VAT: The Partial Exemption Annual Adjustment

By Marcus Ward 4 December 2023

What is the annual adjustment? Why is it required?

An annual adjustment is a method used by a business to determine how much input tax it may reclaim.

Even though a partly exempt business must undertake a partial exemption calculation each quarter or month, once a year it will have to make an annual adjustment as well.

An annual adjustment is needed because each tax period can be affected by factors such as seasonal variations either in the value supplies made or in the amount of input tax incurred.

The adjustment has two purposes:

to reconsider the use of goods and services over the longer period; and
to re-evaluate exempt input tax under the de minimis rules.

An explanation of the Value Added Tax Partial Exemption rules is available here

Throughout the year

When a business makes exempt supplies it will be carrying out a partial exemption calculation at the end of each VAT period. Some periods it may be within the de minimis limits and, therefore, able to claim back all of its VAT and in others there may be some restriction in the amount of VAT that can be reclaimed. Once a year the business will also have to recalculate the figures to see if it has claimed back too much or too little VAT overall. This is known as the partial exemption annual adjustment. Legally, the quarterly/monthly partial exemption calculations are only provisional, and do not crystallise the final VAT liability. That is done via the annual adjustment.

The first stage in the process of recovering input tax is to directly attribute the costs associated with making taxable and exempt supplies as far as possible. The VAT associated with making taxable supplies can be recovered in the normal way while there is no automatic right of deduction for any VAT attributable to making exempt supplies.

The balance of the input tax cannot normally be directly attributed, and so will be the subject of the partial exemption calculation. This will include general overheads such as heating, lighting and telephone and also items such as building maintenance and refurbishments.

The calculation

Using the partial exemption standard method the calculation is based on the formula:

Total taxable supplies (excluding VAT) / Total taxable (excluding VAT) and exempt supplies x 100 = %

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.

Once a year

Depending on a businesses’ VAT return quarters, its partial exemption year ends in either March, April, or May. The business has to recalculate the figures during the VAT period following the end of its partial exemption year and any adjustment goes on the return for that period. So, the adjustment will appear on the returns ending in either June, July, or August. If a business is newly registered for VAT its partial exemption “year” runs from when it is first registered to either March, April or May depending on its quarter ends.

Special methods

The majority of businesses use what is known as “the standard method”. However, use of the standard method is not mandatory and a business can use a “special method” that suits a business’ activities better. Any special method has to be “fair and reasonable” and it has to be agreed with HMRC in advance. When using a special method no rounding of the percentage is permitted and it has to be applied to two decimal places.

Commonly used special methods include those based on staff numbers, floor space, purchases or transaction counts, or a combination of these or other methods.

However, even if a business uses a special method it will still have to undertake an annual adjustment calculation once a year using its agreed special method.

De minimis limits

If a business incurs exempt input tax within certain limits it can be treated as fully taxable and all of its VAT can be recovered. If it exceeds these limits none of its exempt input tax can be recovered. The limits are:

£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)

The partial exemption annual adjustments are not errors and so do not have to be disclosed under the voluntary disclosure procedure. They are just another entry for the VAT return to be made in the appropriate VAT period.

Conclusion

If a business fails to carry out its partial exemption annual adjustment it may be losing out on some input VAT that it could have claimed. Conversely, it may also show that it has over-claimed input tax. When an HMRC inspector comes to visit he will check that a business has completed the annual adjustment. If it hasn’t, and this has resulted in an over-claim of input VAT, (s)he will assess for the error, charge interest, and if appropriate, raise a penalty. It is fair to say that partly exempt businesses tend to receive more inspections than fully taxable businesses.

VAT: Partial exemption – updated HMRC guidance

By Marcus Ward 17 October 2023

HMRC has published updated partial exemption guidance in Manual PE21500.

The main changes are in respect of updated case law, including the Royal Opera House Court of Appeal case dealing with the attribution of input tax.

In that case the CoA considered: the test of direct and immediate link, economic necessity, business/non-business, and chains of transactions.

