HMRC Publications
HMRC has updated its Notice 706 on partial exemption. This guidance explains partial exemption and the methods and calculations a business may use to calculate the amount of input tax it can recover.
More detailed guidance has been added to Paragraph 10.2 on a company’s sale of existing shares.
This is a common myth, and while charities and Not-For-Profit entities (NFPs) do enjoy some VAT reliefs, they are also liable for a number of VAT charges.
Charities have a very hard time of it in terms of VAT, since not only do they have to contend with complex legislation and accounting (which other businesses, no matter how large or complicated do not) but VAT represents a real and significant cost.
By their very nature, charities carry out “non-business” activities which means that VAT is not recoverable on the expenses of carrying out these activities. Additionally, many charities are involved in exempt supplies, eg; fundraising events, property letting, and certain welfare and educational services, which also means a restriction on the ability to recover VAT on attributable costs.
These two elements are distinct and require separate calculations which are often very convoluted. The result of this is that charities bear an unfair burden of VAT, especially so since the sector carries out important work in respect of; health and welfare, poverty, education and housing etc. Although there are some specific reliefs available to charities, these are very limited and do not, by any means, compensate for the overall VAT cost charities bear.
Another issue is legal uncertainty over what constitutes “business income” for charities, especially the VAT status of grants. It is worth bearing in mind here the helpful comment in the EC case of Tolsma translated as: “…the question is whether services carried on by [a person] were carried on for the payment or simply with the payment”.
Many charities depend on donations which, due to the economic climate have fallen in value at a time when there is a greater demand on charities from struggling individuals and organisations.
What can be done?
We have considerable expertise in the NFP sector and would be pleased to discuss any areas of concern, or advise on ways of reducing the impact of VAT on a charity.
More detail on VAT and Charities for guidance
Business activities
It is important not to confuse the term ‘trading’ as frequently used by a charity to describe its non-charitable commercial fund-raising activities (usually carried out by a trading subsidiary) with ‘business’ as used for VAT purposes. Although trading activities will invariably be business activities, ‘business’ for VAT purposes can have a much wider application and include some or all of the charity’s primary or charitable activities.
Registration and basic principles
Any business (including a charity and NFP or its trading subsidiary) which makes taxable supplies in excess of the VAT registration threshold must register for VAT. Taxable supplies are business transactions that are liable to VAT at the standard rate, reduced rate or zero rate.
If a charity’s income from taxable supplies is below the VAT registration threshold it can voluntarily register for VAT but a charity that makes no taxable supplies (either because it has no business activities or because its supplies or income are exempt from VAT) cannot register.
Charging VAT
Where a VAT-registered charity makes supplies of goods and services in the course of its business activities, the VAT liability of those supplies is, in general, determined in the normal way as for any other business. Even if VAT-registered, a charity should not charge VAT on any non-business supplies or income.
Reclaiming VAT
This is usually a two stage process (a combined calculation is possible but it must have written approval from HMRC – Notice 706 para 7) . The first stage in determining the amount of VAT which a VAT-registered charity can reclaim is to eliminate all the VAT incurred that relates to its non-business activities. It cannot reclaim any VAT it is charged on purchases that directly relate to non-business activities. It will also not be able to reclaim a proportion of the VAT on its general expenses (eg; telephone, IT and electricity) that relate to those non-business activities.
Once this has been done, the remaining VAT relating to the charity’s business activities is input tax.
The second stage: It can reclaim all the input tax it has been charged on purchases which directly relate to standard-rated, reduced-rated or zero-rated goods or services it supplies.
It cannot reclaim any of the input tax it has been charged on purchases that relate directly to exempt supplies.
It also cannot claim a proportion of input tax on general expenses (after adjustment for non-business activities) that relates to exempt activities unless this amount, together with the input tax relating directly to exempt supplies, is below the minimis limit.
Business and non-business activities
An organisation such as a charity that is run on a non-profit-making basis may still be regarded as carrying on a business activity for VAT purposes. This is unaffected by the fact that the activity is performed for the benefit of the community. It is therefore important for a charity to determine whether any particular transactions are ‘business’ or ‘non-business’ activities. This applies both when considering registration (if there is no business activity a charity cannot be registered and therefore cannot recover any input tax) and after registration. If registered, a charity must account for VAT on taxable supplies it makes by way of business. Income from any non-business activities is not subject to VAT and affects the amount of VAT reclaimable as input tax.
