What businesses should be doing at the end of the partial exemption VAT year

The VAT partial exemption rules can be complex, and this can lead to some businesses overlooking the end of the partial exemption year and the year-end adjustments they are required to make. However, it is a critical point in the VAT compliance cycle and can affect how much input VAT is ultimately recoverable.

While many businesses carry out partial exemption calculations throughout the year, these are only provisional. The year-end process is where the final VAT recovery position is determined, and where risks and opportunities often arise.

In this article, we look at some of the key areas businesses should be considering at the end of their partial exemption VAT year, including the annual adjustment, de minimis position, standard method override and whether the current method of VAT recovery remains appropriate.

A business’s partial exemption year normally aligns with its VAT stagger:

• Stagger 1: Year ends 31 March
• Stagger 2: Year ends 30 April
• Stagger 3: Year ends 31 May

Annual adjustment – confirming the correct VAT recovery

The most fundamental requirement at year end is the annual adjustment. This involves recalculating the recoverable VAT position using the full year’s data and comparing it to the amounts provisionally recovered during each VAT return period.

Any difference, whether additional VAT can be recovered or needs to be repaid, must be reflected in the relevant VAT return following the end of the VAT year (or the following return period).

This is not simply a mechanical recalculation. The annual adjustment is also the point at which businesses are expected to revisit how input VAT has been attributed.

In-year calculations often rely on assumptions about how costs will be used. At year end, those assumptions should be tested against actual use. For example, costs initially treated as wholly exempt or wholly taxable may need to be revisited if the actual use has differed.

Businesses should also consider whether any Capital Goods Scheme (CGS) adjustments are required. Where assets within the scheme, such as certain properties and high-value capital expenditure, have experienced a change in taxable or exempt use during the year, a CGS adjustment may be required to increase or reduce the amount of VAT recoverable. Given the values often involved, these adjustments can be significant and should not be overlooked as part of the year-end review. For further information on CGS, please see our article on Changes to VAT recovery on fixed assets.

We often see adjustments arising due to factors such as seasonal variations, changes in business activity, or large one-off transactions that distort the in-year recovery profile.

For businesses using the standard method of partial exemption, the standard method override (SMO) is not optional.

At the end of each VAT year, businesses are required to assess whether the standard method result gives a fair and reasonable reflection of how costs are actually used. If it does not, an adjustment must be made.

Broadly, this involves comparing the standard method recovery position against a use-based calculation. Where the difference is significant, the override must be applied, which may result in additional VAT being payable or recoverable.

Although not all businesses will be affected, this is an area that is frequently overlooked and can give rise to material adjustments where applicable.

De minimis rules

For businesses that meet the de minimis thresholds, the year-end position is especially important.

It is possible to fall within the de minimis thresholds in some VAT periods but not others. The annual calculation effectively reassesses the position based on full-year figures, which can lead to a different outcome overall.

Where the de minimis test is met for the year, businesses may be able to recover all of their input VAT – including VAT that would otherwise be restricted. On the other hand, if the test is not met at year end, VAT may need to be repaid to HMRC.

Given the potential impact, it is important that the year-end calculation is robust and supported by accurate data.

The end of the VAT year is also a good point to step back and consider whether the current partial exemption method remains appropriate.

Changes in business activities, supply chains, income streams or cost structures can mean that the standard method no longer produces a fair or representative VAT recovery outcome. In these cases, a partial exemption special method (PESM) may be more suitable, particularly where it could improve the accuracy of the calculation and optimise VAT recovery.

Similarly, where businesses find themselves regularly needing to apply the standard method override, that can be a strong indicator that an alternative approach should be considered.

Common pitfalls and missed opportunities

From our experience, a number of issues commonly arise at year end:

• Annual adjustments being performed too late or not at all
• Attribution of costs not reflecting actual use
• De minimis calculations based on incomplete or inconsistent data
• Failure to perform or document the standard method override assessment
• Continued use of a method that no longer reflects the profile of the business.

These issues not only create a risk of under- or over-recovery of VAT but can also increase the likelihood of HMRC queries.

How we can help

The partial exemption year-end process is often more complex than it first appears. While the principles are relatively well understood, applying them in practice, particularly in larger or evolving businesses, requires careful judgement.

A proactive review at year end can help ensure that:

• the correct amount of VAT is recovered
• risks are identified and addressed early
• opportunities to improve the VAT recovery position are not missed.

If you would like support in reviewing your VAT recovery position, please get in touch with your usual Crowe contact.