Many law firms are not considering the interest that they may earn on client accounts when calculating their recoverable input VAT. If you’re one of these firms, HMRC may be poised to target you.
Where a law firm is entitled to keep all or part of this interest, this is VAT-exempt income that should be taken into account when calculating the recoverable proportion of the firm’s input VAT.
In HMRC’s view, it is the gross interest received which should be taken into account for partial exemption purposes.
Why this is happening now
Historically there has been limited enforcement by HMRC. Between 2009 and 2022, the low levels of interest would likely result in a de minimis position for partial exemption purposes.
With the Bank of England base interest rate being at or above 4% since February 2022, there is now more reason to take notice. HMRC are already scrutinising the larger firms’ input VAT recovery.
How your law firm could approach this
There is scope to put in place or update Partial Exemption Special Methods (PESMs) with HMRC. These apply an alternative approach to the standard (turnover values based) method. This may lead to higher recoveries, given that the income is essentially passive.
HMRC do, however, appear to be taking a firm stance when it comes to such methods. In their view, the partner effort in earning fees equally results in client money sitting in the client accounts generating the exempt income.
Why you should take action now
Whichever approach is taken, it is becoming clear that ignoring the matter will no longer be accepted by HMRC, especially given the UK’s current tight fiscal situation. We therefore recommend addressing this as a matter of urgency to avoid incurring additional costs such as penalties and interest.
Would you like to know more?
If you have any questions about the PESM rules, or would like to discuss your firm’s VAT accounting, please get in touch with your usual BKL contact or Luigi Lungarella from our specialist VAT team.
