If you sell both VATable and exempt goods or services, you’re required to make a special adjustment to the VAT you reclaim in your VAT returns. At the end of the year you must consider if a further adjustment is needed. What should you be checking to ensure you get the right answer?

Partial exemption

One of the basic VAT rules is that you can’t reclaim VAT on purchases which you use to make exempt sales. However, some expenses, essentially overheads, such as premises and IT costs, may be used in the process of making exempt and VATable sales. This is known as residual VAT and you’re entitled to reclaim a proportion of it.

Quarterly calculation

HMRC’s standard method for working out reclaimable residual VAT involves comparing the value of your exempt and VATable sales in each VAT period. For example, if your VATable sales for a quarter were £200,000 and your exempt sales £50,000, you’re entitled to reclaim 80% of the residual VAT.

Annual adjustment

Having made a quarterly calculation of the residual VAT you can reclaim, you’re not quite out of the woods. Remember that for the return period which includes the 31 March you’re required to repeat the calculation for a twelve-month period. If this shows a difference compared with the VAT you actually reclaimed (this will almost always be the case) you have to account for it on your next VAT return. This might mean paying or reclaiming more VAT. Either way the annual adjustment must be made.

Tip. To avoid the need for relatively small adjustments the rules include a de minimis limit. If the total VAT in a period that relates to exempt supplies (including the claimable proportion of the residual tax) is less than £625 per month on average, and not more than 50% of the total VAT you paid on purchases, you can reclaim it in full.

Check for excluded transactions

Some transactions should be excluded from your calculation of reclaimable residual VAT. These are easily overlooked in your quarterly returns, so make sure you pick them up when calculating your annual adjustment. When working out the value of your exempt and VATable supplies leave out:

  • the sale of capital items, e.g. cars, vans or other machinery (unless your business is selling them); and
  • some types of incidental supplies such as those relating to the sale of land or financial services transactions.

Time for a change

Making your annual adjustment calculation is the perfect time to consider whether using a so-called special method, instead of the standard method, might allow you to reclaim more residual VAT.

Tip. A special method can use any formula to work out the reclaimable residual VAT as long as it produces a fair and reasonable result. For example, if your production costs for exempt supplies were proportionately less compared with those used for VATable supplies, you could use a formula based around them.