‘Business’ has a wide meaning for VAT purposes based upon Directive 2006/112/EC (which uses the term ‘economic activity’ rather than ‘business’), UK VAT legislation and decisions by the Courts and VAT Tribunals. An activity may still be business if the amount charged does no more than cover the cost to the charity of making the supply or where the charge made is less than cost. If the charity makes no charge at all the activity is unlikely to be considered business.
An area of particular difficulty for charities when considering whether their activities are in the course of business is receipt of grant funding.
The VAT a business incurs on running costs is called input tax. For most businesses this is reclaimed on VAT returns from HMRC if it relates to standard rated or zero rated sales that that business makes. However, a business which makes exempt sales may not be in a position to recover all of the input tax which it incurred. A business in this position is called partly exempt. Generally, any input tax which directly relates to exempt supplies is irrecoverable. In addition, an element of that business’ general overheads are deemed to be in part attributable to exempt supplies and a calculation must be performed to establish the element which falls to be irrecoverable.
Input tax which falls within the overheads category must be apportioned according to a so called; partial exemption method. The “Standard Method” requires a comparison between the value of taxable and exempt supplies made by the business. The calculation is; the percentage of taxable supplies of all supplies multiplied by the input tax to be apportioned which gives the element of VAT input tax which may be recovered. Other partial exemption methods (so called Special Methods) are available by specific agreement with HMRC. There is also a de minimis relief.
My flowchart may be of use: partial exemption flowchart
Summary
One may see that this is a complex area for charities and not for profit entities to deal with. Certainly a review is almost always beneficial, as are discussions regarding partial exemption methods.
Please click here for more information on our services for charities.
VAT basics
None of us are perfect, and any business can make mistakes with VAT despite all intentions to take reasonable care. So what are the most common errors? Here’s a list of pitfalls to avoid:
Wrong rate of output tax charged
Land and property transactions
Cross-border issues
Inter-company charges
Partial exemption
Business entertainment
Registration
VAT groups
Tax points (Time Of Supply)
Bad Debt Relief issues
Overseas issues
Claiming input tax without the correct documentation
Recovering irreclaimable input tax
Return errors
Business promotion schemes
Composite or separate supplies
Changes to a business
Fuel and motoring costs
Special schemes
One-off transactions
Non-business (NB) and charitable activities
Errors can lead to draconian penalties, and ignorance is not a defence.
A guide to VAT triggerpoints here .
HMRC has published Revenue and Customs Brief 4 (2025), which provides information about changes to VAT deduction on costs incurred in respect of the management of pension funds.
The Brief explains a further policy change to VAT deduction on the management of pension funds – Employers can now claim all the VAT on investment costs linked to pension funds. HMRC will no longer view investment costs as being subject to dual-use. Instead, all the associated input tax incurred will be seen as the employer’s and deductible by the employer, subject to normal deduction rule
They no longer need to split the costs with pension trustees. This was (prior to the introduction of the changes on 18 June 2025) a dual-use apportionment.
This Brief is relevant to:
Impact on partial exemption methods
Businesses may need to propose new partial exemption special method (PESM) to align their VAT recovery with the new policy.
Background
HMRC’s historic policy was that employers could recover input tax they incurred on costs relating to the administration of their occupational pension funds, but not those in relation to the asset management of investments made by the fund.
Subsequently, HMRC changed its policy to allow employers recovery of input tax incurred on investment costs, provided that the employer could show evidence that they contracted and paid for the investment services.
HMRC has said that it will publish additional guidance on the new policy by Autumn 2025.
Commentary
This is very welcome news for managers of pension funds. It provides clarity and simplification in accounting, plus, more significantly; a much-improved VAT position whereby irrecoverable input tax can be avoided.
The HMRC climbdown is originally a result of the Fiscale Eenheid PPG Holdings BV cs te Hoogezand (C-26/12) CJEU case which considered an employer’s entitlement to deduct VAT paid on services relating to the administration of defined benefit pension funds and the management of the assets of the fund..
Notice 749 has been updated. This is guidance for Local authorities, government departments, non-departmental public bodies, NHS bodies, local government bodies, the police and the fire and rescue services.
It sets out:
The changes amend:
Section 33 bodies
“Section 33 bodies” per The VAT Act 1994, section 33)
These entities have special VAT treatment which is effectively the opposite of normal VAT rules. To avoid a cost to the taxpayer, these entities are permitted to specifically recover input tax that relates to non-business activities. Nobody said that VAT was straightforward and in these cases, the VAT rules are inverted!
