How to Survive Partial Exemption
A VAT registered business falls within the scope of partial exemption when it makes both taxable and exempt supplies.
Partial exemption is not a matter that concerns only a few businesses. Most businesses make exempt supplies at one time or another. Typical exempt supplies that can give rise to partial exemption include:
- The sale of business premises or land;
- The subletting of business premises;
- and The sale of shares or securities (e.g. for example, the sale of a subsidiary company).
However, there are many businesses that are less obviously partially exempt. Sole traders receiving additional income from letting residential properties, estates agents receiving commission from acting as intermediaries in relation to the sale of mortgages and farmers letting excess land to neighbouring farms should all be carrying out partial exemption calculations.
For many businesses and advisors partial exemption can be a daunting area of the VAT legislation. Indeed, the practical implementation of partial exemption is notoriously complex. This article provides an overview of the partial exemption rules but also highlights measures that can be used to simplify the calculations.
Output VAT cannot be charged on an exempt supply and equally any input VAT incurred directly in making the exempt supply, generally, cannot be recovered.
In terms of input tax recovery, a partly exempt business needs to split its purchase invoices into three different categories for each VAT period:
- input tax incurred directly in relation to taxable supplies – 100 percent of the input tax can be claimed (subject to normal rules)
- input tax incurred directly in relation to exempt supplies – no input tax can be claimed (unless it falls within the de-minimis limits)
- input tax incurred in relation to taxable and exempt supplies – e.g. general overheads. This is called residential input tax.
A partly exempt business will need to use a method to work out how much residual input tax can be recovered. This is usually the standard method. The standard method of apportioning residual input tax is based on turnover. The recoverable amount is the percentage of taxable sales as a proportion of total sales whilst the exempt amount is the percentage of exempt sales as a proportion of total sales.
(If the standard method is deemed not to give a fair and reasonable result, it is possible to apply to HMRC to use a special method for the calculation).
The De-minimis Limit
A partly exempt business is able to claim all of its input tax in a VAT period if it is classed as de-minimis.
A business is de-minimis if its exempt input tax (which includes the proportion of the residual input tax) is:
- not more than £625 per month on average; and
- not more than 50 per cent of total input tax.
In April 2010, HMRC introduced two simpler versions of this de-minimis test which can be used first to check whether or not the limit is breached.
Simple de-minimis test 1:
- Total input tax is not more than less than £625 per month on average
- The value of exempt supplies is not more than 50% of the value of all supplies (i.e. taxable plus exempt supplies and also outside the scope supplies that would be taxable if provided in the UK, e.g. consultancy services to an overseas business customer)
Simple de-minimis test 2:
- Total input tax less input tax directly attributable to taxable supplies is not more than £625 per month on average
- The value of exempt supplies is not more than 50% of the value of all supplies.
A business only needs to pass one of the three tests in order to be entitled to claim input tax on all costs.
At the end of each VAT year (either March, April or May depending on VAT stagger) a partly exempt business is required to carry out an annual adjustment. This is to determine if the de-minimis limit has been passed or failed for the year.
If the result of the annual calculation is that the de-minimis threshold has not been breached all of the input tax incurred in the year can be recovered. This includes any input tax directly attributable to exempt supplies and any input tax that may have been restricted during the year because the de-minimis threshold was breached.
However, it is possible for a business to be fully taxable in some periods but then breach the de-minimis test at the annual adjustment meaning that the business must repay to HMRC any proportion of residual input tax previously claimed and any input tax directly attributable to exempt supplies.
The annual adjustment should be made on either the final return of the year or on the first return of the following year.
Other Simplification Measures
The Annual Test
If a business was de-minimis in its previous partial exemption year, then so long as the total input tax for the current year is less than £1 million, it can assume it will be de-minimis in the next partial exemption year as well. It is, therefore, able to reclaim all of the input tax incurred during the year without having to do quarterly calculations. However, the business is still required to carry out an annual adjustment to confirm if it is actually de-minimis for this year as well.
The main risk of using the annual test is that if a business provisionally recovers input tax relating to exempt supplies in-year but then fails the test at year-end it is required to repay this input tax to HMRC. This could mean a big payment on the VAT return when the annual adjustment calculation is made.
If a business thinks that it is likely to fail the test at year-end and repaying the input tax would cause it difficulties, then it would not be advisable for it to take up the option of the annual test.
In Year Provisional Recovery Rate
A business can use its previous year’s recovery percentage to determine the provisional recovery of residual input tax in each VAT return for the following year. Again, the business is still required to carry out an annual adjustment. The finalised annual recovery percentage can then be used as the provisional recovery percentage for the next year and so on.
For example, a business has a partial exemption tax year that runs from 1 April to 31 March. For the year ending 31 March 2017, its annual recovery percentage was 60 per cent. For its VAT returns in the tax year commencing 1 April 2017 it may now provisionally recover 60 per cent of its residual input tax, thereby saving the need to calculate separate recovery percentages for each return. At the end of the year it must perform an annual adjustment calculation in the normal way, using actual figures for the year, to account for any under or over-recovery of input tax.
The rules enable a new partly exempt business to recover input tax on the basis of ‘use’ in the following circumstances:
- during its registration period – i.e. from the date when it first became VAT registered to either 31 March, 30 April or 31 May, depending on when it completes its VAT returns;
- during its first tax year – normally the first period of 12 months commencing on 1 April, 1 May or 1 June following the end of the registration period (except that this concession only applies if the business did not incur any exempt input tax during its registration period); and
- during any tax year – provided it did not incur any exempt input tax in its previous tax year.
The principle of ‘use’ means that input tax recovery is based on how an expense will be used in the future rather the percentage of taxable income generated in the period when it is incurred.
For example, a business registered for VAT on 15 July 2016 and its registration period ends on 31 March 2017. During this period, it incurred input tax of £50,000 on setting up costs. To secure funding it drew up a three-year business plan. The costs relate to future income that is both taxable and exempt. The input tax is therefore classified as residual. According to the business plan it is anticipated that its taxable income will be 70 per cent of total income in its first three years of trading and so the business can provisionally recover a total of 70 per cent of the residual input tax (£35,000) in the VAT returns that fall within the registration period. The business would still be required to perform its first annual adjustment on the basis of use to finalise the calculation. However, this will only alter its input tax recovery if the use or intended use of costs has changed by that time. For simplicity, if we assume that in this example there are no significant changes, the finalised amount of recoverable input tax would be £35,000 and so the annual adjustment would be nil.
When advising clients for VAT purposes it is important to consider all of the activities of the business including any secondary activities or incidental supplies. If exempt supplies are made ensure that partial exemption calculations are carried out, taking advantage of the simplification measures where appropriate.
If you have a client that is partially exempt and you need support or advice, or if you have a more complex issue, why not contact the VAT advice line today! Our consultants have a wealth of knowledge on partial exemption and making them perfectly placed to advise you.
For more complex issues, we can offer written advice at £180.00 per hour