What Is VAT Partial Exemption?
A business is partially exempt for VAT purposes when it makes both taxable supplies (standard-rated, reduced-rated, or zero-rated) and exempt supplies. While input VAT on purchases related to taxable supplies can be reclaimed in full, VAT on purchases relating to exempt supplies generally cannot be reclaimed.
The partial exemption rules determine how to split your input VAT between these two categories and calculate how much you can recover on your VAT return.
Common Exempt Supplies
Supplies that are exempt from VAT include:
- Financial services — loans, credit, securities, insurance
- Property — selling or leasing commercial property (unless you opt to tax)
- Education — courses provided by eligible bodies
- Health services — medical and dental care by registered practitioners
- Burial and cremation services
- Subscriptions to certain professional and trade bodies
- Betting and gaming (unless subject to specific rules)
- Cultural events — admission to some museums and galleries
If all of your supplies are taxable, you are fully taxable and can reclaim all your input VAT (subject to normal rules). If all supplies are exempt, you cannot register for VAT at all. The complexity arises when you make both.
Three Categories of Input Tax
When you are partially exempt, your input VAT falls into three categories:
| Category | Description | Recovery |
|---|---|---|
| Directly attributable to taxable supplies | VAT on purchases used solely for making taxable supplies | Fully reclaimable |
| Directly attributable to exempt supplies | VAT on purchases used solely for making exempt supplies | Not reclaimable |
| Residual (non-attributable) | VAT on purchases used for both taxable and exempt supplies (overheads) | Partially reclaimable using a recovery method |
The challenge lies in correctly categorising each item of input VAT and calculating the recoverable proportion of the residual input tax.
The Standard Method
Most partially exempt businesses use the standard method to calculate the recoverable proportion of residual input VAT. The calculation uses a turnover-based ratio:
Recoverable percentage = Taxable turnover / (Taxable turnover + Exempt turnover) × 100
This percentage is rounded up to the nearest whole number.
Standard Method Example
| Item | Amount |
|---|---|
| Taxable supplies (standard + zero-rated) | £800,000 |
| Exempt supplies | £200,000 |
| Total supplies | £1,000,000 |
| Recoverable percentage | 80% |
If total residual input VAT for the period is £10,000, the business can reclaim £8,000 (80% × £10,000).
What Is Excluded from the Calculation
Certain items are excluded from the turnover figures in the standard method:
- Sales of capital goods (land, buildings, computers over £50,000)
- Self-supplies of goods or services
- Incidental financial or real estate transactions
- Supplies within a VAT group
Excluding these prevents one-off large transactions from distorting the recovery percentage.
The De Minimis Test
Even if you are partially exempt, you can treat all your input tax as reclaimable if the exempt input tax is de minimis. You must meet both conditions:
| Condition | Threshold |
|---|---|
| Total exempt input tax | Less than £625 per month on average (£1,875 per quarter) |
| Proportion of total input tax | Less than 50% of all input tax |
If you pass the de minimis test, you can reclaim all your input VAT as if you were fully taxable. This significantly simplifies VAT accounting for businesses with small amounts of exempt activity.
Simplified De Minimis Tests
HMRC provides two simplified tests that can be applied before the full calculation:
- Test 1: Total input tax minus input tax directly attributable to taxable supplies is less than £625 per month on average
- Test 2: Total input tax minus input tax directly attributable to taxable supplies is less than 50% of total input tax, and the total residual input tax is less than £625 per month on average
If either test is passed, no further calculation is needed.
The Annual Adjustment
Partial exemption calculations are performed each VAT period (usually quarterly) on a provisional basis. At the end of the partial exemption tax year (which normally aligns with your VAT return periods), you must perform an annual adjustment.
The annual adjustment:
- Recalculates the recoverable percentage using the full year’s figures
- Compares the annual result with the total recovered during the year
- Adjusts the final VAT return of the year to correct any over- or under-recovery
This ensures the input VAT recovery is based on the actual annual proportions rather than quarterly fluctuations.
Special Methods
If the standard method does not produce a fair and reasonable result for your business, you can apply to HMRC for a special method. Common special methods include:
Sector-Based Methods
- Property developers — methods based on floor area or property values
- Financial services — transaction count methods
- Charities — methods reflecting funding streams
Types of Special Methods
| Method | Basis |
|---|---|
| Floor area | Proportion of floor space used for taxable vs exempt activities |
| Headcount | Proportion of staff engaged in taxable vs exempt activities |
| Transaction count | Number of taxable vs exempt transactions |
| Income-based | Variations on turnover using different income measures |
| Combination | A blend of methods for different cost categories |
A special method must be agreed in writing with HMRC before it can be used. Once agreed, it must be applied consistently unless circumstances change materially.
The Capital Goods Scheme
The Capital Goods Scheme (CGS) adjusts the amount of input VAT reclaimed on high-value capital items over a period of years. It applies to:
| Asset Type | Threshold | Adjustment Period |
|---|---|---|
| Land and buildings | VAT of £250,000 or more | 10 years |
| Computers and computer equipment | VAT of £50,000 or more | 5 years |
| Aircraft, ships, and other vessels | VAT of £50,000 or more | 5 years |
Each year, the business compares its actual taxable use of the asset with the initial recovery percentage. If the use changes, an adjustment is made on the VAT return to reflect the increased or decreased taxable use.
Practical Considerations
Record Keeping
Partially exempt businesses must maintain detailed records showing:
- How each item of input tax has been attributed (taxable, exempt, or residual)
- The calculation of the recoverable percentage each period
- The annual adjustment computation
- Any capital goods scheme adjustments
These records must be kept for at least 6 years and maintained digitally under Making Tax Digital.
Opting to Tax Property
One common strategy to manage partial exemption is opting to tax commercial property. By making an option, rental income and property sales become standard-rated rather than exempt, which means the related input VAT becomes reclaimable. This can be particularly valuable for property investors and developers.
However, opting to tax has consequences for tenants who may not be able to reclaim the VAT, so the commercial impact must be carefully considered.
Interaction with Other Taxes
The partial exemption calculation affects only VAT — it has no direct impact on corporation tax or income tax calculations. However, irrecoverable VAT (the portion you cannot reclaim) is treated as part of the cost of the purchase for direct tax purposes. This means it forms part of the tax-deductible expense or the capital cost of the asset.
Accurate accounting records are essential for correctly splitting input VAT and ensuring the right amount is claimed on each VAT return.