Guidance

Government departments partial exemption framework

Find out about partial exemption special methods for government departments.

From:
HM Revenue & Customs
Published
29 March 2023
Last updated
29 March 2023 — See all updates

Introduction

HMRC has developed frameworks for specific sectors in relation to business and non-business and partial exemption. These frameworks are not mandatory or binding and do not replace the contents of the:

However, adopting the principles set out in the framework will enable HMRC to more readily give approval for the use of a either a partial exemption special method (PESM) or a combined method.

Frameworks are not intended to be a complete VAT guide for specific sectors and do not cover generic business, non-business or partial exemption principles. Instead, they provide additional guidance on issues for sectors to consider when reviewing their business or non-business apportionment and partial exemption methodology. This means frameworks should be read in conjunction with the relevant guidance in HMRC’s VAT manuals.

Framework for government departments

This framework should be read in conjunction with the following sections of the VAT Government and Public Bodies Manual:

It covers those departments eligible for refunds of VAT under the following sections of the VAT Act 1994:

The framework does not cover government departments of the Northern Ireland Government because different legislation applies (section 99 of the VAT Act 1994).

Further guidance can be found in VAT Government and Public Bodies Manual VATGPB9350: section 99 refund scheme.

The guidance in the framework is only applicable to some government departments and is in no way meant to suggest that all (or even most) government departments should apply to HMRC for approval to use either:

The partial exemption standard method is the default option for calculating the deductible input tax.

This may be adequate for the needs of some government departments, especially smaller government departments or those with a limited range of activities. Read the VAT Partial Exemption Guidance Manual PE30500: the standard method for more information.

Additionally, the standard method simplification measures introduced on 1 April 2009 will also assist in easing any administrative burden when completing the quarterly VAT returns. Read the VAT Partial Exemption Guidance Manual PE31000: simplifications to the standard method for more information.

The framework is intended to provide guidance on the methodology that is likely to achieve a fair and reasonable recovery of input tax where the standard method fails and a PESM or a combined method is considered by a government department. It discusses the challenges a government department may face in formulating a PESM or a combined method that is fair and reasonable and describes how those challenges can be overcome.

Some government departments are very large organisations and include many other entities such as executive agencies within their single VAT registration, which is similar to a VAT group. HMRC cannot approve partial exemption methods for anyone but the main government department as if it were the representative member of a VAT group. The method must cover the registration as a whole.

Government department activities

Non-business activities

The principal activities of a government department are predominantly undertaken for no consideration and are carried out under statutory regulation to deliver public services. These activities are non-business and are therefore outside the scope of VAT.

Normally VAT incurred on goods and services used exclusively in undertaking non-business activities is irrecoverable. However, section 41(3) of the VAT Act 1994 provides for a direct refund scheme for government departments whereby the VAT incurred on certain contracted out services, used for non-business activities, may be refunded.

Read the VAT Government and Public Bodies Manual VATGPB9340: VAT recovery on non-business activities for more information.

Business activities

Some government departments also undertake business activities which are not carried out under any statutory requirement or the activity may be defined as a business activity in accordance with section 41A of the VAT Act 1994 .

Read the VAT Government and Public Bodies Manual VATGPB2100: Bodies governed by public law for more information.

These business activities may result in supplies that are taxable or exempt and any VAT cost incurred in relation to these activities will be deductible subject to the normal VAT rules. Read VAT Guide (VAT Notice 700) section 10 for more information.

Taxable activities

These are supplies that are liable to VAT at either the standard rate, reduced rate or zero rate:

  • standard-rated supplies include but are not limited to: catering, car parks, supplies related to land where an option to tax has been exercised, sale of assets, administration fees, salary sacrifice (for example, cycle to work), publications, radio service provisions, non-specialist staff secondments
  • reduced rate supplies are listed in schedule 7A of the VAT Act 1994
  • zero rate supplies are listed in schedule 8 of the VAT Act 1994

Exempt activities:

  • supplies of land which have not been subject to an option to tax
  • education services when delivered by an eligible body
  • financial services, for example loans

The VAT exemptions are listed in schedule 9 of the VAT Act 1994.

