VAT – The Partial Exemption Trap

For businesses registered for VAT, managing different types of income can take time and effort. If a business only has taxable income, including zero-rated sales, it can fully recover the VAT it paid on expenses, following standard rules. However, businesses that only have exempt income usually cannot claim any VAT back and often won’t need to register for VAT. The problem arises when a business has both taxable and exempt income and incurs VAT on costs related to both. In such cases, the business needs to figure out how to split the VAT correctly, a process known as input tax apportionment.

A common example of a partial exemption business is an estate agent. This agent earns exempt income from mortgage commissions and taxable income from commissions received when selling a property. If the agent buys a computer solely for the mortgage broker, the VAT on that computer cannot be reclaimed because the income is exempt. However, buying a computer just for a sales negotiator means the VAT can be fully reclaimed. For an office manager’s computer, the VAT is treated as an overhead or mixed cost, so only part of the VAT can be reclaimed. The challenge is figuring out how much of the overhead VAT can be claimed back.

Calculation – Standard Method

The standard method starts with ‘direct attribution,’ where a business must allocate VAT on its expenses into three categories: expenses related to standard rate VAT, expenses related to exempt sales, and the remaining expenses called ‘residual.’ According to HMRC’s standard calculation method, residual VAT is split based on the total supplies and expressed as a percentage:

Recoverable percentage of residual input tax = (Value of taxable supplies in the period (excluding VAT) / Total value of supplies in the period (excluding VAT)) × 100

This percentage is estimated each quarter and adjusted annually using the same formula as yearly figures. To simplify, businesses can use the previous year’s recovery percentage as a provisional rate for the current year, adjusting it at the end of the tax year. This avoids having to calculate separate rates for each quarter. Reverse charges and capital goods purchases are also included in this calculation.

Calculation – Special Methods

Sometimes, the standard method doesn’t fit a business’s situation well, especially for new businesses with high start-up costs. In these cases, a special method might allow for more VAT to be reclaimed if it is fairer and more reasonable than the standard method. Special methods can involve comparing output values, the number of transactions, staff time or numbers, inputs or input tax, square footage allocations, or cost allocations. 

If you need help with tax compliance and looking for proactive services, please contact Tax Accountant at 0800 135 7323 or email info@taxaccountant.co.uk for expert advice.