VAT partial exemption and the de minimis tests

Who is partly exempt

VAT Notice 706 defines a partly exempt business as one that makes, or intends to make, both taxable and exempt supplies and incurs VAT on costs which relate to both.

Input tax that relates only to exempt supplies cannot be recovered, unless the business is within the de minimis limits. Input tax relating to both kinds of supply is shared out by a partial exemption method.

The standard method

1. Directly attributable to taxable supplies

   Identify the input tax on costs used only for taxable supplies. It is recoverable in full (VAT Notice 706).

2. Directly attributable to exempt supplies

   Identify the input tax on costs used only for exempt supplies. This is exempt input tax.

3. Residual input tax

   What is left, on overheads used for both, is residual input tax.

4. Work out the recovery percentage

   Divide the value of taxable supplies in the period by the value of all supplies, both excluding VAT, and multiply by 100. Leave out supplies of capital goods used in the business, incidental financial or real estate transactions, and self-supplies.

5. Round it

   Round the percentage up to the next whole number. A business with more than £400,000 of residual input tax a month on average rounds to 2 decimal places (VAT Notice 706).

6. Apply it

   Recover that percentage of the residual input tax. The rest is exempt input tax.

A worked example

For example, a quarter's figures are £6,000 of input tax on taxable costs, £1,500 on exempt costs and £4,000 of residual input tax. Taxable supplies are £300,000 and exempt supplies £110,000.

The fraction is £300,000 divided by £410,000, which is 73.17%, rounded up to 74% under VAT Notice 706. The business recovers £2,960 of the residual input tax (74% of £4,000), and £1,040 is exempt.

Exempt input tax for the quarter is £1,500 plus £1,040, which is £2,540. The de minimis limit for a quarter averages £625 a month, so £1,875. £2,540 is over that, so the business is not de minimis and recovers £6,000 plus £2,960, which is £8,960. The £2,540 is lost, subject to the annual adjustment.

The de minimis limits

A partly exempt business can be treated as fully taxable, and recover all its input tax, in any period where its exempt input tax is not more than £625 a month on average and not more than half of its total input tax (VAT Notice 706). Both conditions must be met.

The simplified tests

• Test one: total input tax is no more than £625 a month on average, and the value of exempt supplies is no more than 50% of the value of all supplies (VAT Notice 706).
• Test two: 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 the value of all supplies.
• A business that passes either test is treated as de minimis for the period without working through the full calculation.
• For example, with £3,000 of input tax on taxable costs, £300 on exempt costs and £800 residual, total input tax is £4,100. Less the £3,000 directly taxable, £1,100 remains, which is under £1,875 for the quarter. If exempt supplies are £20,000 of £200,000 in total, that is 10%. Test two is passed and all £4,100 is recovered.

The annual test

A business that passed the de minimis test for its previous partial exemption year may treat itself as de minimis for each return in the current year, without calculating each period. VAT Notice 706 requires it to apply this consistently for the whole year, to have reasonable grounds for not expecting more than £1 million of input tax, and to review its position at the year end.

The annual adjustment

Each period's calculation is provisional. At the end of the longer period, normally the VAT year ending 31 March, 30 April or 31 May depending on the client's return periods, the business redoes the calculation for the whole year and the de minimis test on annual figures (VAT Notice 706).

The difference between the year's result and the total of the quarterly results is the annual adjustment. It goes on the first return after the longer period ends, or the business may bring it forward to the last return of the longer period without telling HMRC.

A business may also use the previous year's recovery percentage for its provisional recovery in each period, then correct it in the annual adjustment (VAT Notice 706).

Special methods and the standard method override

A special method is any calculation other than the standard method. A business must not use one, or change one, without HMRC's written approval (VAT Notice 706).

Under the standard method override, a business using the standard method must adjust if the result differs substantially from the use of its costs. A difference is substantial if it exceeds £50,000, or 50% of the residual input tax and £25,000. The override applies only where residual input tax is more than £50,000 a year, or £25,000 a year for group undertakings that are not in the same VAT group.

Larger purchases of computers, land, buildings, aircraft and vessels fall under the Capital Goods Scheme, which adjusts recovery over up to 10 years (VAT Notice 706).

Questions