Businesses that make taxable and exempt supplies are referred to as partly exempt, which means that they’re unable to recover all the input tax they have been charged.
When making a calculation for VAT recovery, these businesses can either operate the standard method or can agree a special method with HMRC known as a partial exemption special method (PESM).
VAT recovery: the basic principles
UK VAT registered businesses can recover VAT that relates to:
- taxable supplies;
- supplies that would be taxable if they were made in the UK (“foreign supplies”); and
- certain supplies that would be exempt if they were made in the UK (“specified supplies”).
These supplies all carry what is known as the right to deduct.
Input tax cannot be recovered on non-business activities, exempt supplies and supplies that would be exempt if made in the UK (subject to the exception above). It is important to identify these revenue streams and allocate the costs according to one of the partial exemption methods explained below.
Regardless, certain types of input tax will always be blocked. Examples include cars in certain situations and business entertainment, subject to some specific exceptions.
Attribution, apportionment and adjustment
There are three steps in any partial exemption calculation: direct attribution; apportionment; and adjustment.
Direct attribution
Direct attribution is the identification of the costs that are wholly used (or to be used) in either making taxable supplies or wholly used (or to be used) in making exempt supplies. Attribution requires a direct and immediate link between the costs and the relevant supplies, and has been the subject of significant litigation.
The input tax incurred on the cost components of taxable supplies can be recovered in full. That incurred in making exempt supplies cannot.
Apportionment
The second step is the apportionment of residual input tax used for both taxable and exempt supplies. Residual input tax is the tax that has not been attributed directly in the first step.
The treatment of residual input tax depends on the partial exemption method used. The method must produce a result which:
- reflects the usage for taxable supplies;
- can be administered without undue complexity by the taxpayer; and
- can be reviewed simply by HMRC.
Such a method is described as “fair and reasonable”.
Where a partial exemption calculation does not accurately reflect the use of the input tax in making taxable supplies, an override may apply (explained below). If the override is applying on a regular basis, then agreeing a PESM with HMRC may be appropriate.
Adjustment
The third step in calculating how much input tax you can recover is completing an annual adjustment. The input tax claimed each tax period is provisional, and it is reviewed at the end of the longer period. This is because each VAT return period can be affected by factors such as seasonal variations or a mismatch between inputs and outputs.
The adjustment also requires the business to reconsider the use of goods and services over the longer period, i.e. to assess whether input tax had been attributed to taxable supplies but it later transpires those inputs had been used in making exempt supplies. The annual adjustment also requires a re-evaluation of exempt input tax under the ‘de minimis’ rules, explained below.
Standard method calculation
The standard method is used to calculate how much residual input tax is attributable to taxable supplies and therefore recoverable. It is generally appropriate for most smaller businesses to use the standard method.
Value of taxable supplies in the period (excluding VAT) ÷ total value of supplies in the period (excluding VAT) × 100 = recoverable percentage of residual input tax
However, there are specific transactions that are excluded from the calculation as they can be distortive.
The recoverable percentages under the standard method must be rounded up to the next whole number unless it exceeds £400,000 residual input tax that is acquired each month. In these circumstances, you must round to 2 decimal places.
Additionally, it is essential that a business record the total exempt input tax to calculate whether it is within the de minimis limits. In order to calculate the total that can be recovered, your directly attributable costs and residual input tax related to exempt supplies should be totalled.
Override
The standard method is subject to the standard method override. This requires the business to compare the amount of input tax recovery using the standard method, against the amount that would be recovered applying a specific calculation on the basis of the use or intended use of purchases.
Where this calculation results in a substantial difference – for which there are set thresholds – then the override will apply. If a business is using the override on a regular basis, it may be more appropriate to apply for a special method.
Special methods
A taxable person may apply to HMRC to use a special method if it considers that the standard method does not provide a fair and reasonable result. HMRC requires specific details of how the proposed method will practically play out and is prepared to discuss proposals before a formal application is submitted. HMRC will approve a special method if it is fair and reasonable.
There are advantages to using a special method as it allows individual apportionment metrics to be used based on output values such as floor area. If HMRC identifies an issue, it may give notice and direct a business to use a specific method or to stop using an existing special method until a replacement method is implemented. Where a business has identified that its special method is not producing a fair and reasonable result, it may submit a special method override notice.
A special method has a 'gap' if it fails to identify how to deal with an amount of residual input tax. This could occur if the method has been poorly drafted or the taxable entity’s situation has changed after the method has been approved. Consequently, a revised or newly developed proposal may need to be considered to address the gaps.
Record keeping
In addition to the standard VAT records required, HMRC also require partially exempt businesses to maintain sufficient records to work out the amount of input tax they can recover in each tax period and in each tax year. Any other relevant record used to calculate recoverable input tax must also be maintained.
HMRC considers that partial exemption calculations do not need to be completed within functional compatible software for the purposes of the Making Tax Digital requirements for VAT. This is helpful as relatively few off-the-shelf accounting packages can handle partial exemption calculations.
Errors
Where an error has occurred then this needs to be corrected in the usual way for VAT errors. This may require disclosure to HMRC via an error correction notification or can in some instances be corrected in the next VAT return dependent on the nature and size of the error.
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