Since 2021, bank interest rates have climbed significantly, peaking in 2024 before easing slightly, with the Bank of England base rate currently at 4%.
Recent increases in interest rates have led many professional services firms to earn more interest on client funds held in deposit accounts. As bank interest may be treated as a VAT-exempt supply, law firms and other businesses with significant interest income should assess whether this additional income affects their ability to recover VAT on overhead costs under the partial exemption rules.
Partially exempt businesses are found in many sectors, including healthcare, banking, insurance, education, charity/not-for-profit, sports, casinos, welfare services and others.
Partial exemption and bank interest income
A general principle of VAT is that input VAT on costs is generally only reclaimable to the extent it has a direct/immediate link with VAT-taxable supplies/outputs, with VAT being blocked from reclaim to the extent that it is attributable to VAT-exempt supplies.
Under VAT rules, firms that make both taxable and exempt supplies must carry out a partial exemption calculation. This determines how much input VAT (on overheads like rent, utilities, and professional fees) can be reclaimed. The more exempt income you have, the greater the restriction on VAT recovery.
Bank interest is exempt from VAT. Businesses with higher VAT-exempt income typically suffer a higher restriction on VAT reclaim on costs.
For example, a business using the “standard” partial exemption method with 10% VAT-exempt turnover and 90% VAT-taxable turnover may be blocked from reclaiming 10% of the VAT on their mixed use/overhead costs. If bank interest increased this 10% figure to, say, 20%, this could potentially restrict input VAT recovery more significantly. For firms with large client accounts or high deposits, this is a real risk.
Grounds to exclude bank interest income from the calculation
HMRC allows “incidental” financial transactions to be excluded from the calculation, noting that this is because “these arise merely as a consequence of your normal business activity rather than being a separate aim in their own right”.
However, “incidental” is not legally defined, and for some businesses, bank interest will not be incidental.
Relevant factors could include:
• Is the interest related to the business’s normal activities, and not part of one or all of them?
• Does the interest arise from passive action rather than active management or specific actions?
• Is input VAT incurred on costs wholly related to the interest?
• Are any associated costs covered by a wider area of the business?
• Are many staff involved with actively managing deposits e.g. monitoring, calculating, moving funds to generate higher returns? And are these a significant part of that persons duties?
If the interest income generation is a permanent extension of your business activity, HMRC may argue it’s not incidental – meaning it must be included in your partial exemption calculation.
VAT caselaw and HMRC policy can provide guidance on whether there is a partial exemption risk area. With legal practices holding large sums in client accounts, interest income can be significant, and if this pushes your exempt percentage up, your VAT recovery could drop substantially.
If your business is partially exempt and has significant interest income (or other financial-related income such as dividends), and if you are concerned or would like assurance on your position, please get in touch for further information and advice. Call 0808 144 5575 or email help@armstrongwatson.co.uk.
