VAT aspects of client account interest earned by professional services firms

With the recent rises in interest rates, many professional services firms have had a corresponding increase in their bank interest income earned on client deposits. While bank interest is VAT free as an exempt supply, organisations need to consider whether this income has any implications for the recovery of their VAT incurred on their costs under the partial exemption VAT rules. It is possible that firms may have overclaimed VAT on the basis that they are not entitled to full recovery because they have exempt income.

What’s the issue?

The receipt of bank interest income is a VAT exempt supply. The starting point is that if an organisation makes both taxable supplies (such as the provision of professional services) and exempt supplies, then it is partly exempt and most likely only able to reclaim a proportion of the VAT it incurs. A partial exemption calculation, with the default method being based on turnover, is used to determine how much of its residual VAT it can reclaim.

In recent years, the UK’s extremely low interest rates has meant that any bank interest income received by organisations was likely very small in value and therefore had negligible impact. Indeed, for many firms if the interest income was less than 1% of total turnover it could benefit from 'rounding up' so that the firm was entitled to recover 100% of its residual VAT.

However, recent increases in interest rates means that much larger sums are now being earnt and if they exceed 1% of turnover then they cannot round up to 100%, suggesting that a restriction to residual VAT recovery is necessary. It is important to note that the restriction would be applicable to the firm’s residual VAT recovery (as well as there being no VAT recovery on costs incurred directly relating to the exempt income) and an exercise would need to be carried out to determine what VAT is residual and therefore impacted by the calculation.

An important additional point is that no residual VAT recovery adjustments may be needed if it can be shown that the bank interest income is “incidental” to the organisation’s activities.

What is incidental income?

The VAT partial exemption rules allow 'incidental' finance income to be excluded when calculating the amount of VAT that an organisation can reclaim. Unfortunately, the term 'incidental' is not defined in the law. However, it is generally accepted by HMRC that interest earned on own bank accounts is incidental income so the issue is really with client account interest and whether this should be treated any differently.

HMRC’s guidance goes on to refer to the income arising “… merely as a minor consequence of normal business activity”. The meaning of incidental has also been the subject of litigation, but the case-law is fact specific, and we are not aware of a professional services firm having litigated this point.

The case-law though does give guidance as to the principles to be taken into account. Alongside the quantum of the income received, a range of factors will need to be considered based on the context of each firm’s own circumstances.

For example:

• How actively and/or frequently is the bank interest income being managed?
• What amount of staff time is used in managing this?
• What is the process for managing the bank interest earned?
• Does the activity use many inputs of the business?
• What is the relationship between the bank interest income and the activities of the organisation?

The latter point comes from a European Court of Justice decision in a case concerning a property management company. That business held monies on behalf of its clients in its own bank account and retained the interest earned. The court concluded that the income was a 'direct, permanent and necessary extension' of the business’ economic activity and so could not be incidental to it. The principles of this judgment will need to be considered when UK professional services firms review their positions.

How Crowe can help

It is recommended that firms which have received significant amounts of VAT exempt bank interest income review whether they are required to carry out VAT partial exemption calculations to restrict recovery/ or repay VAT overclaimed on their costs. This review should include consideration of whether the amounts received are ‘incidental’ to their professional services activities. If the income is incidental, it would negate the need for the recovery calculations to be carried out.

If the income is not incidental, then a calculation will need to be done. A question to be addressed is whether the value of the exempt supply made by the professional services firm is the gross payment received from the bank, or just the net amount it retains. Crowe can advise on the partial exemption calculation and, if necessary, assist with a disclosure to HMRC to repay overclaimed VAT.

Any existing VAT compliance processes may also need to be updated to reflect the implications of this income stream.

For assistance, please contact Robert Marchant, VAT Partner, or Hayley Hill, VAT Senior Manager, or your usual Crowe VAT contact.