When a business that is registered for VAT makes exempt supplies it will normally fall within the scope of partial exemption. This creates two problems:
output VAT cannot be charged on exempt supplies – sounds obvious but the business needs to make sure it knows exactly which of its sales/services are affected
input VAT associated with the exempt supplies cannot be reclaimed – again sounds very simple but in reality it may be difficult to identify which inputs are directly connected with the exempt sale.
What is an exempt supply? HMRC has published a lengthy list of goods and services showing which rates of VAT apply and which items are exempt or outside the scope of VAT. Businesses need to review this to ensure they are correct in what rate – if any – they charge on their supplies.
As an example of the complications a business might face, look at the differences below:
Sports and physical education is generally exempt subject to various conditions. HOWEVER, if you let facilities for playing any sport or for taking part in any physical recreation these supplies are normally standard-rated. BUT, if the rental is for more than 24 hours or is for a series of 10 or more sessions, subject to conditions, then your supply may be exempt.
Medical services provided by registered health professionals are normally exempt. HOWEVER, there is an official list of practitioners to whom this applies and this involves a ‘statutory register’. Therapists such as acupuncturists, psychotherapists, hypnotherapists and others who do not have statutory registers cannot currently exempt their services. BUT, some services performed by a doctor may be taxable or exempt. For example where a medical report is produced solely to provide a third party with a necessary element for taking a decision for insurance or legal purposes, the supply is taxable at the standard rate.
So the first hurdle of identifying exempt supplies may be harder than it first appears.
How is the claimable input VAT calculated? The second hurdle is working out what inputs can be claimed. There are three main steps to calculating how much input tax you can recover. These are:
direct attribution of input tax
apportionment of residual input tax
completion of an annual adjustment.
Option 1 is quite straightforward and simply involves identifying the amount of VAT incurred on purchases that are used, or intended to be used, exclusively in making taxable supplies. Remember that the opposite is also true and a business cannot recover the input tax directly attributable to exempt supplies. This option might help many businesses and the problem ends here.
Option 2 is more complicated. Residual input tax is input tax on purchases used to make both taxable and exempt supplies. For instance this could be because it is an expense used directly to make both taxable and exempt supplies or because it is an overhead of the business and thus cannot be directly attributed to either taxable or exempt supplies. The amount that can be recovered is worked out using a set calculation - full details from HMRC here. Businesses will need to perform this standard calculation each quarter and be aware of the anomalies such as capital goods and reverse charges which are not taken into account and also ‘overrides’ to the standard method.
Option 3 may suit businesses where the VAT periods are affected by factors such as seasonal variations either in the value of supplies made or in the amount of input tax incurred. Basically the input tax claimed in each period is only provisional. This is reviewed at the end of a longer period (which is normally a tax year). Any difference between the amount of recoverable input tax as a result of the longer period calculation and the total amount you have provisionally claimed on your VAT returns during the longer period is deemed to be annual adjustment. The calculations are again complex with more guidance at section 12 here.
The good news! If the above options do not fit a particular business then HMRC does allow what it calls a ‘special’ method to be used. A special method is any calculation, other than the standard method, that enables the business to calculate how much of the input tax is recoverable. This method is unique to the particular business circumstances. Written approval is needed from HMRC before it is used but it may be a more convenient way to calculate inputs where the established methods produce results which are not fair and reasonable.
More good news – the de minimis limit In most circumstances, where the business has exempt input tax which is ‘insignificant’ (judged by a de minimis limit) it can simply be treated as if it were taxable input tax and recovered in full. This de minimis limit is where the total value of your exempt input tax is not more than:
£625 per month on average; and
half of your total input tax in the relevant period.
The total value of exempt input tax is that which is directly attributable to exempt supplies plus the proportion of any residual input tax that is attributable to exempt supplies.
‘Total input tax’ excludes blocked input tax (such as VAT on the costs of business entertainment) which is irrecoverable. 'On average’ means the average over the tax period or longer period.
There is some ‘small print’ to go through (section 11 here) but use of these provisions could potentially enable the business to simplify its VAT calculations and also to claim back inputs which would normally not be allowed.
Of particular interest would be the scenario where a business has residential property income (exempt supply) and so would normally be unable to reclaim any input VAT.