VAT: HMRC partial exemption guidance updated

By Marcus Ward 18 September 2023

VAT Notice 706 has been updated on 14 September 2023 and the option to send an email to get an approval for a partial exemption special method has been removed from sections 6.2, Appendix 2 and how to apply.

Para 6.2 – “Get approval for a special method

You cannot change your method without our prior approval. You must continue to use your current method, whether that is the standard method or a special method, until we approve or direct the use of another method or direct termination of its use.

You can get approval for a special method by using the online service.

If you are unable to use the online service, contact VAT Written Enquiries team by post.

You must explain clearly how your proposed method will work, you should see Appendix 2 in this guide.

When you propose a special method you must include a declaration that the method is fair from its effective date of application, and for the foreseeable future so that from its effective date a fair amount of input tax is recovered”.

Examples of special methods (PESM) are:

sectors and sub-sectors
multi pot
time spent
headcount
values
number of transactions
floor space
cost accounting system
pro-rata
combinations of the above methods

Partial Exemption guidance here

VAT: Insurance partial exemption

By Marcus Ward 24 January 2023

HMRC has issued new guidance for the insurance sector. It will be relevant to those dealing with partial exemption for insurers, including business and HMRC when discussing how partial exemption applies in practice for an insurer.

The guidance is intended to help insurers agree a fair and reasonable partial exemption special method (PESM) with the minimum of cost and delay. It also helpfully sets out definitions of various insurance/reinsurance transactions and business structures.

Background

Insurance businesses usually make a mixture of exempt and taxable supplies and may also provide specified services to customers located outside of the UK which incur a right to recover input tax.

When determining how to calculate the recoverable elements of input tax, the starting point is with the standard partial exemption method, as defined within The VAT Regulations 1995, regulation 101, but this will rarely be suitable for the insurance sector.

Many insurance businesses are complex organisations that provide many different services of differing liabilities to customers, often in different countries, using costs form suppliers around the world in different proportions. In addition, certain costs may have little relation to the value of the supplies for which they are incurred.

Therefore, most insurance businesses will need to apply to HMRC for approval to use a PESM.

Fair and reasonable

Partial exemption is the set of rules for determining recoverable input tax on costs which are used, or intended to be used, in making taxable supplies which carry a right of deduction. The first step is usually allocating costs which are directly attributable to taxable or exempt supplies. The balance (overhead input tax, or “the pot”) is required to be apportioned by either a standard method (The “standard method” requires a comparison between the value of taxable and exempt supplies made by the business) or a PESM.

A PESM needs be fair and reasonable, namely:

robust, in that it can cope with reasonably foreseeable changes in business
unambiguous, in that it can deal, definitively with all input tax likely to be incurred
operable, in that the business can apply it without undue difficulty
auditable, in that HMRC can check it without undue difficulty
fair, in that it reflects the economic use of costs in making taxable and exempt supplies

HMRC will only agree the use of a PESM if a business declares that it has taken reasonable steps to ensure the method is fair and reasonable. HMRC cannot confirm that a special method is fair and reasonable but will make enquiries based on an assessment of risk and will never knowingly approve an unfair or unreasonable special method.

Attribution of input tax

In the insurance sector, relatively few costs are either used wholly to make taxable or exempt supplies.

The VAT regulations (see above) require direct attribution to be carried out before cost allocation to sectors. However, direct attribution at this stage can cause difficulties where tax departments are unaware of how particular costs are used and have a large number of such costs to review.

It has therefore been agreed between HMRC and the Association of British Insurers that, whilst direct attribution must still take place, it need not always be the first step, and could, for some costs, follow the allocation stage. Methods could refer to direct attribution both pre- and post-allocation, so that costs are dealt with in the most appropriate way. The underlying principle is that the method must be both fair and reasonable.

Types of PESMs

The guidance gives the following examples of special methods:

sectors and sub-sectors
multi pot
time spent
headcount
values
number of transactions
floor space
cost accounting system
pro-rata
combinations of the above methods

with descriptions of each method.

