Partial exemption for VAT: how much input tax can you reclaim?

VAT you pay on costs is only recoverable to the extent it relates to making taxable supplies. A business whose sales are all standard-rated, reduced-rated or zero-rated recovers everything. A business whose sales are all exempt recovers nothing. Partial exemption is the set of rules for the many businesses in between: landlords with commercial and residential lets, dental practices offering cosmetic treatments, financial advisers, schools with a trading arm, and charities.

Which businesses are partly exempt

You are partly exempt if you make both taxable and exempt supplies. Common exempt supplies include:

• residential lettings, and commercial lettings where the landlord has not opted to tax
• insurance, and many financial services such as lending and arranging finance
• education and training by eligible bodies
• health and medical care by registered professionals
• betting, gaming and lotteries

If you only make exempt supplies, you cannot register for VAT at all, and none of these rules apply.

Step one: direct attribution

Sort the VAT on your costs (input tax) into three groups:

Attribution follows how a cost is actually used, or intended to be used, not where it is booked in the accounts.

Step two: the standard method for residual VAT

Unless HMRC has approved a special method, residual input tax is apportioned using the standard method:

Recoverable percentage = value of taxable supplies ÷ value of all supplies (both excluding VAT)

The percentage is rounded up to the next whole number, provided your residual input tax is no more than £400,000 a month on average. Above that, it is rounded to two decimal places. Some items are left out of the calculation, such as sales of capital assets and incidental financial transactions.

Worked example

A dental practice’s annual figures, excluding VAT:

• cosmetic treatments (standard-rated): £120,000
• NHS and private clinical treatments (exempt): £380,000
• input tax on whitening kits and cosmetic materials: £6,000
• input tax on clinical materials: £9,000
• residual input tax on rent, equipment and overheads: £18,000

Exempt input tax of £22,680 a year is well above the de minimis limit, so the practice recovers £10,320 and the rest is a cost.

The de minimis rule

If the VAT relating to exempt supplies is small, you can treat yourself as fully taxable and recover it all. You are de minimis if exempt input tax is:

• no more than £625 a month on average (£7,500 a year), and
• no more than half of your total input tax

The simplified tests

Since April 2010 you can check de minimis status with either of two simpler tests, based on your figures for the period:

• Test 1: total input tax is no more than £625 a month on average, and the value of exempt supplies is no more than 50% of all supplies.
• Test 2: total input tax, less input tax directly attributable to taxable supplies, is no more than £625 a month on average, and the value of exempt supplies is no more than 50% of all supplies.

If you pass either test you can recover all your input tax for the period without further calculation. If you fail both, do the full partial exemption calculation, as you may still be de minimis under the original test.

The annual adjustment

Partial exemption is calculated return by return during the year, but the figures for individual quarters can be distorted by timing. At the end of your partial exemption year, usually ending in March, April or May depending on your VAT periods, you recalculate using the figures for the whole year. The difference between the annual result and the total of the quarterly results is adjusted on a later return, normally the first return of the next year.

You can also choose to use the previous year’s recovery percentage provisionally during the year, then correct it in the annual adjustment. This makes quarterly returns simpler.

Special methods

If the standard method does not give a fair result, for example where a large exempt sale distorts the ratio or a business has very different activities, you can apply to HMRC for a special method. Examples include apportioning by floor area, staff time, number of transactions or a sectoral split. A special method must be approved in writing before you use it.

Even under the standard method, a standard method override can apply: if the standard method result differs substantially from actual use (by more than £50,000, or by more than £25,000 and 50% of the residual input tax), you must adjust to reflect use.

Capital items

If you buy land or buildings costing £250,000 or more, or computers, aircraft or ships costing £50,000 or more (all excluding VAT), the capital goods scheme adjusts the recovery over several years if the taxable use changes. This is common for landlords who change between opted and exempt lettings. See VAT on property.

Partial exemption and the Flat Rate Scheme

Businesses on the Flat Rate Scheme do not do partial exemption calculations, because they do not recover input tax in the normal way. Their exempt income is included in their flat rate turnover instead.

Frequently asked questions

What is the VAT de minimis limit for partial exemption?

Exempt input tax of no more than £625 a month on average, and no more than half of all input tax. If you are within both limits you can reclaim all your input tax.

How is residual input tax apportioned?

Under the standard method, by the ratio of taxable supplies to total supplies, excluding VAT, rounded up to the next whole percentage for most businesses.

When is the partial exemption annual adjustment made?

After the end of your partial exemption year, usually on the first VAT return of the following year, using the full year’s figures.

Can I use a different apportionment method?

Yes, if HMRC approves a special method in writing. You cannot use one without approval.