Partial exemption and input VAT recovery

This article was originally published in February 2020 and has been updated to reflect changes occurring as a result of the UK leaving the EU.

If a business or a charity makes (or intends to make) both taxable and VAT exempt supplies, it is ‘partly exempt’. Partly exempt businesses must complete partial exemption calculations to calculate how much input VAT incurred can be recovered.

Generally, a VAT registered business can recover VAT incurred on expenditure that relates to:

  • taxable supplies it makes (or intends to make)
  • ‘foreign supplies’ (supplies made outside the UK that would be taxable if made in the UK)
  • ‘specified supplies’ (financial services supplied to persons belonging outside the UK or directly related to an export of goods, insurance services supplied to persons belonging outside the UK or directly related to an export of goods, and the making of arrangements for these specified supplies)

VAT incurred on expenditure that directly relates to exempt business activities is irrecoverable.

Business activities that may fall within VAT exemption include supplies of:

  • Insurance
  • Education
  • Finance
  • Health and welfare
  • Certain supplies of membership
  • Residential lets
  • Certain supplies of land/buildings where an option to tax has not been made by the supplier

Businesses making supplies of this nature may need additional support to calculate how much VAT incurred they can recover.

Standard method

This is the method ordinarily used by businesses that have not agreed a different method with HMRC. It is not necessary to agree use of this method beforehand but very occasionally it may give a result that is ‘unfair’ and further action may be required. This is dealt with later in this article.

The first step in the standard method is direct attribution of VAT bearing costs to supplies made.

A proportion of any non-attributable VAT incurred (aka residual VAT or VAT incurred on overheads) can be recovered.

The standard method of partial exemption uses an income based method to calculate the proportion of non-attributable input VAT that can be recovered:

* The value of taxable supplies includes those supplies with a right to VAT recovery i.e. ‘foreign’ and ‘specified’ supplies. The value of supplies used in the calculation excludes VAT.

The value of supplies of capital goods, incidental financial or real estate transactions, and self-supplies should not be included in the calculation.

Deminimis limits

If input tax attributed to a business’ exempt supplies is insignificant it may recover all input VAT incurred. If exempt input VAT is not more than:

  • £625 per month on average
  • half of the total input tax in the relevant period

a business can be treated as fully taxable.

There are simplified de minimis tests that may be appropriate for some businesses and charities.

Annual adjustment

Partly exempt businesses recover VAT incurred provisionally throughout their VAT accounting year. Partly exempt businesses are then required to complete an annual adjustment calculation that takes account of supplies made and input tax incurred across the entire VAT year and an adjustment to the VAT claimed may be required. This adjustment is normally made on the VAT return following a business’ partial exemption year end.

Partial exemption simplifications

Some businesses and charities may benefit from simplifications in place, such as:

  • In-year provisional recovery rate
  • Early annual adjustment
  • Use based method for new partly exempt businesses

Standard method override (SMO)

The standard partial exemption method is not suitable for all businesses, at all times. The standard method override applies when the standard method does not provide a ‘fair and reasonable’ recovery of input VAT.

If input VAT recovered in the year under the standard method differs ‘substantially’ to recoverable input VAT based on ‘use’ an SMO adjustment is required.

A difference is ‘substantial’ if it exceeds:

  • £50,000 or
  • 50% of the residual input tax incurred and £25,000.

This is not a common situation, but it is important to consider particularly in larger businesses.

Partial exemption special method (PESM)

If the standard method does not provide a ‘fair and reasonable’ input VAT recovery a business or charity may apply to use a partial exemption special method (PESM). A PESM is unique to the business. HMRC’s written approval is required to use a PESM. A formal PESM application to HMRC is required. Some examples of allocations and apportionments that may be appropriate are provided by HMRC in its VAT Notice 706:

  • output values
  • numbers of transactions
  • staff time or numbers
  • inputs or input tax
  • floor area
  • costs allocations
  • management accounts

With effect from 1 January 2011 a business or charity may apply for a ‘combined method’ which combines the business/non-business VAT recovery calculation and partial exemption calculation.

How Constable VAT can help

Constable VAT can assist businesses and charities in many different ways tailored to the client’s specific need, including:

  • Partial exemption workshops/training
  • Review of partial exemption calculations/annual adjustment calculations
  • Review of partial exemption method
  • Partial exemption special method (PESM) applications to HMRC

If you require assistance with partial exemption and want to discuss how Constable VAT can help please do not hesitate to contact us at any time on 01206 321029 or email info@constablevat.com and we would be pleased to assist. You may also wish to read HMRC’s Notice 706 (Partial Exemption).

 

 

Please note that this blog post is intended to provide a general overview of partial exemption. No liability is accepted for the opinions it contains or for any errors or omissions. Constable VAT cannot accept responsibility for loss incurred by any person, company or entity as a result of acting, or failing to act, on any material in this blog post. Specialist VAT advice should always be sought in relation to your particular circumstance.