VAT Partial Exemption

VAT registered entities that make both taxable and VAT exempt supplies are referred to as being “partly exempt” for VAT purposes which could mean that they can only reclaim a proportion of the VAT that they incur on expenditure ie the input tax you can recover.

The VAT partial exemption ‘standard method’ calculation that is based on turnover to be applied. This method may not be suitable for entitiess that have more complex arrangements and a VAT Partial Exemption Special Method (PESM) could be used whereby the recovery calculation is based on other criteria and may therefore be more appropriate for the unique circumstances of each individual entity.

It should be noted that the operation of a PESM requires HMRC’s agreement which may not always be readily obtainable. As an alternative, the Standard Method Override (SMO) is required to be considered, which can produce a fairer and more reasonable level of VAT recovery without the need to navigate through HMRC’s PESM application process.

Background to partial exemption

If an entity makes, or intends to make, both taxable and exempt supplies, they are regarded as being partly exempt for VAT purposes.

If an entity is partly exempt, it is likely that they will not be able to recover all of their input VAT, and a VAT partial exemption method can be used to work out how much of this input VAT they are able to recover on their costs that relate to both taxable and exempt supplies.

There are two types of partial exemption methods that can be used:

the standard method, which is specified in the law, and is suitable for organisations with more simple VAT arrangements
a special method, which is devised by an organisation to reflect their unique circumstances.

Partial exemption de-minimis limits

There are special VAT provisions referred to as de-minimis rules where relevant input tax attributable to exempt supplies in any period or in any longer period is not more than

£625 per month ‘on average’, and
one half of all input tax for the period concerned, all such input tax in that period is treated as attributable to taxable supplies and is therefore recoverable in full.

It is essential for businesses to monitor their taxable and exempt supplies closely, as well as their input VAT, to ensure they remain able to recover exempt input tax under these rules. The de minimis rule may be particularly beneficial for small businesses that have a mix of taxable and exempt sales.

If a business exceeds the de minimis limits, it will need to adjust its input tax claims accordingly. In this case, the business may not be able to recover the input tax associated with the exempt supplies, which will potentially increase VAT due to HMRC as a result of a VAT return. Therefore, it is crucial for businesses to keep accurate records of their sales and purchases and to review their eligibility for the de minimis rule on a regular basis.

The standard VAT partial exemption method

The standard method uses revenue as a proxy, and the calculation to determine the percentage of residual input VAT that can be recovered is:

(Taxable supplies / Total supplies) x 100

This percentage can often, subject to conditions, be rounded up to the nearest whole number, and an organisation does not need any approval from HMRC to operate this method of residual input VAT recovery, unless they currently operate a special method.

A VAT partial exemption special method (PESM)

A PESM is any calculation, other than the standard method, that enables an organisation to calculate how much of their VAT input tax they can recover. A PESM is unique to each individual entity, and it can be developed to deal with particular circumstances.

For example, a PESM can use different criteria to apportion the input VAT on costs including:

using the number of taxable and exempt transactions
by the number of staff who work relates to both taxable and exempt supplies
the floor area in which both taxable and exempt supplies are made.

Organisations should be aware that a PESM can only be used or updated through written approval from HMRC, and we have recently seen increasingly long delays in HMRC’s processing times of PESM approvals. Furthermore, HMRC typically require a large volume of information for an organisation to prove that a PESM will produce a fairer and more reasonable rate of input VAT recovery.

The VAT partial exemption Standard Method Override (SMO)

The SMO deals with circumstances where the standard partial exemption method itself does not produce a fair and reasonable deduction of input tax, and the benefits of this may be achieved much quicker when compared to the use of a PESM, as an organisation does not need to have any approval from HMRC for its use.

By law, the SMO must be considered each year when the input VAT recovered in that VAT year using the standard method differs ‘substantially’ to the recoverable input VAT when using a use-based method. A use-based method of input VAT recovery is when input VAT is attributed according to the use or intended use of costs in making taxable supplies. This requires an organisation to examine its main categories of expenditure, and to determine the extent to which they relate to its taxable supplies.

It is also noted that in order for the difference between the input VAT recovered in a year using the standard method and the recoverable input VAT using a use-based method to be ‘substantial’, it will need to exceed either:

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

The SMO calculation is not agreed with HMRC in advance; it should just be applied at the relevant time, the calculation documented and the outcome processed via a VAT return. This means that it does not provide the same level of certainty as a PESM (given a PESM is agreed in writing with HMRC) but what the SMO provides is an opportunity for organisations to determine if using the SMO does in fact produce a fairer and more reasonable apportionment of input VAT and to make an adjustment to recovery without having to agree the position with HMRC in advance.

As adjustments are not disclosed to HMRC in any way, they will only be identified by HMRC if an inspection is carried out. As such, it is now common for HMRC to request for business’ SMO calculations in order to determine if using the SMO does in fact produce a fairer and more reasonable apportionment of input VAT. Nevertheless, given some PESM negotiations take years to resolve, the SMO could be a valuable alternative option.

In certain circumstances HMRC can issue a special method override notice if the method in use is no longer fair and reasonable.

VAT partial exemption summary

In summary, a PESM may prove to be a good alternative to the standard partial exemption method in terms of input VAT recovery if it can be shown to HMRC that the standard method does not produce a fair and reasonable rate of recovery. As mentioned previously applying for a PESM may not always be the most time-efficient alternative when the standard partial exemption method no longer provides a fair and reasonable input VAT recovery rate.

As such, the SMO (which is required by law to be considered), may be used to obtain a fairer and more reasonable rate of input VAT recovery if this produces a result whereby the input VAT recovered in a year using the standard method differs ‘substantially’ to the recoverable input VAT when using a use-based method.

VAT specialists

Contact our VAT specialists with regard to VAT partial exemption https://www.solvevat.co.uk/vat-expertise/vat-specialists/

HMRC VAT partial exemption guidance

HMRC’s guidance in relation to VAT partial exemption can be found at https://www.gov.uk/guidance/vat-exemption-and-partial-exemption