VAT Exemption and Partial Exemption Explained

Introduction

If you sell goods or services that are exempt from VAT, you cannot usually reclaim the VAT you've paid on related business purchases. This becomes more complicated if you make both taxable and exempt supplies—a situation known as partial exemption. Understanding the difference between exempt and zero-rated supplies, and knowing how to calculate recoverable input tax, is essential for getting your VAT returns right.

What Are Exempt Supplies?

Exempt supplies are goods or services on which VAT is not charged. Common examples include:

• Insurance, finance and credit
• Education and training
• Fundraising events by charities
• Subscriptions to membership organisations
• Selling, leasing and letting of commercial land and buildings (though this exemption can be waived)

You do not include sales of exempt goods or services in your taxable turnover for VAT purposes. If you buy exempt items, there is no VAT to reclaim.

It's important to understand that exempt supplies are different from zero-rated supplies. With both, no VAT is added to the selling price, but zero-rated goods or services are still taxable for VAT—they're just taxed at 0%. This distinction matters because you can reclaim VAT on purchases related to zero-rated supplies, but not on purchases related to exempt supplies.

Exempt Businesses

If you only sell goods or services that are exempt from VAT, yours is an exempt business. This means:

• You cannot register for VAT
• You cannot recover any VAT you incur on your purchases or expenses

This is different from businesses that sell only or mainly zero-rated items. Those businesses can reclaim the VAT on purchases that relate to their sales. If you sell mainly or only zero-rated items, you can apply for an exemption from VAT registration, but if you choose this route you will not be able to reclaim any VAT.

What Is Partial Exemption?

Your business is partly exempt if you make (or intend to make) both taxable and exempt supplies and incur VAT on costs which relate to both. Put simply: if you're VAT-registered and you incur VAT on any items that will be used to make exempt supplies, you are classed as partly exempt.

As a partly exempt business, you may not be able to recover all your input tax (the VAT you pay on business purchases). The VAT relating to taxable supplies is called "taxable input tax" and can normally be recovered. The VAT relating to exempt supplies is called "exempt input tax" and cannot normally be recovered.

However, there's an important exception: provided the amount of exempt input tax is below a certain limit, it can be recovered in full.

How to Calculate Recoverable Input Tax

If you're partly exempt, you must use a partial exemption method to work out how much input tax you can recover. There are three main steps you need to carry out:

Step 1: Direct Attribution of Input Tax

Direct attribution means identifying the VAT you've incurred on purchases that you use (or intend to use) exclusively for either:

• Taxable supplies (or other supplies that carry the right to deduct VAT)
• Exempt supplies

You carry out this process based on the use you make, or intend to make, of those purchases at the time you receive them. You can recover in full any input tax on purchases used exclusively to make taxable supplies.

Step 2: Apportionment of Residual Input Tax

Some purchases relate to both taxable and exempt supplies. The VAT on these is called residual input tax. You need to apportion this residual input tax to work out how much you can recover. The law does not specify a particular method—the only requirement is that the result is fair and reasonable.

Step 3: Annual Adjustment

At the end of each tax year, you must complete an annual adjustment. This recalculates your recoverable input tax for the whole year and adjusts for any over- or under-claims made during the year.

Steps 1 and 2 must usually be carried out for each VAT return, with step 3 undertaken at the end of each longer period (usually your tax year).

Non-Business Use and Partial Exemption

You cannot reclaim VAT you pay on goods and services that are not for business purposes. VAT incurred on purchases used exclusively for non-business purposes is not input tax and cannot be recovered.

If your business is partly exempt and you buy goods or services that you use partly for business and partly for non-business purposes, you must split the VAT accordingly. You then use your partial exemption method to work out how much of the business VAT you can reclaim.

Special Methods

If the standard partial exemption method doesn't give a fair and reasonable result for your business, you can apply to HMRC for approval to use a Partial Exemption Special Method. You'll need to provide:

• A proposal document
• A worked example of your proposal
• Your latest annual adjustment calculation
• A declaration (requirements are set out in the official guidance)
• Any additional documents

HMRC will contact you within 30 days to tell you whether they accept your proposal, need more information, or find it unsuitable. From 1 August 2022, you can no longer send an email for a special method request—you must apply online using the HMRC portal.

Opting to Tax Land and Buildings

If you sell, lease or let commercial land or property, the supply is normally exempt. However, you can choose to waive the exemption and charge VAT at the standard rate instead. This is known as opting to tax land and buildings. Once you've opted to tax, the VAT you incur in making these supplies becomes recoverable.

The Capital Goods Scheme

If you acquire or create an expensive capital asset, you may have to use the Capital Goods Scheme to adjust how much input tax you initially reclaimed in future years. The scheme applies when your capital spending (net of VAT) is:

• £250,000 or more on land or buildings, or on building or civil engineering works
• £50,000 or more on a single computer or piece of computer equipment
• £50,000 or more on an aircraft, ship, boat or other vessel

You'll have to adjust the amount of VAT you reclaimed if the extent to which you use the asset to make taxable supplies (rather than exempt supplies) varies over the following 5 or 10 years (depending on the asset). You can reclaim more if the proportion of your taxable supplies increases, but you'll have to repay some if it decreases.

Record-Keeping Requirements

If you make both taxable and exempt supplies, you must keep a separate record of your exempt sales and details of how you've worked out how much VAT to reclaim. Your records must enable you to work out the amount of input tax you can recover in each tax period and in each tax year. You must also keep any other records that you use to calculate your recoverable input tax.

Moving Goods from Great Britain to Northern Ireland

If you move your own goods from Great Britain to Northern Ireland, you will usually be able to recover the full amount of VAT as if it had been a taxable supply. However, if you make exempt supplies, this can create complications.

When you first purchase goods in Great Britain for exempt supplies, you may not be able to recover some or all of the VAT. If you then move those goods to Northern Ireland, you'll incur another VAT charge—and may face further restrictions on what input tax you can recover. This would mean you've incurred an input tax restriction twice on the same goods.

To prevent this double restriction, you should reattribute the previously unrecovered input VAT on the original purchase in Great Britain as if the goods had been used for a taxable purchase. You can do this when making your annual adjustment, treating the movement as if it were a fully taxable supply.

Sources

• Exemption and partial exemption from VAT
• Partial exemption (VAT Notice 706)
• Apply for a Partial Exemption Special Method

This article provides general guidance based on current HMRC rules. For advice specific to your situation, speak to your accountant.