We act for many Local Authorities and Academies. Please contact us should you, or your clients, have any queries on this matter.
Put simply, income which is outside the scope (OSC) of VAT is UK VAT free. It means that either there has been no supply in respect of that income (non-business, or ‘NB’), or if there is, it has a place of supply (POS) which is outside the UK. Although VAT free, OSC is distinct from exempt or zero-rated supplies and has a different impact for the entity involved in NB activities.
So, here I consider the different types of OSC income and how it affects the VAT position of the recipient of such a payment.
Charity
Charities and NFP organisations often receive income from various sources and often receive NB income which is OSC. This income is often donations for which the donor does not receive anything (there is no consideration provided by the charity). An organisation such as a charity that is run on a non-profit-making basis may still be regarded as carrying on a business activity for VAT purposes. This is unaffected by the fact that the activity is performed for the benefit of the community. It is therefore important for a charity to determine whether particular transactions are business or NB activities. This applies both when considering registration (if there is only NB activity a charity cannot be registered and therefore cannot recover any input tax) and after registration. ‘Business’ has a wide meaning for VAT purposes – an activity may still be business if the amount charged does no more than cover the cost to the charity of making the supply or where the charge made is less than cost. If the charity makes no charge at all the activity is unlikely to be considered business. A common area of complexity for charities when considering whether their activities are in the course of business is receipt of grant funding (please see below).
Grants
There is no ‘standard’ VAT treatment of grants. The VAT outcome depends on the precise facts of each specific agreement. The most important test is whether the grantor receives any consideration in return for the payment. It may be that the donor recognises the good work a body does and wishes to contribute (akin to a donation) which is OSC. Alternatively, the recipient of the grant may be obliged to provide something in return (a supply which is not OSC). A helpful way of looking at this is to consider, not what the recipient does with grant money, but what it does for it.
Inter-company charges
Charges between VAT group members are OSC. Moreover, charges between non-VAT-grouped companies may also be OSC. These are commonly called ‘management charges’ and the VAT treatment depends on a number of facts. It is often the case that a management charge is used as a mechanism for transferring “value” from one company to another. If it is done in an arbitrary manner with no written agreement in place, and nothing identifiable is provided the income is likely to be OSC. Otherwise, it is likely to be a taxable supply. What is important is not how a management charge is calculated, but what the supply actually is (if it is one). The calculation, whether based on a simple pro-rata amount between separate subsidiaries, or via a complex mechanism set out in a written agreement has no impact on the VAT treatment. As always in VAT, the basic question is: what is actually provided?
Place of supply not the UK
If the POS is outside the UK, then the resulting payment for that supply is OSC. The POS rules can be complex and care must be taken in identifying the correct country to declare output tax (this may include the use of the OSS). In some instances, the Reverse Charge is applied. Input tax incurred in relation these supplies is recoverable, subject to the normal rules, and this distinguishes this type of supply from some of the others discussed here.
Transfer Of a Going Concern (TOGC)
A TOGC is deemed to be neither a supply of goods nor services, so consequently, it is OSC. Input tax incurred in respect of the costs of making a TOGC are considered an overhead of the business for partial exemption purposes, so it is not automatically disallowed because it relates to a ‘non-supply’.
Supplies by a non-taxable person
Sales by a business person who is not liable to be VAT registered.
Insurance etc
A payment between persons, which is paid under a contract of indemnity, is OSC, because it does not represent consideration for a supply, eg; sums paid under an insurance policy.
Private transactions
These transactions between individuals or gifts received are OSC.
Statutory fees
These are OSC, an example of such fees are: the London congestion charge, MOT testing, some road tolls, and parking fines.
Input tax recovery
VAT incurred on costs directly relating to OSC activities is not input tax and cannot be recovered (there are no de minimis limits). This is separate to partial exemption and a business/NB calculation is required before a partial exemption calculation is carried out, so it is a two-tier exercise. It may be possible to combine these two calculations, but that is an article for another day.
