Melanie Lord explains why the VAT exemption really isn’t as good as it might sound.
So my client says: “We are really lucky, a lot of our sales are exempt.”
My heart sinks as I say: “But making exempt supplies can be really bad news as your VAT claims might be blocked.”
My client says “What? You’re kidding me, right?”
I say – in a sad voice – “No, I’m afraid I’m not.”
And POP! went his balloon…
So here’s why VAT exemption isn’t anywhere near as good as it sounds.
VAT is based on the foundation of some good old-fashioned adages, including ‘guilty until proven innocent’ and ‘you can’t have your cake and ha’penny’. In practice this translates into:
- VAT relief is very narrowly applied so a supply is VATable unless it squarely falls within a VAT exemption or zero-rating, and
- If you don’t charge VAT because your sale is exempt, then you can’t reclaim VAT on the related costs.
Both are equitable concepts but can prove very costly, especially where someone doesn’t realise there’s a quid pro quo cost attaching to sales being VAT exempt.
What can be exempt?
The relief covers some (not all) supplies associated with:
- Insurance, finance, investment gold and credit.
- Health and welfare.
- Education and training.
- Land and buildings (although this might be waived on commercial).
- Betting and gaming.
- Burial and cremation.
- Various miscellaneous categories including fundraising events by charities; cultural services; subscriptions to membership organisations; postal services; sport; cost-sharing groups and works of art.
The first step should always be to critically review the scope of the relief by reference to the wording in the legislation. Once you are happy that supplies are properly exempt the second step is to decide how much input VAT can be claimed? This all rests on how costs are ‘used’. If costs are used directly in connection with exempt activities then the related input VAT recovery is at risk.
Also at risk is the exempt proportion of VAT on general business running costs (‘Pot VAT’), which should normally be split by reference to the percentage of VATable sales. The total of these two input VAT amounts is called ‘total exempt input VAT’ and, while potentially blocked from recovery, it might still be recoverable if it is below both of two tests, called the ‘de minimis’ limits.
Under the normal method input VAT can be reclaimed in full if exempt input VAT is below both 50% of the total input VAT incurred in the same period and £625 per month on average. If the total exempt input VAT is over either of these limits, then the exempt input VAT cannot be reclaimed for that particular return.
There is still a chance to recover exempt input VAT that failed the de minimis test in one period if the overall figures for a VAT year fall under the annual limits. Here, irrespective of the accounting year, the VAT year coincides with the VAT return cycle and ends in either March, April or May. The annual adjustment is a prescribed requirement and has to be carried out on the return following the VAT year, so it must be included in the return workings for the period ending June, July or August.
The annual adjustment re-runs the same calculation as run for each period return but uses the annual totals for all input VAT; Pot VAT; directly exempt input VAT; VATable sales and total sales. If the total exempt input VAT for the year is below both 50% of the total input VAT incurred in the VAT year and £7,500 for the year, then it can be claimed in full. If exempt input VAT has not been claimed for some of the periods included in the VAT year, this can then be reclaimed.
Conversely if the annual total is over either of the limits, then any claims made during the VAT year would be reversed and the exempt input VAT claims have to be repaid to HMRC.
In practice many businesses can use one of the simplified partial exemption tests that typically involve less input VAT analysis. The de minimis test is passed and all input VAT can be reclaimed in full if one of the following applies:
- If total input VAT incurred is less then £625 per month on average and the value of exempt supplies is less than 50% of the value of all supplies then
- If total input VAT less input VAT directly attributable to VATable supplies is not more than £625 per month on average and the value of exempt supplies is not more than 50% of the value of all supplies.
There are also two other simplifications that still required detailed input VAT categorisation but may benefit those who do not want to do quarterly calculations:
- Prior Year Percentage – The input VAT recovery percentage for the previous year can provisionally be used to calculate input VAT recovery on Pot VAT although a year end adjustment is still required as normal.
- An annual de minimis test can be applied where a business has passed the de minimis limit in the previous year and the total input VAT is not more than £1 million in the current year.
What to watch for
Over the years, many mistakes have been made in handling partial exemption, notably:
- Not knowing about or acting on the quid pro quo nature of VAT exemption and reclaiming all input VAT being incurred;
- Assuming that the annual £7,500 limit applies to a VAT year, whereas only a pro rata proportion of the de minimis limit is available – for example, where exempt supplies are first started to be made during the course of the VAT year;
- Treating all costs as falling in the overhead ‘Pot VAT’ category and applying the de minimis tests to the wrong value. This approach overlooks directly attributable exempt input VAT which pushes the value over the de minimis test and means VAT is over-claimed;
- Not recognising the flexibility in attribution available during the first year of registration when Pot VAT attribution can be based on ‘use’ in place of the standard ‘turnover’ method which can unnecessarily reduce available VAT claims;
- Using turnover to split Pot VAT where this does not reflect how the costs are actually used. Alternative special methods can be agreed with HMRC but must be looked after in advance leading to ongoing VAT losses, and
- Interaction with the Capital Goods Scheme, clawback and payback rules can also easily lead to declaring the wrong amounts of VAT.
Final words of caution
Partial exemption is one of the most notoriously difficult areas of VAT accounting and probably the one that is more misunderstood than any other. In theory it is easy to avoid having any problems with these rules but it does mean you have to think carefully about how the rules apply before you do anything. As we always say – ‘sooner is always better’.
- Melanie Lord is a director of AVS VAT. Email email@example.com or call 01438 716176 if you need help with VAT