MHA | Retained Interest – a VAT Problem for Law Firms?

Retained Interest – a VAT Problem for Law Firms?

Glyn Edwards · January 8th 2024 · read

Lady Justice Holding Weight

The recent and sustained rise in interest rates has changed the perception of the importance of retained interest in professional service firms. In particular, it has led some tax advisors to suggest that the rise creates a partial exemption problem for practices by increasing the value of exempt supplies – interest being payment for a financial service.

How real is this risk? 

The theory behind the scare stories is that VAT recovery on practice overheads is usually determined by a calculation known as the partial exemption standard method. Unless a practice has agreed an alternative with HMRC, this standard method apportions VAT on expenses in the ratio of taxable to exempt supplies. As interest rates rise, the value of exempt supplies increases relative to taxable supplies, and the problem of irrecoverable VAT increases.

So much for the theory. Describing it in that way immediately highlights a potential oddity. Should a practice, which has spent no more effort, and incurred no additional expenses, suffer a greater loss of input tax just because interest rates have risen?

Firstly, it is important to remember that there have been no changes to the legislation and no recent significant case law. Nothing has changed other than that interest rate rises mean that the amount of interest received and retained by practices on client moneys held in general funds has increased. A basic reading of the standard method might suggest a problem, but there is an important exclusion from the figures used to calculate the value of supplies in the standard method. This exclusion is for ‘incidental financial supplies’. HMRC specifically refer to bank interest in their VAT Notice on Partial Exemption (Notice 706):

4.8 Supplies that should be excluded from the standard method

Some supplies must not be included in the standard method calculation as they can be distortive. Therefore, you need to exclude the value of the following supplies, irrespective of whether they are taxable or exempt:

  • incidental financial [supplies], for instance, interest received on a bank account — these arise merely as a consequence of your normal business activity rather than being a separate aim in their own right.

The aim of any partial exemption calculation is to fairly apportion VAT on expenses to reflect how those expenses are used to generate taxable or exempt supplies. The purpose of the ‘incidental financial services’ rule is therefore to ensure that the standard method, when using income as a proxy for determining how expenses are used, does not include income which is essentially passively received. Most practices spend very little time and effort earning bank interest – related VATable expenses are small and those expenses certainly do not increase just because interest rates rise.

There is one note of caution here however - each practice is different from the next. Some will be very active in moving money around – larger practices may have staff dedicated to managing money to earn the practice the best amount of interest. That uses up resources, ceases to be passive and will need including in a partial exemption method because the interest earned ceases to be incidental. Most just won’t have the time to do that – and will put minimal time and resource into it. For those businesses, the only potential risk is that HMRC might argue that interest earned on clients’ deposit does not arise merely as a consequence of your normal business activity. MHA are not aware that HMRC have made any challenges on that basis.

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If you would like to discuss further, please contact our VAT specialists.

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