An introductory guide to VAT Partial Exemption
Ryan Bevan 26 May 2016 No comments
VAT is consumption based tax and is designed to have a dual purpose – it is both incurred from vendors and suppliers of goods and services and also charged by taxable persons on its taxable supplies where applicable under the VAT legislation.
Consequently, there are two broad types of VAT – Input VAT which is incurred on purchases made by the business that are subject to VAT, and, Output VAT which is charged by a VAT registered business on its taxable supplies.
(N.B. this is assuming supplies made to and from taxable persons located in the same EU member state)
The almost simplistic and straight-forward example given above does not apply to certain businesses, particularly those that make either solely supplies that are VAT exempt or even some supplies that are exempt from VAT. In most instances, those businesses that make solely VAT exempt supplies are precluded from registering for VAT. This can have significant impacts upon the Output VAT charged (since there will be none) and the Input VAT recovered on its costs incurred.
As explained above, in some cases a business may supply goods or services which are exempt from VAT in addition to goods or services that are taxable and subject to VAT at either the standard, reduced, or zero rate. These businesses are known as ‘Partially Exempt’ and must follow some guidelines and rules which are associated with these sorts of businesses.
It is essential for ‘Partially Exempt’ businesses to ensure that they understand the rules and VAT liability of the types of goods or services that they are supplying to their customers. It is crucial that partially exempt businesses apply Output VAT to the taxable supplies and no Output VAT on their exempt supplies.
It is crucial for partially exempt businesses to apply VAT correctly for two main reasons; 1. So that the customer is not charged VAT where they should not have been, and thus that business is not reporting VAT on its VAT Return which should be due to HMRC, and 2. To work out the Partial Exemption Recovery percentage that is to be applied to the Input VAT to be reclaimed.
Following on from point 2 above, one of the main impacts of making VAT exempt supplies is the effect it has upon the input VAT incurred by that business. In theory, Input VAT is reclaimable on costs that are put in to use in the business, in the course of carrying on the business activities and is then 100% directly attributable to the making of a taxable supply. Of course, as the partially exempt business is making both taxable and exempt supplies, in principle the Input VAT that is associated with the making of the exempt supply should be reclaimable, as no associated Output VAT has been charged.
It follows that difficulties for partially exempt businesses arise when dealing with Input VAT that is incurred in association with the making of both exempt and taxable supplies. There is a set formula and method for apportionment this Input VAT as set out by HMRC in the UK (and other tax authorities in other EU member states) and is known as the Partial Exemption Standard Method which is based on the ratio of VAT exempt turnover compared to the total turnover of the business. This is called the ‘Standard’ method since it is used as a default – there are however different methods that are simply anything other than the ‘Standard’ method. These are known as ‘Partial Exemption Special Methods’ and must be agreed in writing by HMRC in the UK.
However, for the purpose of this example, we will analyse a partially exempt business under the Partial Exempt Standard Method.
The Partial Exemption Standard Method has a multi-step approach and at its heart is the breakdown of all Input VAT incurred on costs which are placed into one of three categories. This process is known as Direct Attribution’. The three categories are as follows;
- ‘100% Exempt Input VAT’: VAT relating to the making of 100% wholly exempt supplies
- ‘100% Fully Taxable Input VAT’: VAT relating to the making of 100% wholly taxable supplies
- ‘Residual Input VAT’: VAT that is associated to the making of both taxable & exempt supplies
In the process of direct attribution of input VAT, the VAT that is 100% and entirely associated with the making of exempt supplies (1) cannot be recovered at all. Input VAT on costs incurred that relate entirely to the making of ‘taxable’ supplies (2) can be fully recovered. The ‘Residual’ Input VAT – i.e. the VAT leftover and that cannot be fit into either category, however requires more apportionment under the standard method formula.
The standard method formula used to apportion the residual Input VAT is to find the value of the total supplies (i.e. all sales made that are taxable and exempt) that the business makes and calculate the percentage of exempt supplies to total supplies. This is known as the Recovery percentage. The recovery percentage is then applied to the amount of residual Input VAT which is added to the amount of Input VAT already being restricted in the 100% exempt supplies category.
An example of working out a partial exemption recovery percentage and the partial exemption position is demonstrated below. Please click the image to see the exmaple in full screen.
Please note that if the total exempt Input VAT is below £1,875 per quarter (which the sum of the de minimis threshold of £625 per month on average), and less than an amount totalling to 50% of all Input VAT recoverable, then it falls below a de minimis threshold and can be recovered without any requirement for a restriction. The de minimis threshold is designed for businesses that make only a small or incidental amount of exempt supplies for which if there was an Input VAT restriction, the result would be unfair and unreasonable for the business.
For more information on how we can help your business, please get in touch.