VAT: Partial exemption de minimis relief

By Marcus Ward 17 October 2022

VAT Basics

The VAT a business incurs on running costs is called input tax. For most businesses this is reclaimed on VAT returns from HMRC if it relates to standard rated, reduced rated, zero rated or certain outside the scope sales that a business makes.

However, a business which makes exempt sales may not be in a position to recover all of the input tax which it incurred. This is because input tax which relates to exempt supplies is generally irrecoverable.

This may affect any business which is involved in:

Property letting and sales – generally all types of supply of land
Financial services
Insurance
Betting, gaming and lotteries
Education
Health and welfare
Sport, sports competitions and physical education
Cultural services

(This list is not exhaustive)

A business in this position is called partly exempt. (If a business is fully exempt, it can neither VAT register nor recover any VAT at all). Input tax which directly relates to exempt supplies is irrecoverable. In addition, an element of that business’ general overheads, eg; light, heat, telephone, computers, professional fees, etc are deemed to be, in part, attributable to exempt supplies and a calculation must be performed to establish the element which falls to be irrecoverable. Such apportionment is called a partial exemption standard method. There are a number of alternative methods that may be used (so called “special methods”) but these must be agreed with HMRC.

De Minimis

There is, however, a relief available for a business in the form of de minimis limits. Broadly, if the total of the irrecoverable directly attributable (to exempt suppliers) and the element of overhead input tax which has been established using a partial exemption method falls below de minimis, all of that input tax may be recovered in the normal way.

The de minimis limit is currently £7,500 per annum of input tax. As a result, after carrying out the partial exemption method should the result fall below £7,500 and half of the total input tax for a year it is recoverable in full. This calculation is required on a quarterly basis (for businesses which render returns on a quarterly basis) with a review of the year, called an annual adjustment carried out at the end of a business’ partial exemption year. The quarterly

VAT: Partial Exemption -What Is It? What do I need to know?

By Marcus Ward 21 July 2021

VAT Basics

As part of our guides to VAT basics, we take a brief look at partial exemption and how it affects a business.

The first point to make is that partial exemption is often complex and costly. In some cases it may be avoided by planning and in others it is a fact of life for a business which needs to be managed properly.

Background

The VAT a business incurs on its expenditure is called input tax. For most businesses this is reclaimed from HMRC on VAT returns if it relates to standard rated or zero rated sales (referred to as “taxable supplies”) that that business makes. Exempt supplies are not to be confused with non-business income which are dealt with under a different regime.

However, a business which makes exempt sales may not be in a position to recover all of the input tax which it incurred. A business in this position is called partly exempt. Generally, any input tax which directly relates to exempt supplies is irrecoverable. In addition, an element of that business’ general overheads, e.g.; light, heat, telephone, computers, professional fees, etc are deemed to be in part attributable to exempt supplies and a calculation must be performed to establish the element which falls to be irrecoverable.

Input tax which falls within the overheads category must be apportioned according to a so called; partial exemption method. The “Standard Method” requires a comparison between the value of taxable and exempt supplies made by the business. The calculation is; the percentage of taxable supplies of all supplies multiplied by the input tax to be apportioned which gives the element of VAT input tax which may be recovered. Other partial exemption methods (so called Special Methods) are available by specific agreement with HMRC. A flowchart which illustrates the Standard Method of apportionment is below.

partial exemption flowchart1

Which businesses are affected?

Any business which receives income from the following sources may be affected by partial exemption:

Property letting and sales – generally all types of supply of land*
Financial services
Insurance
Betting, gaming and lotteries
Education
Health and welfare
Sport, sports competitions and physical education
Cultural services

This list is not exhaustive.

* Most businesses which do not routinely make exempt supplies usually encounter exemption in the area of land and property and it is an easy trap to fall into not to consider VAT when involved in property transactions. This is one area where VAT planning may be of assistance as it is possible in most situations to deliberately choose to add VAT to an exempt supply to avoid a loss of input tax. This is known as the option to tax, and it is considered in more detail here.

