Paying tax as a company can be incredibly complicated especially when it comes to areas such as VAT. Not only are there different bands with taxable and exempt supplies and the de minimis limit but calculating liability and what can be recovered can also seem incredibly complex.
Partial exemption is a an integral part of VAT and understanding at least the basic principles is critical for the businesses that it applies to. Some supplies that a business offer are either exempt from VAT or have VAT incurred. When a company has a mixture of these, they can end up paying VAT on both.
Partial exemption means that you can sometimes offset this and reclaim VAT incurred in certain circumstances but not in others. The process is highly complicated and depends on how much input tax and output VAT is incurred over an accounting period. It is, however, particularly important for smaller businesses that may have a range of revenue streams and need to lower their tax burden and boost profits.
Here we look at what qualifies as exempt input tax and exempt supplies and how this affects partial exemption calculations.
What does partial exemption mean?
Some products and services such as education, insurance and finance are exempt from VAT. Most, however, are what are called taxable supplies. Whether they incur a rate of 0% or 20%, they need to be declared if you are registered for VAT.
If you are a company that only deals in exempt products and supplies, you don’t need to register for VAT and it can’t be claimed back through the HMRC. Many businesses and organisations, however, create a mix of exempt and taxable supplies which means they may be subject to a partial exemption calculation.
In short, your VAT incurred and paid to HMRC needs to balance. What you pay in VAT and what you charge customers and pay to the HMRC somehow have to match up. If supplies for your business are exempt under the rules, you cannot claim back the VAT on that portion unless you fall under the de minimus rule.
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Partial exemption example
Let’s say, you have a VAT taxable turnover of £50,000 in a 3-month period. £40,000 of this relates to taxable supplies and £10,000 relates to exempt supplies. You can only recover the VAT on the taxable supplies.
There are different ways to calculate partial exemption and much will depend on how your company operates and the mix of taxable and exempt supplies. In the long run, however, it is designed to give a fair and reasonable result according to HMRC.
What is the partial exemption de minimis?
The de minimus rule is a threshold set by the government. Below this level, exempt input tax is considered negligible and the company can reclaim the VAT incurred.
What is the de minimis test?
There are two input tax tests that you can carry out:
- Test 1: You’ve incurred input tax of less than £625 on average and less than half of this comes from exempt supplies.
- Test 2: The total input tax minus the input tax directly attributable to taxable supplies is less than £625 and less than half of the value from all supplies can be attributed to exempt supplies.
Although a simple calculation, the de minimis limit can often be confusing for business owners which is why working with a qualified accountant can help.
How does partial exemption VAT work?
The regulations relating to partial exemption are contained in the VAT Act 1994 and are essentially there to help facilitate a fair and reasonable deduction for input tax. Businesses incur VAT for a variety of reasons and these overheads are termed input tax. In most cases, bearing in mind a few exceptions, these can be reclaimed, mainly because the VAT is added to the price when selling to the customer.
If you are a company that only produces VAT-exempt sales then you cannot charge VAT to your customers. Because of this you can’t claim back or recover input tax incurred.
What information do you need to provide?
In short, the company needs to:
- Note the input tax that is incurred for goods that are considered taxable. The VAT here is recoverable.
- Note the input tax that is incurred for goods that are used for exempt supply. The VAT here is not recoverable unless it falls within the scope of the de minimis limit.
- Note the input tax that is part of overheads relating to both exempt and taxable elements. You then need to apportion the input tax between exempt and taxable supplies and compare to the de minimis rules.
If this sounds complicated, you’re not alone in thinking so. It can be an area that leaves businesses scratching their heads and wondering what to do next. If you want to ensure that you get the best VAT recovery, however, it’s important to get to grips with this complicated area.
How is it calculated?
Calculating partial exemption needs to be done in an open and transparent way. The simplest method is using the proportion of taxable income against total sales to give a recoverable amount. The amount you can’t recover can similarly be calculated by comparing the proportion of exempt sales to total sales.
Is it accurate?
While it’s not totally accurate, it does give a reasonable indication and that is what HMRC and the regulations are looking for. This method works for the majority of business circumstances. For a few others, however, it doesn’t.
What is the special method?
The ‘special method’ can be used with the blessing of HMRC if the calculation for a partly exempt business is way off the mark. This involves liaising with HMRC to find a more accurate solution that reflects your business operation.
When can I claim VAT back?
You can reclaim VAT on expenses that have been incurred in your business such as travel, mobile phone usage and supplies to make products and services. When it comes to partial exemption, you can reclaim VAT back on taxable elements of your business where you incurred VAT related to the running of your business.
Is it worth becoming VAT registered?
You can’t reclaim VAT incurred unless you are VAT registered. Much depends on the amount of VAT that you are able to reclaim and discussing this with a qualified accountant is a good idea.
What things are exempt from VAT?
Many goods and services are exempt from VAT including things like educational services, financial services and insurance and health services.
If you are a partially exempt business, navigating the rules and regulations and calculating what you need to pay or claim back can be bewildering. That’s why it pays to get the input of a professional accountancy team.
Want to find out more? Contact us at VWTaxation today.