VAT Basics
As part of our guides to VAT basics, we take a brief look at partial exemption and how it affects a business.
The first point to make is that partial exemption is often complex and costly. In some cases it may be avoided by planning and in others it is a fact of life for a business which needs to be managed properly.
Background
The VAT a business incurs on its expenditure is called input tax. For most businesses this is reclaimed from HMRC on VAT returns if it relates to standard rated or zero rated sales (referred to as “taxable supplies”) that that business makes. Exempt supplies are not to be confused with non-business income which are dealt with under a different regime.
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, e.g.; light, heat, telephone, computers, professional fees, etc 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. A flowchart which illustrates the Standard Method of apportionment is below.
Which businesses are affected?
Any business which receives income from the following sources may be affected by partial exemption:
- Property letting and sales – generally all types of supply of land*
- Financial services
- Insurance
- Betting, gaming and lotteries
- Education
- Health and welfare
- Sport, sports competitions and physical education
- Cultural services
This list is not exhaustive.
* Most businesses which do not routinely make exempt supplies usually encounter exemption in the area of land and property and it is an easy trap to fall into not to consider VAT when involved in property transactions. This is one area where VAT planning may be of assistance as it is possible in most situations to deliberately choose to add VAT to an exempt supply to avoid a loss of input tax. This is known as the option to tax, and it is considered in more detail here.
De Minimis relief
There is however relief available for a business in the form of de minimis limits. Broadly, if the total of the irrecoverable directly attributable (to exempt suppliers) and the element of overhead input tax which has been established using a partial exemption method falls to be de minimis, all of that input tax may be recovered in the normal way. The de minimis limit is currently £7,500 per annum of input tax and one half of all input tax for the year.
As a result, after using the partial exemption method, should the input tax fall below £7,500 (£625 per month) and 50% of all input tax for a year it is recoverable in full. This calculation is required every quarter (for businesses which render returns on a quarterly basis) with a review at the year end, called an annual adjustment carried out at the end of a business’ partial exemption year. The quarterly de minimis is consequently £1,875 of exempt input tax which represents spending of under £10,000 net; not a huge amount.
Should the de minimis limits be breached, all input tax relating to exempt supplies is irrecoverable.
The value for the de minimis limit has been in place for over 25 years (when it was increased by a huge £25 per month) and it is rather ridiculous that it has not been increased to reflect inflation. This, coupled with the fact that the VAT rate has increased significantly means that the relief which was once very useful for a business has withered away to such an extent that partial exemption catches even very small businesses which I am sure goes against the original purpose of the relief.
In summary – for a business exemption is a burden not a relief. It represents a real cost in terms of tax payable, time and other resources, in addition to uncertainty. We often find that this is an area which HMRC examine closely and one which benefits from proactive negotiation with HMRC.