De Minimis relief

There is however relief available for a business in the form of de minimis limits. Broadly, if the total of the irrecoverable directly attributable (to exempt suppliers) and the element of overhead input tax which has been established using a partial exemption method falls to be de minimis, all of that input tax may be recovered in the normal way. The de minimis limit is currently £7,500 per annum of input tax and one half of all input tax for the year.

As a result, after using the partial exemption method, should the input tax fall below £7,500 (£625 per month) and 50% of all input tax for a year it is recoverable in full. This calculation is required every quarter (for businesses which render returns on a quarterly basis) with a review at the year end, called an annual adjustment carried out at the end of a business’ partial exemption year. The quarterly de minimis is consequently £1,875 of exempt input tax which represents spending of under £10,000 net; not a huge amount.

Should the de minimis limits be breached, all input tax relating to exempt supplies is irrecoverable.

The value for the de minimis limit has been in place for over 25 years (when it was increased by a huge £25 per month) and it is rather ridiculous that it has not been increased to reflect inflation. This, coupled with the fact that the VAT rate has increased significantly means that the relief which was once very useful for a business has withered away to such an extent that partial exemption catches even very small businesses which I am sure goes against the original purpose of the relief.

In summary – for a business exemption is a burden not a relief. It represents a real cost in terms of tax payable, time and other resources, in addition to uncertainty. We often find that this is an area which HMRC examine closely and one which benefits from proactive negotiation with HMRC.

VAT Glossary – Partial Exemption

By Marcus Ward 9 July 2019

The VAT world of partial exemption can be complex with some arcane language used in guidance. Here is your “cut out and keep” guide:

A general guide to partial exemption here.

VAT Glossary Partial Exemption
Term	Explanation
Allocation	Some special methods have different sectors where the recoverable element of residual input tax is different. Allocation is the means by which residual input tax is distributed to specific sectors within a method.
Annual adjustment	At the end of the tax year the partial exemption calculation is recalculated using annual figures.
Apportionment	Residual input tax must be apportioned to reflect the extent to which the purchases on which it is incurred are used in making onward taxable supplies. The partial exemption method carries out this function.
De minimis tests	Tests designed to allow recovery of minimal amounts of exempt input tax.
Direct attribution	The identification of input tax on supplies that are wholly used, or to be wholly used in making taxable supplies or are wholly used or to be wholly used in making exempt supplies.
Exempt input tax	Input tax incurred on purchases which are used or to be used in making exempt supplies. It comprises input tax directly attributable to exempt supplies and, after the partial exemption method has been applied, the exempt element of residual input tax identified by the partial exemption method.
Exempt supplies	Supplies made by a business, which are listed in Schedule 9 of the VAT Act 1994. VAT incurred in making exempt supplies is non-recoverable, unless they are ‘specified’ supplies, subject to the de minimis test.
Input tax	VAT incurred by a VAT registered person on goods and services purchased for the purposes of a business.
Longer period	This is usually the tax year for annual adjustment purposes but may in certain circumstances be shorter than a tax year. It may also be longer in the case of a mid-year stagger change.
Foreign supplies	Supplies made by a business which are made outside the UK but which would be taxable if they were made in the UK.
Residual input tax	Input tax which is used, or to be used, to make both taxable and exempt supplies. It is apportioned between taxable and exempt supplies by the partial exemption method. Residual input tax is commonly referred to as ‘non-attributable input tax’ or ‘the pot’.
Special method	Any partial exemption method, other than the standard method, used to identify the taxable element of input tax incurred. Special methods require prior approval from HMRC.
Specified supplies	Supplies specified by Treasury Order which are not taxable supplies, but which carry the right to recover input tax incurred in making them.
Standard method	This is the default partial exemption method. It is specified in law and is suitable for most smaller businesses.
Taxable input tax	Input tax incurred on purchases of goods and services which are used or to be used in making taxable supplies and other supplies which carry the ‘right to deduct’.
Taxable supplies	Supplies made by a business, which are either standard, reduced or zero-rated. Input tax incurred in making taxable supplies is deductible.
Tax year	Every VAT registered business has a tax year. This usually ends at the end of March, April or May each year, depending on the business’s VAT return periods.
VAT Groups	Two or more corporate bodies accounting for VAT under a single VAT registration number. One acts as representative member and any supplies between the members of the group are disregarded for VAT purposes.