Specified supplies

This refers to certain financial and insurance related services, and services directly related to the export of goods, made to persons outside the UK which carry the right to deduct VAT under section 26(2)(c) of the VAT Act 1994.

The qualifying services are listed under the Value Added Tax (Input Tax) (Specified Supplies) Order 1999/3121.

Read the VAT Partial Exemption Guidance Manual PE34000: Regulation 103 — recovery of input tax attributable to foreign and specified supplies for more information.

Direct attribution of VAT incurred

The first step of a partial exemption or business/non-business calculation is direct attribution. This involves identifying VAT which is wholly used, or to be used in the following categories. For more information see:

Taxable input tax

Identify all supplies, acquisitions and imports you receive which are used, or to be used, in whole by you exclusively in making taxable supplies, the input tax thereon is recoverable under section 26 of the VAT Act 1994.

Input tax incurred in making specified supplies

This (as defined under the Value Added Tax (Input Tax) (Specified Supplies) Order 1999) is also recoverable. These supplies would be exempt if made in the UK, but when supplied to a non-UK customer, they are treated as supplies made with the right to deduct VAT.

Exempt input tax

Identify all supplies, acquisitions and imports you receive which are used, or to be used, in whole by you exclusively in making exempt supplies, the VAT thereon is not recoverable.

Non-business VAT (contracted out services)

Identify all supplies, acquisition and imports you receive which are used, or to be used, in whole by you exclusively for non-business activity, which fall under a contracted out services (COS) heading, the VAT thereon will be considered in accordance with the provisions of refund mechanism set out under section 41(3) of the VAT Act 1994 to determine the refundable element.

Care must be taken not to simply identify everything from a certain supplier as a COS. Each COS heading has its own conditions on what is refundable, and what is not.

Read the VAT Government and Public Bodies Manual VATGPB9700: Contracted Out Services for a list of headings and to find out what is eligible under a specific COS heading.

Non-business VAT (not contracted out services)

Identify all supplies, acquisition and imports you receive which are used, or to be used, in whole by you exclusively for non-business activity, which do not fall under a COS heading. This will not be refundable under section 41(3) of the VAT Act 1994 or recovered under section 26 of the Act.

The amount remaining which cannot be directly attributed will be mixed-use VAT. Where VAT cannot be directly attributed, it should be apportioned between business activities (taxable, specified and exempt supplies) and non-business activities in accordance with section 24(5) of the VAT Act 1994. This mixed-use VAT, will include VAT on costs used to perform both business and non-business activities. Within the business portion, there may be both taxable and exempt use, where the exempt portion is irrecoverable.

The non-business portion will only be refundable if the cost the VAT was incurred on fell under a COS heading. VAT incurred on goods, certain utilities, or any other service not under a COS heading, which relates to both business and non-business activity will be within this pot of mixed-use VAT, where the non-business portion will not be refundable under section 41(3)of the VAT Act 1994.

There are various methods to apportion mixed-use VAT and these are referred to further in this framework. The important point to note is that the method itself must be fair and reasonable and represent the economic use, or intended use, of those VAT-bearing costs for non-business and business activities and further, for business activities, between taxable and exempt supplies.

It is important to note that costs which fall under a COS heading may be mixed-use VAT if they are used for both business and non-business activity just like any other cost. We refer to this as non-attributable COS VAT in the worked example.

For example, the following COS might be used to support all of the government department’s activities, such as overheads of the government department, and therefore fall into mixed-use VAT:

If they relate to all of the activities, there could be an element of business (taxable and exempt) and non-business use of the costs. However, like any other cost, it depends on how the COS are actually used. For example, let’s looks at the following COS headings:

There could be a mixed-use of VAT-bearing costs on the COS listed here if they were used in relation to a building you own from which you undertake both business and non-business activities. This would be treated like an overhead and require apportionment to identify the element of business and non-business use.

