In recent years there has been a significant rise in fintech businesses; businesses who use technology solutions to help deliver financial service products. Experience has shown that these businesses don’t always appreciate how to calculate the amount of UK VAT they can reclaim on their operating costs. There is often a presumption that all UK VAT can be reclaimed from HMRC, but this is not the case when a business makes UK VAT-exempt sales, which many fintechs do. This leads to a risk of UK VAT errors and penalties.
If your business makes both taxable and VAT-exempt supplies, then you will be required to perform partial exemption calculations. Although regarded as one of the more complicated areas of VAT, it needn’t be. It can also be an area that can give rise to cash savings.
If you make exempt supplies, you benefit from not having to charge VAT to your customer (which may prevent them from incurring VAT they cannot reclaim). Still, the downside is that there is generally a restriction on your ability to recover VAT on your purchases. Partial exemption is the process that helps a business to calculate the extent it can claim VAT on costs. Having a partial exemption calculation that accurately reflects how you ‘use’ your VAT on purchases to make your sales can save you money and staff time.
Where Do You Start?
VAT recovery is a step-by-step process.
1. Has VAT been correctly charged on a cost? If not, this ought to be easily remedied through contact with the supplier.
2. Is the VAT charged on a purchase directly attributable to a sale you have made? If it relates solely to making taxable supplies, it is fully recoverable. If it solely relates to making exempt supplies, it is fully irrecoverable.
3. If a VAT cost relates to both taxable and exempt supplies, it is an overhead cost, and this is where partial exemptions comes in to calculate how much of the VAT can be recovered.
Insights: It helps if you can classify the expenses when they are input onto the accounting software, using cost codes or similar. This avoids manually checking and classifying all transactions later when it is time to do the VAT return – simplifying the process and making it more efficient.
There are several ways to apportion partially recoverable VAT. However, you have to use the standard method based on your entire taxable and exempt income unless you negotiate a special method with HMRC.
If the standard method produces a significantly different result from how the VAT taken is actually used, then an ‘override’ may be triggered. The override requires an adjustment to be made to reflect usage.
Insights: Using the standard method allows all but very large businesses to round up the recovery percentage to the next whole percentage eg 50.01% become 51% – thus increasing claims. The same is true for a business with a small amount of exempt income whereby they can round up to 100% from 99.01%.
The standard method is relatively easy to operate but may not always provide the best and most positive result for you. A special method can be based upon– staff count, staff time, floor area, costs, a hybrid of these, etc. but needs to reflect how your business ‘uses’ the VAT it incurs on purchases. A special method also requires negotiation and a written agreement with HMRC.
Insight 1: A tailored special method can often bring about a much better recovery rate.
Insight 2: A complicated special method can be impractical and difficult to operate. It is important that the right balance is struck between VAT recovery and additional administration required.
Whether you use the standard method or a special method, if the amount of irrecoverable purchase VAT is below certain thresholds or ‘de minimis‘, you may treat it as recoverable.
Insights: There are several de minimis tests available. A ‘simplified’ test can save some businesses the administration of performing full partial exemption calculations.
Are The Supplies Actually Exempt?
VAT exemptions are applied narrowly, and there is often a fine line between when a business is providing software (standard rated VAT) and financial services (VAT exempt). As new VAT laws are introduced, and the interpretation of established law evolves or changes, it may also be the case that there is a change in treatment. This affects your sales (whether VAT should be charged) and what VAT you can reclaim (generally, the more sales you make on which you charge VAT, the more VAT you can reclaim on your costs).
A regular review of your VAT position is therefore recommended to understand the liability of the supply (whether or not you need to charge VAT to your customers) and to prevent unexpected VAT costs arising on your purchases (entitlement to reclaim VAT you incur).