Who uses VAT partial exemption and how it affects the VAT cost to business

VAT is currently the second largest source of revenue for the UK government, with receipts of £143bn in 2017/18 estimated in the 2017 Budget Red Book. This makes the tax second only to income tax where receipts are £175bn.

An Ipsos MORI research report just published, VAT partial exemption research report, looks at the partial exemption restriction which reduces the VAT recoverable by business and which can have a big impact on the amount of VAT income retained by the Treasury. This study into the use of the VAT partial exemption rules looked at how well the rules are understood and also estimates the proportion VAT businesses are recovering in 17 key industry sectors.

Awareness of VAT partial exemption was high though detailed knowledge was more limited and many businesses relied on help from others such as their accountants or tax agents (43%) and HMRC (29%).

The results revealed some big numbers. In the retail sector, of the £494m VAT suffered on purchases, £364m was recoverable, so the cost to business of making exempt sales was around £130m. In construction, VAT paid on purchases was £712m, of which £506m was recoverable, so a cost of £206m to the sector, netting £206m for the government. These are of course costs to business, which are revenue for the UK.

The Office of Tax Simplification report Value Added Tax: Routes to simplification published in November 2017 considered what would happen if we did away with the exemption. It suggested at paragraph 3.36 and 3.37 that in the longer term simplification might be achieved in different ways.

‘3.36… one radical long-term option would be to make everything taxable that is currently exempt, which includes land, insurance, betting, finance, education, health and welfare and sport and physical education. This would sweep away the complexity of a business needing to determine how much of its input tax relates to exempt supplies, but adding VAT to some of these would be quite challenging and would add some complexity, for example in valuing previously exempt services. Such a change could be balanced to ensure prices/revenue remain broadly the same. If there was a significant VAT loss for the Exchequer, that should be passed through in lower prices.

3.37 As businesses would be able to reclaim previously restricted input tax, applying VAT at a reduced rate of, say, 5% to currently exempt activities might not require significantly higher prices to consumers overall. However, the additional input tax reclaimed by businesses would be likely to outweigh the gain from the reduced rate, resulting in a significant cost to the Exchequer.

This will be an interesting area to watch as we leave the EU. Brexit will give the UK more scope to change our VAT rules in the longer term, albeit that change would have to be made in line with any negotiated trade deals on other duties and taxes.

VAT rates rules and the partial exemption - background

VAT registered businesses charge VAT on the sales they make (or supplies as they are more widely described for VAT) and can usually reclaim any VAT paid on the goods and services they buy. The standard VAT rate of VAT charged in the UK is 20%, although a reduced rate of 5% or 0% can be charged on supplies of some goods. These are all taxable supplies. Other services are exempt from VAT, for example education.

VAT incurred on goods and services used by a business to make exempt supplies cannot be recovered.

A business which makes both taxable and exempt supplies, is described as ‘partially-exempt’, and can only recover a proportion of VAT it incurs.

There are different methods that partially exempt businesses can use to work out how much input tax they can recover. The default is the standard method, which applies to most businesses, and is based on the value of supplies the business makes. Alternatively, businesses can apply to HMRC to use a special method, which is bespoke to each business and can only be used with HMRC’s permission.