VAT - 13.05.2020

Partial exemption - improving your VAT recovery

Categorising VAT on purchases

VAT your business incurs on most types of purchase directly relating to VATable sales can be reclaimed in full. Conversely, VAT paid on expenses which directly relate to exempt sales can’t usually be reclaimed. For expenses in neither category, such as overheads like rent, phone, etc., the VAT is known as residual, and can only partly be reclaimed. There’s a standard formula for working this figure out, although you can apply to HMRC to use a special formula instead.

Note. The standard formula for reclaimable residual VAT is: residual VAT x VATable turnover/total turnover.

For detailed commentary on partial exemption formulas, visit http://tipsandadvice-tax.co.uk/download (TX 20.16.07).

Tip. If the total VAT directly relating to exempt supplies plus the proportion of residual VAT is less than the “de minimis limit”, the normal rule is overridden and all the VAT can be reclaimed. Exempt VAT is de minimis for a quarter if it’s no more than £1,875 and no more than 50% of the total VAT on purchases.

Example. Acom is a property developer and manager. For the VAT quarter ending 30 June 2020 it receives rent from letting residential properties (VAT exempt) of £18,000 and £22,000 (plus VAT) from commercial properties (standard-rated). In the same quarter Acom pays £1,800 VAT on expenses relating to letting the exempt properties, £800 relating to the standard-rated rent and £100 on overheads. Acom uses the standard formula to work out the purchase VAT (HMRC calls it input tax) on overheads etc. which must be added to the £1,800. The total is £1,845.

Acom meets the first condition of the de minimis test as its exempt VAT is less than £1,875 for the quarter. However, it fails the second. Because this is more than the de minimis limit Acom can only reclaim the £800 VAT relating to standard-rated rent.

Tip. HMRC allows use of two simplified de minimis formulas instead. These might allow VAT paid on all purchases to be reclaimed.

First simplified test. Total input tax for the quarter is less than £1,875 and exempt sales are less than 50% of total sales. Its exempt VAT is £1,845 for the June quarter and its exempt sales (rent) are less than 50% of total sales (£18,000 / £40,000 = 45%). If Acom uses this test instead of the normal one it could reclaim the VAT on all purchases, i.e. £2,700.

Second simplified test. This test requires total input tax less input tax relating to VATable supplies (£2,700 - £855) to be less than £1,875 for the quarter, and again for exempt sales to be less than 50% of total sales. Acom could also use this method to justify reclaiming all input tax for the June quarter.

Final reckoning. Remember that after the end of your VAT year you must apply the standard partial exemption formula (or a special one you’ve agreed with HMRC) to your input tax for the year as a whole. This might mean you have to repay VAT you’ve recovered using any of the de minimis calculations but at least you will have gained a cash-flow advantage in the meantime.