HMRC has issued new guidance on the amount of input tax claimable when an element is attributable to NB activities. If an entity is involved in both business and NB activities, eg; a charity which provides free advice and also has a shop which sells donated goods, it is unable to recover all of the VAT it incurs. VAT attributable to NB activities is not input tax and cannot be reclaimed. Therefore, it is necessary to calculate the quantum of VAT attributable to business and NB activities. That VAT which cannot be directly attributed is called overhead VAT and must be apportioned between business and NB activities. There are many varied ways of doing this as the VAT legislation does not specify any particular method. It is important to consider all of the available alternatives. Examples of these are; income, expenditure, time, floorspace, transaction count etc (similar to those methods available for partial exemption calculations). Any calculation must be fair and reasonable.
Overall
OSC income should not be recognised in the value box of VAT returns and it does not count towards the VAT registration limit. It is likely to negatively affect the recipient’s input tax recovery position. The distinction between business and non-business is crucial and will significantly impact on an entity’s overall VAT position.
Further reading
The following articles consider case law and other relevant business/NB issues:
Lajvér Meliorációs Nonprofit Kft. and Lajvér Csapadékvízrendezési Nonprofit Kft
VAT Basics
Opting To Tax commercial property
Opting to tax provides a unique situation in the VAT world. It is the only example of where a supplier can choose to add VAT to a supply….. or not.
What is an option to tax (OTT)?
The sale or letting of a property is, in most cases, exempt (VAT free) by default. However, it is possible to apply the OTT to commercial property. This has the result of turning an exempt supply into a taxable supply at the standard rate. It should be noted that an OTT made in respect of a residential property is disregarded and consequently, the supply of residential properties is always exempt (unless it is the first time sale of a new build – in which case it is zero-rated).
Why opt?
Why would a supplier then deliberately choose to add VAT on a supply?
The only purpose of OTT is to enable the optor to recover or avoid input tax incurred in relation to the relevant land or property. The OTT is a decision solely for the property owner or landlord and the purchaser or tenant is not able to affect the OTT unless specific clauses are included in the lease or purchase contracts. Care should be taken to ensure that existing contracts permit the OTT to be taken. Despite a lot of misleading commentary and confusion, it is worth bearing in mind that the recovery or avoidance of input tax is the sole reason to OTT.
Once made the OTT is usually irrevocable for a 20-year period (although there are circumstances where it may be revisited within six months of it being taken – see below). There are specific rules for circumstances where the optor has previously made exempt supplies of the relevant land or property. In these cases, HMRC’s permission must usually be obtained before the option can be made.
What to consider
The important questions to be asked before a property transaction are:
These are the basic questions to be addressed; further factors may need to be considered depending on the facts of a transaction.
Input tax recovery
Input tax relating to an exempt supply is usually irrecoverable. In fact, a business only making exempt supplies is unable to register for VAT. A guide to partial exemption here. So input tax incurred on, say; purchase, refurbishment, legal costs etc would be lost if a property was sold or rented on an exempt basis. In order to recover this tax, it must relate to a taxable supply. If an OTT is taken, the sale or rent of the property will be standard rated which represents a taxable supply. VAT on supply = input tax claim.
Two-part process
The OTT is a two-part process.
There can be problems in cases where the OTT is taken, but not formally notified.
Timing
It is vital to ensure that an OTT is made at the correct time. Even one day late may affect the VAT treatment. Generally speaking, the OTT must be made before any use of the property, eg; sale or rent. Care should also be taken with deposits which can trigger a tax point before completion.
Disadvantages
As mentioned above (and bears repeating) the benefit of taking the OTT is the ability to recover input tax which would otherwise fall to be irrecoverable. However, there are a number of potential disadvantages.
Transfer of a Going Concern (TOGC)
I always say that advice should be taken in all property transactions and always in cases of a TOGC or a possible TOGC. This is doubly important where an opted building is being sold, because TOGC treatment only applies to a sale of property when specific tests are met. A TOGC is VAT free but any input tax incurred is recoverable, so this is usually a benefit for all parties.
Revoking an Option To Tax
Summary
Property transactions are high value and often complex. The cost of getting VAT wrong or overlooking it can be very swingeing indeed. I have also seen deals being aborted over VAT issues. Of course, if you get it wrong there are penalties to pay too. For these reasons, please seek VAT advice at an early stage of negotiations.
More on our land and property services here
Partial Exemption
Businesses which makes exempt supplies may be partially exempt (depending on the de minimis limits). A partially exempt business will be prohibited from claiming all of its input tax. A calculation is required to determine the amount of a claim which is blocked. The majority of businesses use what is known as “the standard method” with an annual adjustment.
