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Steve Allen, Director of VAT Solutions (UK) Ltd, describes the approach for partially exempt businesses when reclaiming input VAT. 

VAT recovery

There have been rumours that there has been a recent change that has made it more difficult to recover VAT.  This seems to be based on changes in the Budget to the authorisation process for partial exemption special methods.

So what exactly is partial exemption, and what is a special method? Input VAT cannot normally be recovered on the costs associated with making an exempt supply.  If you make a mixture of exempt supplies and taxable supplies, you are partially exempt.

The first stage in the process of recovering input VAT is to directly attribute the costs associated with making taxable and exempt supplies.  Any purchases directly attributed to making taxable supplies can be recovered in full.  The balance of the input VAT (light, heat and other general overheads) cannot normally be directly attributed, and so will be the subject of the partial exemption calculation.

Standard method 

Most businesses use what is known as the partial exemption ‘standard method’, which is laid down in the law (Regulation 101, SI 1995/2518). 

The calculation is based on the formula:

                                                          Total taxable supplies                   x 100 =    %
                                                 Total taxable and exempt supplies

This gives the percentage of non-attributable input VAT that can be recovered.  The figure calculated is always rounded up to the nearest whole percentage, so, for example, 49.1% becomes 50%. This percentage is then applied to the non-attributable input VAT to give the actual amount that can be recovered. 

The standard method does not always give a fair and reasonable result, so when that is the case, a business is allowed to negotiate a ‘special method’ with HMRC.  In theory, you can have any special method you like providing it gives a fair and reasonable result.  Before you use a special method, you have to have it agreed with HMRC first.

Common special methods use staff numbers, floor area, transaction counts, or purchases, but others can be used if appropriate to your business.

Proposed changes

In the Budget, the Government proposed a change to the method of authorising special methods, and put it out to a consultation which has now been completed.  The proposed change was to introduce a requirement for a business to declare that 'to the best of its knowledge and belief', its proposed partial exemption 'special method' is fair and reasonable before HMRC gives approval for its use. According to HMRC, the change means that they would no longer approve a special method without such a declaration from the business, and that, if subsequently, in their view, the business 'should have known' the method was not fair and reasonable, they would be entitled to set it aside and require the business to recalculate past returns using the standard method. 

There were some initial worries that an overzealous VAT Officer could cause havoc revoking previously agreed special methods and issuing large assessments as a result, but HMRC have assured us this is not the case.  If a visiting officer considers that an agreed special method is not fair and reasonable, he has to refer it to Headquarters for them to decide if the special method should be revoked, but HMRC think this is only likely to happen a few times a year.

The main advantage of this change is that it will speed up the time taken to approve special methods, which currently takes 6-9 months, to a more manageable couple of months.

Full recovery

The final thing to remember with partial exemption is that if your exempt input tax is below certain limits (known as de-minimis limits), you can recover it all anyway.  These limits are that the exempt input tax is less than:

• £625 per month on average (£1,875 per quarter or £7,500 per annum); and
  
• 50% of the total input VAT (the VAT on purchases relating to taxable supplies should always be greater than the VAT on exempt supplies to pass this test).

If you exceed either of these limits, you will not be able to recover any of your exempt input VAT.