VAT- Partial Exemption Keep calm and carry on......?
Speculation in the Legal sector has grown over the last 12 months in relation to whether law firms need to apply for partial exemption when calculating the amount of input VAT that they can reclaim as a result of the increase in interest income received on client monies.
This article sets out some practical context around this speculation and explores options that firms can consider to help mitigate any concerns that they may have.
What has changed?
To avoid the need to apply partial exemption to the claim for input VAT, a firm needs to demonstrate that interest is an incidental source of income
HMRC’s officers manual on partial exemption states that a supply is incidental if it ‘arises merely as a minor consequence of normal business activity’
HMRC then goes on to reference the ECJ decision in Régie Dauphinoise, where the Advocate General considered what constituted an “incidental transaction” In that case, a property management firm held client funds in its own account and in its own name and used the retained interest as part of its established business model.
The ECJ held in Régie Dauphinoise that in order to be “incidental”, a transaction would “ … have a certain link with the taxable persons other activity but do not form a direct part thereof…”. The ECJ then determined that the interest income the taxpayer earned on these monies was not incidental because the receipt of the interest was a “direct, permanent and necessary extension” of the main taxable activity.
Patricia Kinahan, Legal Partner, offers her insight
By contrast, law firms are subject to strict regulation under Solicitors Regulation Authority rules for dealing with client money and the operation of client accounts
Interest income is highly dependent on external factors - particularly prevailing interest ratesand is often modest, irregular, or non-existent, because the money is held for such a short space of time in the first place In many firms, only some departments or matter types lead to such deposits, and the timing of deposits is often uncertain.
The case of Régie Dauphinoise was in 1996 when interest rates were at 5.94% at the end of that year. Interest rates remained at a high level until they started falling as a result of the financial crisis, when they fell to 0 25% in August 2006
Over a period of 10 years from 1996 to 2006, law firms were receiving a significant amount of interest from client monies, but during that time HMRC accepted that interest income was incidental
Sector update
VAT- Partial Exemption Keep calm and carry on......?
Over that period and since then, the underlying activities of law firms have not changed Interest has not been and is still a direct, permanent and necessary extension of the main activities of law firms.
All that has changed in the last five years, in particular post Covid, is a significant rise in inflation as well as a war on talent that has pushed the cost of employing staff up significantly. Law firms have seen profit margins reduce as a result of the economic climate that they operate within The level of client interest in comparison to total profits appears more acute that it was perhaps 20 years ago.
In my opinion, nothing has changed in the fundamental approach law firms take to the way that they operate their businesses in order to make a profit. What has changed is interest rates have increased and HMRC are looking at ways to collect more income.
My view is therefore in line with HMRC’s current published guidance on partial exemption, i.e. that such income is an incidental consequence of the provision of legal services
Having worked in the legal sector for over 30 years, we have successfully defended a challenge from HMRC on this particular point for a very large law firm Using the facts of that case we were able to demonstrate that the income was incidental.
The recent MOJ consultation on client interest could be seen as additional evidence that interest is not a direct, permanent and necessary extension of their main taxable activity if they have to pay over a substantial proportion of that interest to the MOJ before they even look to pay part of it to clients
What can you do?
It is understandable that there is concern amongst law firms about what is the right course of action to take, especially when advisors to the sectors take different views. Ultimately, if there is an issue, it can only be solved for the sector as a whole by taking a case to the First-TierTribunal, which Brabners did many years ago, and which clarified the position in relation to the reclaiming of VAT on disbursements.
However, that case may take some time and firms may feel that they want to protect themselves as much as possible in the meantime.
There are several options that firms can take to mitigate the position for themselves going forward if they are concerned
Create a VAT group
Often law firm will have a service company that supplies services, mainly people. These entities will charge VAT on their supplies, which increases the level of input VAT for the law firm itself so increases the exposure By the law firm and its service company being in the same VAT group this exposure is minimised, as no VAT needs to be charged on invoices from one entity to another.
Create a separate entity for client monies
It is possible for a law firm to create a separate entity to receive the interest on client monies This would work on the same principles of Third Party Managed Accounts That entity would not be in the same VAT group as the law firm itself and its service company. However, there are SRA and FCA issues to consider when looking at this option.
Register and apply partial exemption
This may seem a bizarre option in light of my comments already in this article However, if you are concerned, then you can apply and make partial exemption adjustments as required. However before the end of 4 years, which is the normal period for making an error or mistake claim, you apply to HMRC to correct the partial exemption adjustments made on the basis that you do not believe that it applies. This will force HMRC to make an enquiry into your business and assess the position.
If the facts of the case support the position that it is incidental, then HRMC would need to refund all of the input VAT that has been restricted during that period.
It is also possible that within that timeframe a case may have been heard to the First-Tier Tribunal and the outcome decided. If HMRC are unsuccessful then you can make the claim earlier than the 4 year window If HMRC are successful, you have already secured your position so will not be exposed to penalties and interest.
In relation to penalties and interest, I am aware of suggestions being made that firms should be putting in a provision into their accounts for the potential exposure to date. Accounting standards only allow a provision to be included where a liability is probable.
Therefore, if a provision has been made, that would suggest that the law firm believes that it has a liability and therefore does it have the responsibility to make partial exemption adjustments and pay that liability across?
Certainly, if at a later date HMRC challenge the position and they are successful, you have to imagine that the level of penalties for firms that have included a provision in their accounts is going to be higher than for those firms who have not, on the basis that they have been deliberate with choosing not to disclose their liability to HMRC until they are forced to
Special MethodTreatment
If partial exemption does apply, HMRC has stated that time-apportionment methods are no longer acceptable, as in their view the standard method (based on income) provides a fair result. Even where special methods have been agreed in the past, HMRC is likely to challenge their ongoing use
This marks a practical shift for many law firms, who had invested time and resource in applying for and agreeing bespoke methodologies
Larger law firms with significant input VAT exposure may be able to rely on the standard method override (SMO) where the standard method produces a result that is not fair and reasonable
The SMO is set out in Regulation 107A of the VAT Regulations 1995. It requires a business to adjust its input tax recovery if:
The amount of VAT recoverable under the standard method differs by more than £50,000 from the amount that would be recoverable using a method that better reflects actual use; or
The amount of VAT recoverable under the standard method differs by more than 50% (up or down) from the amount that reflects actual use, and the difference exceeds £25,000
VAT- Partial Exemption
Keep calm and carry on......?
These tests are applied annually, typically at the end of the partial exemption tax year.
If either test is met, the business must adjust its input VAT recovery to reflect the actual use of inputs in making taxable and exempt supplies, even if it does not have an approved special method.
It would therefore be worthwhile for law firms to keep detailed timesheets for all individuals that are involved with the processing of activities around client monies and other work to help demonstrate that the time apportioned method better reflects actual use
Where do we go from here?
At this point in time HMRC published guidance has not changed, nor a Tribunal decision published, and therefore it is not unreasonable for firms to rely on this in the absence of anything definitive It is important that law firm do look at the guidance carefully to ensure that they are fully compliant and not just assume that they are.
Ultimately the issue can only be dealt with definitively if there is a case at First-TierTribunal