For example, if the government department decided to lease part of its building to third parties it would constitute a business supply and be taxable or exempt subject to the option to tax. VAT-bearing costs that are attributable to the building will have mixed-use in these circumstances, such as those VAT-bearing costs within the aforementioned list of COS. Another example to illustrate this point is COS 65 — training, tuition of education. A government department may use this for either:

  • training staff to support the government departments non-business activity (refundable under section 41(3) of the VAT Act 1994)
  • training staff who will themselves deliver training or education which would be exempt input tax (irrecoverable)
  • both (mixed-use)

Therefore it is important to think of COS just like any other cost, except that the extent that the cost under a COS heading is used to support a non-business activity will be refundable under section 41(3). Note, that these are just examples of how certain costs may be used. The list is not exhaustive and the range of possibilities of how a cost is used will vary depending on individual circumstances.

You might find it easier to identify non-attributable COS VAT within the mixed-use VAT and deal with them both under a separate business/non-business apportionment. This is because if you carry out an apportionment on all the mixed-use VAT you’ll have identified your non-business portion, however it may then be difficult to identify the costs which fall under a COS heading from that figure which you can get refunded. This is entirely dependent on the capabilities of your accounting system.

Business/non business apportionment

Where VAT-bearing costs are used for both business and non-business purposes, for example overheads, then an appropriate business/non-business apportionment should be applied to identify both:

  • the VAT that is used for business activities
  • the VAT that is used in relation to non-business activities

You must apportion your mixed-use VAT.

The government department must identify any mixed-use VAT that is used, or intended to be used, for its non-business activities. The non-business VAT incurred on services which fall under one of the COS headings should be refunded under section 41(3) of the VAT Act 1994.

The recoverable VAT that relates to the government departments business activities will then be dealt with using the partial exemption calculation. Read the partial exemption section of this guidance for more information.

Read the VAT Business/Non-Business Manual VBNB33000: different types of Apportionment methods for more information about business/non-business apportionment and the types of methodology that can be used.

The standard way of apportioning VAT between business and non-business, and also apportioning business VAT (input tax) between taxable and exempt use, is an income based method (outputs).

Income may also be used as a method for allocating VAT to specific sectors if a government department adopts a sectorised method (read the use of sectors section of this guidance for more information). One of the complications for a government department in using income as a method is that they will receive grant funding, where they sometimes use these grants to make onward grants to other entities.

If the government department is not using the grant it receives to undertake its own activity, but instead passes on a certain amount to others, then the total amount of income received will not accurately reflect the use of the VAT-bearing costs. This is because instead of being used to support its own activities, that income is simply passed on and not used by the government department at all.

If a government department decides to adopt an income based method, (which is used in the worked example later in this framework) then one way of remedying onward grants is to deduct them from total grants. This should be explained to HMRC in any method proposal.

An important point to remember is that where a government department is using either the partial exemption standard method or an approved PESM they must carry out the business/non-business apportionment calculation before the partial exemption calculations are carried out.

Partial exemption

The partial exemption standard method is the default option for calculating deductible input tax and a government department does not require approval from HMRC to operate the standard method. Further information on the standard method is detailed in:

Partial exemption special method

Some government departments may find the standard method is unsuitable if it does not achieve a fair and reasonable recovery of input tax attributable to taxable supplies. Read the VAT Partial Exemption Guidance Manual PE24000: fair and reasonable for more information.

In these circumstances, the government department may wish to apply to HMRC for approval to use a PESM which can provide greater accuracy in how input tax is attributed to taxable supplies or supplies which give the right to deduct, based on use or the intended use in making those supplies.

For more information read the VAT Partial Exemption Guidance Manual:

A government department can request the approval of a PESM by submitting a written proposal to HMRC which should outline the proposed methodology that will be used to identify the proportion of input tax attributable to taxable supplies. For more information read the VAT Partial Exemption Guidance Manual:

The PESM request must be accompanied by a statutory declaration that the proposed method is fair and reasonable. Read the VAT Partial Exemption Guidance Manual PE43200: preparing the declaration for more information.

If HMRC is satisfied the proposed method is fair and reasonable, it will approve the use of the PESM in writing and once approved the PESM is binding on both sides until a new special method is approved or directed or until the PESM is withdrawn by HMRC and the government department reverts to the standard method.

