Does your business sell a mix of things, some with VAT (taxable) and some without (exempt)?
Have you heard the unusual words, 'partially exempt' and wondered what that actually means and could it spell trouble?
Not quite, but partial exemption VAT can cause plenty of headaches and stress, if you don't know the rules. You may have income from more than one type of activity — some you charge VAT on, and some you don’t! Then suddenly you find yourself in the world of complex calculations, thresholds, and tax jargon.
As with most VAT legislation, partial exemption can appear confusing and yet another set of regulations you need to understand, navigate, and spend a lot of time on. That's why I've put together this guide, to help you cut through the technical matters and walk you through:
I'll also point out the common pitfalls I come across, the kind that can cost SME businesses significant money if ignored. This blog post covers specifically:
Partial exemption VAT is a rule structure from which you can calculate how much VAT your business may be able to claim back. It depends on the mix of things you sell - some attract VAT, and others don't. You're considered 'partially exempt' if you sell both:
Think of it as 2 business activities taking place under your roof:
1. You collect VAT for HMRC and they then obtain it all from you
2. You pay VAT to your suppliers and some of that you may be able to recover
Consider the example of a consultancy business that might charge VAT at 20% on the Business Development training it runs, but it also has an insurance division and insurance is classified as being VAT exempt.
Or, a small newsagents may sell standard rated confectionery such as chocolate bars and sweets, zero-rated books, and VAT exempt postal services.
From HMRC’s perspective, in each example they've a foot in both camps, they're partially exempt, and the rules for working out your VAT reclaim get more complicated from here.
Being partially exempt means you have to adhere to a different rule set to work out how much VAT you can reclaim.
Here's the basic principles:
Residual input VAT has to be apportioned between your taxable and exempt activities. This then requires a calculation and there are different methods to adhere to depending on your business circumstances.
It's often an area where people can slip up. I once had a colleague review the accounts for a leisure facility that offered both gym memberships (standard-rated) and room hire for community events (exempt). They’d been reclaiming all the VAT on their electricity bills because the lights had to be on for all concerned!
Unfortunately, that’s not how HMRC saw it. After a recalculation, their annual adjustment meant writing a cheque back to HMRC! This goes to show that identifying exempt supplies can be a challenging task based on your circumstances.
If there’s even a hint that a cost supports exempt activities, you need a fair apportionment and in some sectors the rules can vary based on specific, particular conditions. Be sure therefore to double check the VAT status.
You've identified the residual VAT, that challenging matter where costs benefit both taxable and exempt work. The question now is how do you split it fairly?
The default approach applied by HMRC is known as the standard method. It works as a percentage split of your sales that are taxable, and applies to your shared costs.
For the purposes of this blog post, our explanation is simplified from an illustrative perspective as there are rules about how many figures you calculate to, and rounding up and down. To start with you work out the proportion of your sales that are taxable. Then you apply that percentage to your shared costs. So, if 80% of your turnover is taxable and 20% is exempt, you could reclaim 80% of the VAT potentially on shared costs like rent, utilities, or stationery.
It all sounds reasonably straight forward until you hit the grey areas. HMRC actually recognises 3 main ways that this can be calculated:
1. Values-based – the percentage method of taxable sales over total sales
2. Use-based – an estimate based on how much you actually use goods/services for taxable work (this is especially helpful for new businesses)
3. Previous year’s percentage – use last year’s ratio during the year and then adjust it later when you have the real numbers
At the end of your VAT year, you do an annual adjustment to correct any differences between your provisional claims and the actual amounts. Surprises can potentially happen here.
We've worked with many businesses where the assumption has been that the taxable/exempt split would remain roughly the same throughout the year. Only then a big exempt project lands late in the year and that then shifts the ratio significantly. The annual adjustment meant they had to repay an amount of VAT they'd already reclaimed!
HMRC also has what’s called the Standard Method Override. If your values-based result presents a significant gap to the real usage split, they expect you to adjust it.
When done correctly, the standard method works well for most businesses. But if your sales values don’t reflect how you actually use your resources, you might need to look at a special method.
If your taxable sales are high in value but low in volume, or if certain costs clearly relate more to one side of the business than the other, the standard calculation can feel somewhat unfair. You could end up reclaiming far less VAT than is reasonable.
