A business that has some income which is exempt from VAT, but also makes sales that are subject to VAT, is referred to as ‘partly exempt’.
Input VAT on purchases can only be recovered if it relates to ‘VATable’ sales made by the business, i.e., those which carry VAT at 20%, 5% or 0%. If the input VAT relates to a range of sales, some of which are exempt and some of which carry VAT, an apportionment is needed.
The partly exempt businesses must allocate its purchase invoices into three categories depending on the purpose of the expense:
- T – the expense wholly relates to VATable sales and VAT can be fully reclaimed.
- E – the expense wholly relates to exempt sales, so no input VAT can be claimed.
- R – a cost that relates to either both parts of the business (mixed use) or to general overheads, e.g., accountancy fees.
The challenge when allocating purchase invoices to T or E is to establish a ‘direct and immediate link’ between the expense and either VATable or exempt sales (or both). If there is no such link, the purchase must be allocated to R.
The input VAT claimed for the quarter will be all of T plus a percentage of R, based on the ratio of VATable sales to total sales including exempt income. However, you can agree a special method with HMRC for calculating the VAT to recover, if this would suit you.
Small businesses may be able to recover all input VAT, even where it relates to exempt sales.