Combined methods

From 1 January 2011, HMRC can approve a partial exemption method covering business/non-business calculations, this is a single agreement covering the business/non-business and partial exemption calculations and is known as a combined method. For more information see:

Most of the rules relating to PESMs apply to combined methods (read the VAT Partial Exemption Guidance Manual PE30000: Partial Exemption methods. However it’s worth noting that the partial exemption de minimis limit does not apply if a government department operates a combined method.

It is also important to note that the de minimis limits apply to the government department VAT registration as a whole and not to separate divisions within that VAT registration. Read the VAT Partial Exemption Guidance Manual: PE24500: De minimis for more information.

Use of sectors in a PESM or combined method

A government department may wish to propose a methodology that allocates costs according to sectors. These sectors should arise naturally out of the way a government department is structured and organised and should not be an artificial creation just for the purposes of partial exemption. For more information read the VAT Partial Exemption Guidance Manual:

If separate records have to be created in order to operate a sector, it suggests that the sector is not a natural one, but is being created solely for partial exemption and VAT purposes. Sectors should ideally follow the existing commercial and statutory divisions of the government department. In many cases this is likely to mean sectors based on either individual legal entities or collective groups of companies with similar activities, although a government department (and thus its natural sectors) can also be organised along the lines of:

  • specific functions
  • products
  • projects

The examples given are just illustrative. Regulatory requirements might create another natural division.

You may wish to consider creating sectors for specific types of cost pool. For example, if the government department sub-lets its property to third parties it may consider ring-fencing its property related VAT cost and allocating it between its own use to fulfil its statutory functions together with making taxable supplies and sub-letting to third parties.

This would provide a more accurate result since costs are being analysed at a more granular level to determine how they are used. Typically a floor space based allocation will provide a reliable result for property related VAT cost, however this will be determined by the individual circumstances of each government department and how the associated costs are used. Read the VAT Partial Exemption Guidance Manual PE22500: allocation for more information.

It is good practice to include a sector for mixed-use VAT that is not dealt with elsewhere in the special method. This catch-all sector may also be used to deal with any new activities that have yet to be addressed in the method. It is also good practice to include a use-based sector to include major projects and anything outside the usual operation of normal activities. This use based method enables government departments to contact HMRC to discuss and agree a suitable basis for apportionment which reflects the use of VAT in specific circumstances as and when the need arises.

Longer period adjustment (or annual adjustment)

A government department using any type of partial exemption method must undertake a longer period adjustment which reviews how VAT was allocated and attributed to taxable supplies for each VAT return period, and makes adjustments if the use of the underlying cost during the longer period was different from the outcome of the provisional monthly calculations undertaken. Read the VAT Partial Exemption Guidance Manual PE37400: longer periods and annual adjustments for more information.

The longer period adjustment is distinct from the adjustment to provisional refunds of COS VAT, although the method may provide the necessary calculation to determine the COS adjustment.

The default position is that a government department must carry out its longer period adjustment in the period after the end of the VAT tax year. government departments complete monthly or quarterly VAT returns, meaning that HMRC would expect to see the longer period adjustment being carried out in the April or June return as appropriate.

Alternatively, HMRC allow the adjustment to be carried out in the final period of the tax year (the March return).

PESM override

If a government department chooses to operate the partial standard method they will need to consider whether they should carry out a standard method override adjustment. This deals with circumstances where the standard method does not produce a fair and reasonable deduction of input tax, read the VAT Partial Exemption Guidance Manual PE32500: the standard method override.

If the override limits are continually breached then the government department may wish to consider a special method to calculate the recoverable amount of input tax rather than operating the standard method and applying the override provisions each year.

Other issues to consider

Reverse charge

Government departments should be aware that the reverse charge provisions established under section 8 of the VAT Act 1994 will apply to them.

If a government department is engaged in both business and non-business activities, supplies they receive from outside the UK will be treated as a business to business supply for the purposes of the place of supply rules.

This means where a UK based government department is engaged in both business and non-business activities and receives services which would be taxable if made in the UK, they will be required to account for output tax under the reverse charge rules on those supplies, even if they relate solely to its non-business activities.

