A partial VAT exemption allows businesses that supply taxable and exempt products/services to claim back a portion of their input tax on expenses related to both types of sales. The portion of input VAT that they can claim needs to be calculated in line with HMRC’s rules.
In this guide, you’ll find out more about how partial VAT exemption work, how the input calculation works (using either the standard and special methods) as well as the circumstances under which a business can claim VAT on expenses in full without the need for a partial adjustment (using the de minimis rule).
Table of contents
1. What is a Partial VAT Exemption?
Some businesses may supply goods/services which fall both inside and outside the scope of VAT, in other words, taxable and exempt supplies. These businesses must still register for VAT on their taxable sales and are entitled to claim back VAT on expenses, at least in part. In these cases, they need to apply for what is known as a partial exemption.
2. How Does a Partial VAT Exemption Work?
A partial exemption determines how much input VAT a business can claim back on its VAT return each VAT period. Businesses are entitled to recover all input VAT on taxable sales. However, some expenses may relate to both their taxable and exempt sales. Most commonly overheads like rent, rates and office costs. In these cases, they need to follow one of the two HMRC approved methods to work out how much VAT they can claim back on these shared costs – the standard method or special method. Businesses need to get HMRCs approval to use the special method, but not the standard method. But whichever method is chosen, any VAT reclaimed it must be, what they call, a ‘fair and reasonable’ reflection of the cost incurred to generate its taxable sales. In other words, the business must not be found to be claiming back input VAT on exempt supplies that wouldn’t normally be reclaimable.
3. The Standard Method
Under the standard method, you must use a calculation set out by HMRC to work out the percentage of input VAT recoverable in a VAT period. This calculation is as follows:
Say, for example, a business has a taxable turnover of £120,000 for a VAT quarter and £20,000 of exempt turnover, so a total turnover excluding VAT of £140,000. Using the calculation above the recoverable percentage will be 86% (£120,000 ÷ £140,000 x 100). The business can now apply this percentage to work out how much they can claim back VAT on inputs that apply to both its taxable and exempt sales.
4. The Special Method
If a business feels that the standard method doesn’t result in a fair claim for input VAT on costs related to both its taxable and exempt sales, it can develop its own method. But this will need approval from HMRC by contacting them on PESMcovid19@hmrc.gov.uk. You’ll need to include details of your proposed new method and why you feel it is more suitable. Then, once approved by HMRC, you can begin to use it.
5. The De Minimis Rule
To make VAT reporting simpler, where recoverable input VAT is calculated using either the standard or special method is below a set amount you can claim all your input VAT without applying the percentage calculation. For 2021/2022 the de minimis limit is £625 per month (which equates to £1,875 per quarter or £7,500 per annum). In addition, to meet the de minimis criteria, input VAT relating to exempt supplies must not be more than 50% of all input tax incurred.
Once a year, in the closest VAT period ending nearest to the tax year, the business needs to carry out a retrospective calculation to confirm it did not breach the de minimis limit of £7,500 per annum. This is known as an Annual Adjustment.
If the annual adjustment check shows that the business was within the de minimis limit, then it needn’t make any further adjustment for the input VAT it has claimed in full. However, if it is found to have breached the limit then an adjustment needs to be made on the next VAT return it submits.