Partial VAT exemption rules every business should know
Many businesses in the UK fall under partial VAT exemption, meaning their sales will not be subject to the same VAT treatment. Some elements of their activities may be subject to VAT, while others will be exempt from it. Therefore, it is essential to know how this applies to your business, as it will impact your VAT reclaims and minimise any unexpected costs or compliance issues.
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This guide explains what partial exemption means, to which businesses it applies, and how to calculate the amount of VAT that can be reclaimed under HMRC rules.
What does "Partial VAT exemption" mean?
A business is partially exempt when it makes both taxable supplies (where VAT is charged) and exempt supplies (where VAT cannot be charged or reclaimed).
Examples of taxable activities include selling goods, providing professional services, or running an online store. Exempt activities include letting residential properties, offering financial or insurance services, and specific education or health-related services.
Since part of your business is VAT-exempt, you can’t reclaim all the VAT paid on your purchases. You must work out how much of your input VAT relates to taxable business use.
Which businesses are usually partially exempt?
Partial exemption is standard across many industries. Here are some examples:
- Property businesses: A developer might sell new buildings (taxable) and rent out existing ones (exempt).
- Charities: A charity selling products or event tickets (taxable) may also receive grants or donations (exempt).
- Financial firms: Companies that charge fees for advice but also handle exempt services like loans or insurance.
- Education providers: Private schools or training institutions offering both taxable training and exempt courses.
Small businesses and landlords can also fall into this category if they have a mix of taxable and exempt income streams.
Why partial VAT exemption matters
- If you claim too much VAT, you may have to pay penalties or repay HMRC.
- If you claim too little VAT, you unnecessarily diminish your cash flow and profitability.
Understanding input VAT
Input VAT refers to the Tax a business pays on items or services it buys to carry out its operations. When your business is fully taxable, you can usually reclaim all of it.
For partially exempt businesses, purchases are divided into three categories:
- Taxable purchases – used solely for taxable supplies.
- Exempt purchases – used solely for exempt activities.
- Mixed-use purchases – used for both taxable and exempt purposes.
Only VAT related to taxable and mixed-use purchases can be reclaimed, and even mixed-use costs must be calculated carefully.
How to calculate partial exemption VAT
HMRC provides clear rules for calculating the amount of input VAT that can be reclaimed. Most businesses use the standard method, which involves three steps:
- Identify taxable and exempt income: Record all income for the VAT period and separate it into taxable and exempt categories.
- Apportion input VAT: Split VAT on expenses between taxable, exempt, and mixed-use activities.
- Calculate the recoverable percentage: Apply the standard formula — taxable supplies ÷ total supplies = recoverable percentage. Then multiply that percentage by the VAT on mixed-use costs to find the reclaimable amount.
HMRC's de minimis rule
HMRC allows small amounts of exempt input VAT to be reclaimed if the total is considered insignificant. This is known as the de minimis rule.
You can reclaim all your VAT if both of the following apply:
- The exempt input Tax is less than £625 per month on average.
- The exempt input Tax is less than 50% of the total input Tax.
This rule helps small businesses avoid complex calculations when their exempt activities are minimal.
Using a special method
The standard method doesn’t work for everyone. Some businesses have unusual income patterns or cost structures that make the standard calculation unfair.
Suppose the standard calculation method does not accurately reflect your business activities. In that case, you can request HMRC’s approval to use a customised calculation that better represents how VAT is used in your operations.
This tailored approach may offer a more accurate result, but it requires formal approval and proper documentation.
The annual adjustment
Every partially exempt business must complete an annual adjustment at the end of its VAT year. This adjustment compares the VAT reclaimed during the year with the amount that should have been reclaimed based on actual figures.
Steps include:
- Adding up total taxable and exempt supplies for the year.
- Recalculating the recoverable percentage.
- Comparing this with previous quarterly estimates.
- Making the necessary adjustment in your next VAT return.
Keeping clear and consistent VAT records during the year helps make the adjustment process easier and reduces the chance of last-minute errors.
Record-keeping and digital compliance
With Making Tax Digital now in place, all VAT-registered businesses must keep their VAT information in digital form and file VAT returns through approved online software. This applies even to partially exempt companies.
Digital tools make it easier to record supplies, calculate the recoverable VAT, and store audit trails. They also reduce manual errors and ensure your calculations align with HMRC rules.
Common challenges businesses face
Partial exemption can be complicated, especially for organisations with multiple departments or mixed-use assets. Common issues include:
- Misclassification of taxable and exempt income.
- Overlooking de minimis options.
- Forgetting to complete the year-end adjustment.
- Using incorrect percentages over VAT periods.
By ensuring your methods and paperwork remain consistent through VAT periods, you can reduce these errors and have evidence of compliance in the event of an HMRC review.