Any business which receives income from the following sources may be affected by partial exemption:

Property letting and sales – potentially all types of supply of land
Financial services
Insurance
Betting, gaming and lotteries
Education
Health and welfare
Sport, sports competitions and physical education
Cultural services

This list is not exhaustive.

If your, or your client’s business is partially exempt I always recommend a review.

VAT: Partial exemption, the N Brown case

By Marcus Ward 18 March 2019

Latest from the courts.

Partial exemption has always been, and probably always will be, the most complex and oft debated area of the tax.

Attribution

In the First Tier Tribunal (FTT) case of N Brown Group plc the issue was how to attribute input tax incurred on marketing. This included:

online
catalogues and leaflets
parcel packs
inserts in magazines and newspapers
direct mailings
advertisements in publications
TV advertisements
telemarketing
brand development
PR
celebrity endorsements
market research
photo shoots

Background

N Brown, as you may know, sells clothing and household goods online to the public. It has only a few retail stores so does not have the facility that a “bricks and mortar” retailer would have of displaying goods in its stores. It therefore has to incur significant marketing costs to bring its products to the attention of its customers and present them in an attractive way that encourages sales. The activities of the appellant include the sale of these goods, which is standard-rated for VAT purposes, and the provision of finance, which is exempt for VAT purposes. The finance element is the provision of credit which produces significant income from the interest on monthly balances which consumers do not pay off.

Issue

The issue was whether the input tax incurred on the marketing was attributable to the sale of goods which were advertised or, as HMRC contended; to both its taxable and exempt income (so that it was residual). If HMRC were correct an element of the input tax would fall to be irrecoverable via the appellants’ partial exemption calculation. HMRC’s position was that the input tax which N Brown incurred in respect of the marketing is residual because, although they did not seek to deny the existence of a “direct and immediate link” between the relevant goods and services and taxable supplies that the appellant made, they consider that there is also a direct and immediate link to the exempt credit provided.

Unsurprisingly, N Brown’s position was that the vast majority of goods and services received in connection with the marketing had a “direct and immediate link” only with taxable supplies that it made and so the relevant input tax was not residual and is therefore recoverable in full.

A subtle distinction, however, as £42 million of VAT was at stake, quite a vital one!

Technical

A general guide to partial exemption is available here

Broadly, a partially exempt business is required to attribute input tax incurred to three categories:

Taxable activities (here, the sale of goods) fully recoverable
Exempt activities (here the provision of credit) not recoverable
Non-attributable (residual) – input tax attributable to both taxable and exempt activities, or neither. This input tax must be apportioned either by the “standard method” or special method agreed with HMRC.

Decision

The judge found that there was a two-way relationship between the sale of the goods and the provision of credit terms. As a consequence, the input tax fell into the category of non-attributable (residual) even if the relevant advertisements made no mention of credit at all. It was also found that the standard method (used by HMRC) did not produce a reasonable outcome so the assessment issued by HMRC would need adjustment in the taxpayer’s favour. This required a different method to be devised and that certain elements of exempt income could be ignored in the calculation. I suspect that negotiations on an agreeable method might take some time…

Commentary

This case demonstrates that care is always required when costs are attributed to a business’ activities. This is especially important when the costs are significant. There tends to be a lot of “debate” with HMRC on such matters and slight nuances can affect attribution and thus the outcome of the calculation. It is an area which always requires specialised advice.

VAT – The Partial Exemption Annual Adjustment

By Marcus Ward 8 May 2018

What is the annual adjustment? Why is it required?

An annual adjustment is a method used by a business to determine how much input tax it may reclaim.

