VAT partial exemption explained

Why partial exemption exists

You can normally reclaim input VAT on costs that support taxable sales. But if some of your sales are exempt — rent on certain property, insurance, financial services, some education and health — you cannot reclaim the VAT on costs that support those. When costs support both, the VAT has to be apportioned.

How the standard method works

Input VAT falls into three buckets: directly attributable to taxable supplies (fully reclaimable), directly attributable to exempt supplies (not reclaimable), and overhead ("residual") VAT that must be split. The standard method splits residual VAT by the ratio of taxable to total turnover, then rounds up to the nearest whole percent.

The de minimis let-out

If the exempt input VAT you cannot normally reclaim is below the de minimis limit — broadly under £625 a month on average and under half your total input VAT — you can reclaim it anyway. Many small businesses with a little exempt income stay under de minimis and reclaim everything, but you must test it, not assume it.

The annual adjustment

Because quarterly ratios fluctuate, you must do an annual adjustment to true up the year's recovery, which can create an extra payment or refund. Property developers and finance businesses often need a special method agreed with HMRC because the standard method distorts their real activity.

Where it bites hardest

Partial exemption is a frequent, expensive surprise for businesses that add an exempt income stream — letting a property, arranging finance. Get advice before you do, because the input-VAT cost can outweigh the new income.

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