A VAT registered business that makes exempt supplies cannot recover VAT input tax paid in respect of expenses that are directly attributable to those supplies. Where a business is making both taxable and exempt supplies, it is necessary to distinguish carefully between inputs relating to exempt supplies and input tax in relation to taxable supplies.
Where the input tax relating to exempt supplies exceeds a de minimis limit (£625 per month or more than 50% of total input tax) it is also necessary to disallow some input tax relating to general overhead expenses, which are not directly attributable to any supplies made by the business. The VAT that cannot be recovered is computed using a partial exemption method.
UK VAT exemptions include financial services, insurance, health, education and some transactions relating to land and buildings. Businesses that are likely to be partially exempt for VAT purposes include banks, insurance companies, opticians, nursing homes and some schools.
Some construction companies and property investment companies may be partially exempt unless they plan carefully to ensure that they do not have exempt supplies on which input tax exceeds the de minimis limit. They may be in a position to avoid partial exemption by exercising the option to waive exemption (option to tax) which is available in relation to sales of land and leasing of commercial property.
The partial exemption year of a business runs to 31 March, 30 April or 31 May depending on the VAT return periods of the business. Often the business chooses VAT periods that coincide with its accounting period. The de minimis amount is computed for each month but is only provisional at that stage, and must be reworked at the end of the year to establish a final figure for exempt input tax which is computed on an annual basis. An annual adjustment is made on the VAT return for the quarter following the end of the year. The business now also has the option to make the adjustment on its final VAT return for the year.
In computing the exempt input tax, the business must first directly attribute its input tax to the taxable or exempt supplies as far as possible. This includes any input tax on expenses that relate directly to exempt or taxable supplies, whether these supplies were made in the current or the previous year or are to be made at some time in the future.
The “residual” input tax is the VAT on general expenses that has not been directly attributed to taxable or exempt supplies. This is apportioned using either the “standard method” or a special method that must be agreed with HMRC before it is used.
The standard partial exemption method looks at the proportion of taxable and exempt supplies made in the period and apportions the residual input tax on the basis of the proportion of each type of supply. The method is straightforward and the relevant information is readily available.
However this may not be suitable for some businesses as it may not reflect the reality of the relation between general expenses and exempt supplies. For example, a business may have had one very large exempt transaction, where the VAT on related inputs was relatively small, but the standard method would lead to the business not being able to recover a large proportion of the VAT incurred on general overhead expenses.
An example is that a bank may receive small amounts of standard rated management fees for managing shares for clients but may have large exempt sales of securities. Under the standard partial exemption method, the exempt sales would weigh much more in determining the allocation of input tax on general overhead expenses, although the contribution by the exempt transactions to the bank’s profits may not be so great owing to a small margin on sales.
Special partial exemption methods
The business can use any special method approved by HMRC as fair and reasonable. Where HMRC and the business cannot agree on a method, they can direct the business to use a method based on their own assessment of the situation.
A special method could apportion input tax on the basis of staff numbers, transaction counts or the floor areas used for taxable and exempt supplies. The suitability of the special method would depend on the particular facts and circumstances of the business using the method. A method that might be used by a financial institution is an allocation of input tax on general overhead expenses based on the proportions of directly attributable input tax that relate to taxable and exempt supplies. The special method could also use the ratio of the total expenses and costs used in producing taxable supplies as compared to total costs relating to exempt supplies.
When applying to use a special partial exemption method, a business must declare that the method fairly and reasonably represents the extent to which the goods and services are used in making taxable supplies. If the special method proves not to produce a fair result and HMRC consider that the business should have known this beforehand, they can request the business to recalculate irrecoverable input tax retrospectively.
HM Revenue and Customs www.hmrc.gov.uk
“Value Added Tax” by Andrew Needham and Steve Allan, Bloomsbury Professional, 2009