Sector update
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.
Patricia Kinahan, Legal Partner, offers her insight
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.
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.
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.’
Interest income is highly dependent on external factors - particularly prevailing interest rates and 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.
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.
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.