Partial Exemption Special Method (PESM)
However, use of the standard method is not mandatory and a business can use a “special method” (a Partial Exemption Special Method, or PESM) that suits a business’ activities better. Any PESM has to be “fair and reasonable” and it has to be agreed with HMRC in advance. When using a PESM no rounding of the percentage is permitted and it has to be applied to two decimal places.
HMRC says fair and reasonable means it must be:
Types of PESMs
The following are examples of special methods:
How to apply
You will need to provide documents with your application. These include:
More information on the documentation a business needs provide is set out in Appendix 2 of PN706
Apply online
You will need to either:
This is done here
A glossary of partial exemption terms may be found here.
Blocked VAT claims – an overview
In most cases this evidence will be an invoice (or as the rules state “a proper tax invoice”) although it may be import, self-billing or other documentation in specific circumstances. A claim is invalid without the correct paperwork. HMRC mayaccept alternative evidence, however, they are not duty bound to do so (and rarely do unless the amount is minimal). So ensure that you always obtain and retain the correct documentation.
Usually this is an invalid invoice, or using a delivery note/statement/pro forma in place of a proper tax invoice. To support a claim an invoice must show all the information set out in the legislation. HMRC are within their rights to disallow a claim if any of the details are missing.
Broadly speaking, if a business incurs VAT in respect of exempt supplies it cannot recover it. If a business makes only exempt supplies it cannot even register for VAT. There is a certain easement called de minimis which provide for recovery if the input tax is below certain prescribed limits. Input tax which relates to both exempt and taxable activities must be apportioned. More details of partial exemption may be found here.
If a charity or NFP entity incurs input tax in connection with non-business activities this cannot be recovered and there is no de minimis relief. Input tax which relates to both business and non-business activities must be apportioned. Business versus non-business apportionment must be carried out first and then any partial exemption calculation for the business element if appropriate. More details here
If input tax is not reclaimed within four years of it being incurred, the capping provisions apply and any claim will be rejected by HMRC.
This is always irrecoverable unless the client or customer being entertained belongs overseas. The input tax incurred on staff entertainment costs is however recoverable. A flowchart for recoverability in this area here.
In most cases the VAT incurred on the purchase of a car is blocked. The only exceptions are for when the car; is part of the stock in trade of a motor manufacturer or dealer, or is used primarily for the purposes of taxi hire; self-drive hire or driving instruction; or is used exclusively for a business purpose and is not made available for private use. This last category is notoriously difficult to prove to HMRC and the evidence to support this must be very good.
If a business leases a car for business purposes it will normally be unable to recover 50% of the VAT charged. The 50% block is to cover the private use of the car.
The element of fuel costs used for personal use is blocked. There are three ways to treat input tax on fuel:
For instance, a business using the Flat Rate Scheme cannot recover input tax except for certain large capital purchases, also there are certain blocks for recovery on for Tour Operators’ Margin Scheme (TOMS) users
Even if a business obtains an invoice purporting to show a VAT amount, this cannot be recovered if the VAT was charged in error; either completely inappropriately or at the wrong rate. A business’ recourse is with the supplier and not HMRC.
Even if a business has an invoice addressed to it and the services or goods are paid for by the business, the input tax on the purchase is blocked if the supply is not for that business’ use. This may be because the purchase is for personal use, or by another business or for purposes not related to the claimant business.
This is not input tax and therefore is not claimable. However, there are exceptions for goods on hand at registration and which were purchased within four years of registration, and services received within six months of registration if certain conditions are met.
Input tax incurred on certain articles that are installed in buildings which are sold or leased at the zero rate is blocked.
Goods sold to a business under one of the VAT second-hand schemes will not show a separate VAT charge and no input tax is recoverable on these goods.
Assets of a business transferred to you as a going concern are not deemed to be a supply for VAT purposes and consequently, there is no VAT chargeable and therefore no input tax to recover.
A business cannot reclaim VAT when it pays for goods or services to be supplied directly to its client. However, in this situation the VAT may be claimable by the client if they are VAT registered. For more on disbursements see here.
A business cannot reclaim VAT charged on goods or services that it has bought from suppliers in other EU States. Only UK VAT may be claimed on a UK VAT return. There is however, a mechanism available to claim this VAT back from the relevant authorities in those States. Details here. However, in most cases, supplies received from overseas suppliers are VAT free, so it is usually worth checking whether any VAT has been charged correctly.
There are special rules for reclaiming input tax using the Capital Goods Scheme, which means a business must spread the initial VAT claimed over a number of years.