That’s when you may need to look at a special method.
This is a custom VAT apportionment calculation that’s been designed to better match your business to the reality of your circumstances. Instead of just splitting by sales value, you might base it on:
To do this, a special method has to be approved by HMRC in writing, and as part of this you’ll need to prove it’s fair and reasonable.
Consider this example, a mixed-use property business rents out commercial units (taxable) and residential flats (exempt). Their standard method results in them reclaiming just 40% of their shared costs. But here’s the thing: their cleaning and maintenance staff spent almost all their time on the commercial spaces.
They could instead potentially put together a special method based on staff hours worked for taxable vs exempt areas. If HMRC agreed then their outright reclaim rate would likely jump considerably.
HMRC won’t rubber-stamp a special method unless you can prove it’s fair and reasonable. That means good records, clear logic, and not that you’re bending the rules for a better number.
If you think the standard method is short-changing you, it’s worth exploring. Just remember, you need HMRC’s written approval before you start using it!
De minimis is a legal term that means, too small to be considered significant. The good news is if the VAT linked to your exempt sales is very low, you may be able to reclaim it all.
You’re classed as de minimis if:
There are also other simplified de minimis tests that save time by letting you skip the detailed calculation if you clearly fall below the threshold.
We had a client who was a small training provider. They assumed their exempt course income meant they’d lose a chunk of their VAT reclaim. We ran the numbers and discovered their exempt VAT was under the de minimis limit. Overnight, their reclaim jumped by over £4,000 for the year!
If you treat yourself as de minimis during the year but fail the test at your annual adjustment, HMRC will expect you to repay the exempt-related VAT you claimed. That can be financially painful so keep an eye on your rolling totals.
Remember to keep clear records as evidence of your totals. Just because they're considered small doesn't mean HMRC won't be inclined to check!
VAT may have to be reported quarterly, but if you're partially exempt then the annual adjustment comes once a year. This is because all year you’ve been making provisional reclaims based on estimates. The annual adjustment is then when you line up the actuals and see if HMRC owes you, or if you owe them.
At year-end you need to:
1. Total up all taxable and exempt sales for the full year
2. Apply whichever is the agreed method to your actual costs
3. Compare the annual result to what you reclaimed during the year
4. Adjust the difference on your next VAT return
We've seen the annual adjustment work for, and against business owners. Check out these examples:
As a tip, don’t wait until the year-end to find out where you're at. Has your business mix changed during the year? Think:
If you make mistakes or errors calculating partial exemption then it can be expensive both in terms of money and stress:
So, stay safe by:
Remember when making your calculations, be sure to keep records that can clearly provide evidence to your numbers. HMRC may ask for them years later.
1. Misidentifying exempt supplies
Some service supplies are exempt only in certain conditions. Sports facility hire, some education services, and certain medical treatments can flip from exempt to taxable depending on the circumstances. Always double-check the VAT status small print per HMRC's guidance.
2. Forgetting the Standard Method Override (SMO)
If your values-based split is wildly different from how you actually use goods and services, HMRC expects you to override it. Ignore this, and you’re effectively using an unfair method — something that would be scrutinised in the even of an inspection.
3. Ignoring blocked input VAT
Some costs such as business entertainment can’t be reclaimed at all. Including them in your total input VAT for the de minimis test will skew your results
4. Poor record-keeping
Don't rely on memory alone for how you worked something out! You need clear, evidence based workings and notes for every attribution calculation.
5. Sticking with an outdated method
Businesses evolve over time. What worked as a method and was fair three years ago may now distort your claim. So be sure to review annually or even sooner if your revenue mix shifts.
Ask yourself:
Working out the partial exemption VAT due to your business is simply the first step. Applying the regulations accurately, meeting the deadlines, and choosing the correct method can be a complex set of matters.
If VAT and the finances aren't your specialism then be sure to seek professional advice to help you:
Remember the right advice can save you a lot of potential, time, money, and hassle when completing your next VAT return.
The content of this post was created on 03/10/2025.
Please be aware that information provided by this blog is subject to regular legal and regulatory change. We recommend that you do not take any information held within our website or guides (eBooks) as a definitive guide to the law on the relevant matter being discussed. We suggest your course of action should be to seek legal or professional advice where necessary rather than relying on the content supplied by the author(s) of this blog.
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