Accounting for VAT using the reverse charge procedure is not a complicated procedure in accounting terms. Instead of being charged VAT by the supplier, a UK government department who receives any of the relevant services, credits their VAT account with the necessary amount of output tax as if they had supplied the services themselves, and at the same time, debits his account with the amount of VAT they are entitled to recover as input tax under section 26 of the VAT Act 1994.

Where the reverse charge services relate to non-business activities, any proportion of VAT relating to COS should be dealt with under section 41(3) of the VAT Act 1994.

The practical effect of this is that there will be no net tax payable to HMRC on the transaction except by government departments which are not entitled to a full deduction of VAT on costs (that is, they make exempt supplies or undertake non-business activities where the VAT does not fall under a COS heading). Therefore, the government department should account for the output tax and restrict the recovery of the input VAT as appropriate.

Provisional recovery rates

It is recommended that a government department asks for provisional recovery to be considered as part of its special method request. Provisional recovery means that the previous year’s recovery percentage can be applied in all tax periods during the current tax year.

This can ease the administrative burden for a government department because the full calculation only has to be undertaken once each year. The revised figure is then applied to the tax year as part of the longer period adjustment that forms part of the partial exemption or combined method.

A government department that does not apply for provisional recovery has to determine its recovery percentage in each individual prescribed accounting period.

The disadvantage of using provisional recovery rates based on last year’s calculations is that if in the current year the government department is using its costs in a different way, for example more VAT is incurred on costs relating to taxable business activities, then using the previous year’s recovery percentage may lead to a substantial difference when undertaking the annual adjustment. However, where costs are likely to be used in the same proportion of business and non-business each year, using the previous year’s recovery percentage will reduce the administrative burden and is unlikely to result in a large annual adjustment.

The Capital Goods Scheme

The Capital Goods Scheme applies to capital expenditure, on land and buildings with a value of £250,000 or more (exclusive of VAT), which was subject to VAT at the standard or reduced rate. For more information see:

VAT on costs allocated entirely to non-business activities is not eligible for adjustment under the Capital Goods Scheme rules.

New PESM or combined method proposals

HMRC’s position is that prior to the use of a PESM or combined method, government departments were funded for their irrecoverable VAT (HMRC’s letter 30 August 2016 issued to all government departments refers). Therefore any PESM or combined method proposal will only be approved from the start of the current tax year in which the declaration is received.

If you consider that your request for a PESM or combined method should be applied retrospectively then advise the reasons why and HMRC will consider these on a case by case basis. It is worth noting that requests for retrospective changes will only be allowed in exceptional circumstances. This is usually where the HMRC has been at fault, the method is inoperable, or where the method of calculation does not give any result, for example because both the top and bottom of the calculation are zero.

Changes to an existing PESM or combined method

After the use of a special method has been approved by HMRC, a government department may need to change its method if new circumstances arise or new activities are being undertaken.

Read the VAT Partial Exemption Guidance Manual PE47500: requests for changes to special methods for information about the actions to take.

Government department and registration

Government departments must register for VAT regardless of the annual value of the taxable supplies they make. This allows them to claim a refund of VAT, under section 41(3) of the VAT Act 1994, on qualifying contracted out services used for non-business purposes.

Government departments must account for VAT and can reclaim any relevant VAT that relates to the entities included within that government department’s VAT registration. Therefore, it is important to include the activities of all the entities associated with the government department VAT registration in any special method proposed to HMRC. This ensures the method considers all business and non-business activities of the government department as a whole when considering how, and to what extent, the VAT-bearing cost are used in making taxable supplies.

Example of a combined method and calculation

This example is purely for illustrative purposes and should not be taken as implying that certain mixes of activities will result in the recovery rates quoted. Each government department should consider its own mix of activities and own accounting systems before applying the principles shown in the following example.

VAT registration number [insert number]

Business/non-business and partial exemption special method (combined method)

Consideration has been given to your request dated [insert date] in which you seek approval for the use of a special method to determine your recoverable input tax and your declaration of the same date that to the best of your knowledge and belief your proposals are fair and reasonable. The method is set out in this letter and the Commissioners approve that method (and hereby record their approval of it) subject to the conditions below.