Even though a partly exempt business must undertake a partial exemption calculation each quarter or month, once a year it will have to make an annual adjustment as well.

An annual adjustment is needed because each tax period can be affected by factors such as seasonal variations either in the value supplies made or in the amount of input tax incurred.

The adjustment has two purposes:

to reconsider the use of goods and services over the longer period; and
to re-evaluate exempt input tax under the de minimis rules.

A MWCL explanation of the Value Added Tax Partial Exemption rules is available here

Throughout the year

The calculation

Using the partial exemption standard method the calculation is based on the formula:

Total taxable supplies (excluding VAT) / Total taxable (excluding VAT) and exempt supplies x 100 = %

Once a year

Special methods

Commonly used special methods include those based on staff numbers, floor space, purchases or transaction counts, or a combination of these or other methods.

However, even if a business uses a special method it will still have to undertake an annual adjustment calculation once a year using its agreed special method.

De minimis limits

£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)

Conclusion

VAT: Latest from the courts – partial exemption attribution

By Marcus Ward 4 October 2017

In court about courts…

In the First Tier tribunal (FTT) case of The Queen’s Club Limited the issue was whether certain input tax was attributable to the company’s taxable activities or, as HMRC contended; to both its taxable and exempt income (so that it was residual). If HMRC were correct an element of the input tax would fall to be irrecoverable via the appellants’ partial exemption calculation. A brief guide to partial exemption here

Background

The Queen’s Club (The Club) is a well-known members’ tennis club in West London. The Club’s tennis facilities are world-class and each year the Lawn Tennis Association hires the Club’s courts to put on the Aegon Championship which is a precursor to the Wimbledon tournament and attracts many of the world’s leading players. It makes exempt supplies of sporting services to its members and also makes taxable supplies of food and drink in its bars and restaurants. It incurred VAT on the costs of refurbishing the bars, restaurant and café facilities on its premises. The Club considers that it is entitled to a full credit for input tax on those expenses as they were wholly attributable to the taxable supply of catering.

The Club’s revenue comes primarily from the membership fees that it charges. For the year 2012-13 the annual membership fee was £1820. By becoming a member of the Club, a person obtains the right to use both its sporting and non-sporting (catering) facilities. It was decided by the FTT that the Club had a discretion, but not an obligation, to provide the café etc to its members, however it was accepted that most members do not use the social facilities. It was agreed that the membership fee was consideration for an exempt supply of services closely linked with sport for the purposes of Value Added Tax Act 1994, Schedule 9, item 10. The Club also receives five main sources of taxable income:

Fees from the LTA to use its courts for the Aegon Championship
Sales of food and drink from restaurant and bars
Sales of sporting and other goods
Provision of the use of the restaurant and bars, usually with catering
Rental income for certain other rooms

The decision

There was no dispute that there was a direct and immediate link between the refurbishment of the restaurant and bars and taxable supplies made from them. The question that divided the parties was whether there was also a direct and immediate link between the refurbishment the exempt membership supplies.

The judge decided that “In short, viewed objectively, what members obtain when they join the Club is a right of access to world-class sporting facilities together with such additional facilities as the Club decides, in its discretion, to offer. The focus is on the sporting facilities…” and that, viewed objectively, the renovated bars and restaurant are a means by which members are able enjoy the Club’s sporting offering. The overall conclusion was that there was no direct and immediate link between the renovation goods and services and exempt supplies that the Club made.

The decision was that the Club was entitled to credit for the full amount of input tax that it incurred.

Commentary

This case demonstrates that care is always required when costs are attributed to a business’ activities. This is especially important when the costs are significant; particularly when they are incurred on land and property. There tends to be a lot of “debate” with HMRC on such matters and slight nuances can affect attribution. These type of costs are often covered by the Capital Goods Scheme, so care must be taken over a ten year period which adds to the complexity. As always, when considering land and property transactions it pays to obtain professional advice as mistakes are costly. A brief guide to land and property issues here