Solicitor Client Account Interest and Hidden VAT Implications

Although interest rates are expected to dip, client account bank interest is on the rise—this could present potential VAT issues with VAT recovery on expenses.

In principle VAT cannot be reclaimed on costs used to make exempt supplies. The receipt of bank interest is payment for an exempt supply of credit by the account holder to the bank.  Does the receipt of bank interest by Solicitors have an impact on the VAT that can be reclaimed on expenses? 

HMRC guidance suggests interest on a bank account can be seen to be an incidental financial transaction which means it can effectively be ignored and should not have an impact on VAT recovery. However there are some suggestions HMRC may take a different approach to interest earned on client funds held by solicitors and there is some, albeit old, caselaw that could support their position. 

With a few exceptions VAT on expenses (input VAT) that are used solely to make taxable supplies, e.g. the provision of legal services, can be reclaimed in full. VAT on expenses used solely to make exempt supplies cannot be reclaimed. 

Where expenses relate to both the making of taxable and exempt supplies, for example overheads such as accounting software, administrative expenses, accountancy, the associated VAT has to split and a proportion allocated to the exempt and taxable activities. The standard method of splitting is based on the ratio of taxable to exempt income and the percentage allocated to the taxable activity is rounded up to the nearest whole percentage point

In broad terms if the VAT allocated to the exempt business activities is less than £7,500 in a VAT Tax year and is also less than 50% of all input VAT it can be reclaimed. If it exceeds these limits it cannot be reclaimed. 

If the standard partial exemption method does not produce a fair result, perhaps because the VAT bearing expense required to generate exempt income is significantly lower than that used to generate the same level of taxable income, a special partial exemption method can be agreed with HMRC.

If exempt income is minimal, certainly under 1% of income, it is unlikely to be an issue. 

However where solicitor firms receive meaningful interest income it may be harder to argue this is incidental, particularly where firms negotiate bank terms or proactively manage interest flows. 

As HMRC scrutiny seems to have increased it would be worth considering the potential implications of bank interest.

• Review your potential partial exemption position to identify the scale of any potential issue. HMRC can go back up to four years to correct an overclaimed input VAT
• Maintain clear records to support passive treatment where appropriate
• Be prepared to defend your approach if interest income becomes more central
• Speak to our team 

Every firm’s position is unique. Our dedicated team can review your position, guide you through partial exemption complexities, consider special partial exemption methods and ensure your VAT strategy remains robust.