Scope of the method

This method has been approved under regulation 102ZA of the VAT Regulations 1995.

It incorporates VAT attributable to non-business activities as defined in section 24(5) of the VAT Act 1994 and input tax attributable to foreign and specified supplies as defined in regulation 103 of the VAT Regulations 1995.

Duration of the method

You must use this method to calculate your recoverable input tax with effect from [insert date] and must use it until such time as the commissioners approve or direct the termination of its use. You should make proposals to this office for a new method if this one no longer results in a fair and reasonable recovery of input tax.

This approval is given in the context of your current business structure and trading patterns as advised by you to this office. Should there be any change in the structure of your business and (or) trading patterns that prevent this method from giving a fair and reasonable recovery of input tax, you should inform this office of the change or changes immediately in writing, and comment on how the changes affect the operation of this method.

Planned changes should, wherever practicable, be notified to this office at least 30 days in advance of implementation and in any event, no later than upon implementation. You should also inform this office in writing immediately if any connected company commences or re-commences trading with the business. For the purposes of this letter any question as to whether a person is connected shall be determined in accordance with section 1122 of the Corporation Tax Act 2010.

Meaning of terms

For the purposes of this method the words used shall have the meanings defined in this letter, or if not defined here, their meaning as defined in the VAT Act 1994 and the VAT Regulations 1995, or if not defined there, their normal everyday meaning.

Definition of taxable supplies

Where this method refers to taxable supplies it should also be taken to include:

Definition of exempt supplies

Where this method refers to exempt supplies, it should also be taken to include any supply made outside the UK, which would be exempt if made inside the UK, other than any supply specified in an Order made under section 26(2)(c) of the VAT Act 1994.

Definition of mixed-use VAT

Where this method refers to mixed-use VAT it means VAT on a supply which is used, or to be used, in making supplies in the course or furtherance of your business other than supplies made under paragraph 5(4) of schedule 4 of the VAT Act 1994 and which is also used, or to be used, in any non-business activity.

Non-attributable contracted out services

Where the method refers to non-attributable COS, this is mixed-use VAT which has been incurred on a service which falls under a COS heading and is used for both business and non-business purposes. An apportionment is required to identify the element of VAT incurred on mixed-use VAT (including non-attributable COS VAT) that is attributable to business activities (taxable supplies and exempt supplies). The remaining VAT used or intended to be used to undertake non-business activities will be refundable if the service falls under a COS heading and should be dealt with under section 41(3) of the VAT Act 1994.

Tax year

Your tax year begins on [insert date] and ends on [insert date].

Attribution

In each prescribed accounting period you’ll:

  • identify all supplies, acquisitions and imports you receive which are used, or to be used, in whole by you exclusively in making taxable supplies, the input tax thereon is recoverable
  • identify all supplies, acquisitions and imports you receive which are used, or to be used, in whole by you exclusively in making exempt supplies, the VAT thereon is irrecoverable
  • identify all supplies, acquisitions and imports you receive which are used, or to be used, in carrying on any non-business activities which do not fall under the contracted out services section 41(3) of the VAT Act 1994, the VAT thereon is not recoverable
  • identify all supplies, acquisitions and imports you receive which are used, or to be used, in whole by you exclusively for non-business activities which fall under a COS heading, the VAT thereon should be dealt with under section 41(3) of the VAT Act 1994
  • determine the amount of any remaining mixed-use VAT that can be recovered using the calculations demonstrated below

Step 1: business/non-business apportionment

Identify the proportion of mixed-use VAT that is attributable to business activities using the following calculation:

  1. Add together total exempt supplies and taxable supplies to give (A).
  2. Add together total exempt supplies, taxable supplies and non-business income to give (B).
  3. Divide (A) by (B) to give (C).
  4. Multiply (C) by 100 to give (D) the proportion of mixed-use VAT attributable to business activities.

