Chelsea chairman increased his initial offer to 8p in the pound and also agreed to extend the period that an extra £5m would be paid to creditors if Leeds reached the Barclays Premier League within ten years.

Before today's announcement, Bates voiced his fears for the future of the Elland Road club: "From 4pm on Tuesday there'll either be a Leeds United or there won't. It's not about personalities, it's about Leeds United and the many people who support the club on and off the field. I've always been told Leeds city needs a successful football club, and I hope Wednesday can be the first step towards Leeds United being a successful team for the city of Leeds," he said.

The club's administrators KPMG have insist they have acted within the laws of insolvency. A spokesman confirmed they were now considering their options and were not in a position to comment. He said: "We've not had time to study the Inland Revenue's notification yet."

Meanwhile, Leeds fans reacted with dismay at the Inland Revenue's decision to launch a legal challenge. Matthew Knowles, of Leeds fanzine The Square Ball, said: "This is very worrying news. Many of us are not in the Ken Bates fan club, but we knew that this was the only deal in town to get the team ready for the start of next season. If the club folds or is unable to challenge for promotion because of this legal limbo the local MPs who pressed for this action will have to answer to their constituents. "This challenge is not in the best interests of Leeds fans or the promotion prospects of the club," he said.

The club issued a statement following the announcement: "We do not have all the details as yet and do have a number of options available to us. We remain confident of a positive outcome despite this disappointing news and will carry on with business as usual in the meantime."