Rising interest rates in recent years has been good news for many law firms holding client funds in interest bearing general accounts.
However, this has led to an increase in the amount of VAT exempt income received by firms, meaning that they may be required to restrict the amount of VAT incurred on associated costs and expenses.
How has the position changed?
Historically, law firms may have considered interest earned from deposit accounts to be incidental to core business activities and as such not considered the VAT partial exemption position.
Even where VAT partial exemption was considered, given the previous low rates of interest earned, many law firms possibly fell within the ‘de minimis’ limits (where calculations show that input VAT relating to VAT exempt activities is less than £7,500 per annum), meaning that they could treat themselves as being fully taxable for VAT purposes.
However, the rise in interest rates and HMRC’s interpretation of whether interest earned from client accounts is in fact “incidental” (spoiler alert: HMRC consider that such interest must be included in partial exemption calculations), means that now VAT may be an absolute cost to the business.
What are the risks?
Firms who do not take action to review their VAT partial exemption positions could be at risk of assessments penalty charges and interest, should HMRC conduct a VAT review of the business and find that input VAT has been recovered incorrectly. It is also important to note that HMRC can trace back up to 4 years.
Additionally, any assessment raised by HMRC would be calculated by reference to the standard method of partial exemption calculations which, in our experience may not provide the most accurate results. This could mean that law firms suffer higher levels of VAT costs than may be necessary.
So, what’s the solution?
The area of VAT partial exemption is complex and one of the most litigated areas of the tax. Processes have to be followed in order but with the right approach it can be possible for law firms to implement, and where required, agree with HMRC on a basis of calculation which reflects how costs are used across the business. Issues arise where processes have not been followed correctly or where a firm may not have sufficient evidence to support its proposed method of calculation. This can lead to protracted and sometimes costly negotiations with HMRC.
We have significant experience of VAT partial exemption and have negotiated methods of calculation with HMRC at all levels. Our approach is to ensure that any method is robust enough to withstand potential changes to a law firm’s business and one that remains simple for the firm to operate. We are aware of HMRC’s approach to VAT partial exemption and can factor this into our evaluation of options available.
Overall, the objective is to try to ensure that any method of calculation reflects the economic and physical use of input VAT across the business and that firms are not subject to unnecessary levels of irrecoverable VAT which creates an absolute cost.
Get in touch with us today to discuss how this could affect your business.