Practical tips for managing partial exemption
- Maintain a clear record of all supplies and categorise them accurately.
- Review your calculations regularly, not just at year-end.
- Verify if your business fits under the de minimis limit.
- Store all invoices and digital records in a single location.
- Seek a professional opinion before making changes to your income sources or VAT structure.
By taking these steps, businesses can effectively manage VAT without the need for later amendments.
Key takeaway
If your business earns taxable and exempt income, you are deemed a partially exempt business for VAT purposes. You can reclaim input VAT only on the recoverable percentage, as calculated and approved by HMRC.
A good understanding of partial exemption and keeping accurate records will help run your VAT scheme in compliance with the law and avoid penalties.
Whether you do this manually or use the best VAT software that supports MTD, the aim is simple — claim what you are entitled to and stay accurate every VAT period.
Frequently Asked Questions:
Your Questions – Answered ,We’re here to help you with anything VAT-related.
1. What does it mean if my business is partially exempt for VAT?
If your business is partially exempt, it means you make both taxable and exempt supplies. Taxable supplies refer to sales where VAT is charged, such as the sale of products or services to customers. Exempt supplies, such as residential property rent or certain financial services, are not subject to VAT.
Because of this mix, you can’t reclaim all the VAT you pay on business purchases. Instead, you must work out how much of your spending relates to taxable activities. HMRC allows you to use methods such as the standard or special method to calculate what percentage of input VAT can be reclaimed.
It’s essential to get this right to avoid overclaiming or missing out on legitimate VAT recovery. Keeping detailed records and regularly reviewing your VAT position ensures your business remains compliant and avoids unnecessary corrections or penalties.
2. How do I calculate VAT recovery for a partially exempt business?
To calculate VAT recovery for a partially exempt business, you first separate your income into taxable and exempt categories. Then, classify your purchases as taxable, exempt, or mixed-use. Only the VAT related to taxable and mixed-use expenses can be reclaimed.
HMRC’s standard method helps with this: divide your taxable supplies by your total supplies to get a percentage. Apply this percentage to your mixed-use VAT costs to find the reclaimable amount. For instance, if 70% of your income is taxable, you can usually reclaim 70% of the VAT on shared expenses.
If your exempt input VAT is below the de minimis limits (less than £625 a month and under 50% of total VAT), you can reclaim all of it. Regularly reviewing these figures at the end of each VAT period ensures accuracy and keeps your filings consistent with HMRC’s requirements.
3. What is the HMRC de minimis rule for VAT exemption?
The HMRC de minimis rule allows small businesses with limited exempt activities to reclaim all their VAT, even if part of their income is exempt from VAT. To qualify, your exempt input VAT must be insignificant—specifically, less than £625 per month on average and less than 50% of your total input VAT for the period.
This rule simplifies things for smaller businesses that might otherwise have to go through complex calculations for minimal exempt sales. For example, a property consultant who occasionally earns exempt income from residential lettings but mainly sells taxable services may qualify.
If your figures exceed these limits, you’ll need to use partial exemption calculations instead. Reviewing your VAT position each quarter helps confirm whether you remain within the de minimis thresholds and ensures compliance without overpaying or underclaiming VAT.
4. When should a business apply for a special method of VAT calculation?
A business should apply for a special method when the standard HMRC calculation doesn’t fairly reflect how VAT is used in its operations. This is common in companies with irregular income streams or unique cost structures, such as charities, financial service providers, or property developers with both taxable and exempt projects.
The special method lets you design a calculation that better aligns VAT recovery with actual business activity. However, you must get HMRC’s approval before using it. The process involves submitting a proposal with supporting data and explaining why the standard method gives an unfair result.
Once approved, you will need to apply the special method consistently and keep clear records to explain your approach. This helps prevent disputes and ensures that your VAT recovery accurately reflects your business’s actual financial situation.
5. What are the common mistakes partially exempt businesses make with VAT?
Many partially exempt businesses struggle with VAT accuracy due to poor record-keeping or misunderstanding HMRC’s rules. Common mistakes include misclassifying income as taxable or exempt, failing to apply the correct percentage when calculating recoverable VAT, or disregarding the de minimis rule.
Some businesses forget to perform the annual adjustment, resulting in incorrect reclaims that can lead to penalties. Another frequent issue is not updating methods when business activities change—such as adding new services or income streams.
To avoid these problems, review your VAT calculations regularly, maintain separate records for taxable and exempt sales, and ensure all staff involved in VAT reporting understand the process. Utilising digital tools or compatible VAT software can also minimise manual errors and simplify compliance. Staying proactive with checks and records keeps your VAT process accurate and stress-free.