The proportion of VAT identified in this calculation relates to business activities, that is the making of taxable and exempt supplies. This VAT is defined as residual or non-attributable input tax. The remaining proportion of VAT identified in the calculation relates to non-business activities and is irrecoverable unless it relates to services falling under the contracting-out direction which should be dealt with under section 41(3) of the VAT Act 1994 .

Step 2

The proportion of residual or non-attributable input tax attributable to taxable supplies shall be quantified by multiplying the input tax calculated in step 1 by the following calculation (this VAT is recoverable):

  1. Divide taxable supplies by (total exempt supplies plus taxable supplies) to give (E).
  2. Multiply by 100 to give (F).
  3. Multiply (F) by (D) from step 1.

The remaining amount is exempt input tax which is irrecoverable.

Use calculation wording

Mixed-use VAT incurred in respect of activities not covered elsewhere in this method is input tax to the extent that it is incurred on goods or services which are used, or to be used, to make taxable supplies or exempt supplies, expressed as a proportion of the whole use or intended use.

Non-attributable input tax incurred in respect of activities not covered elsewhere in this method is deductible to the extent that it is incurred on goods or services which are used, or to be used, to make taxable supplies, expressed as a proportion of the whole use or intended use.

Rounding in apportionment calculations

All ratios are to be expressed as a percentage and shall be rounded up to 2 or more decimal places in each tax period and the longer period adjustment.

Estimated provisional recovery

In each prescribed accounting period, the annual recovery percentage of the previous tax year can be used to calculate the deductible proportion of mixed-use VAT and (or) non-attributable input tax. The calculations detailed in steps 1 and 2 shall be used when performing the longer period adjustment.

Exclusions from an outputs-based calculation

Exclude the value of any supplies specifically excluded by regulation 101(3) of the VAT Regulations 1995 from the calculations. You must also exclude the value of all supplies in the following categories:

  • any supply made from branches situated outside the UK and the value of any non-business activity carried on from branches situated outside the UK
  • any supply of any goods or services sold on in the same state connected to the making of an advance or the granting of any credit, including for example, goods sold on by a finance house under a hire purchase agreement
  • any supply of goods or services made to connected parties, where the supply is acquired for the purposes of your business and supplied to the connected party without material alteration or further processing
  • supplies made where it is intended that the same, or equivalent, goods or services will be subsequently used by the business including for example, goods or services forming part of a sale and leaseback transaction

Supplies and connected parties

Where the value of a supply made to a business connected party is either significantly less than, or significantly greater than, its open market value, then, the value of the supply shall be taken to be its open market value for the purposes of this method.

De minimis

Regulations 105A, 106 and 106ZA of the VAT Regulations 1995 do not apply. You are not permitted to be treated as fully taxable under the de minimis rules.

Longer period adjustment

A longer period adjustment must be carried out and declared in accordance with regulation 107 of the VAT Regulations 1995.

Capital Goods Scheme

Your attention is also drawn to the provisions of the Capital Goods Scheme part XV of the VAT Regulations 1995.

Change of intended use

If you claim any input VAT as deductible by virtue of its intended use and the use, or the intention changes, you may need to make adjustments as described in regulations 108, 109 and 110 of the VAT Tax Regulations 1995.

Requirements

You are required to keep records to show how you’ve calculated your deductible input tax and enable an officer of HMRC to verify the amount claimed.

Contact officer

Should you wish to discuss this letter contact [insert name] at the above address.

Example calculation

This method shown in the following worked example is likely to be suitable for smaller and less complex government departments. Remember that this simple method is still a special method. Like all special methods its use needs to be approved in advance by HMRC. Refer to the Checklist for HMRC approval section for advice on how to obtain that approval.

Remember that, as part of the approval process, you’ll need to make a statutory declaration that the method gives a fair and reasonable recovery of VAT for your organisation, and that you’ve taken reasonable steps to satisfy yourself on this point.

Business and non-business activities are identified first where the income received from each has been identified. With regards to the non-business income (grant funding) you’ll see in the example that an amount has been deducted for an onward grant which would distort the calculation. Read the business non-business apportionment section of this guidance for more information.

Directly attributable VAT on costs that are used, or to be used, wholly in making taxable business supplies or exempt business supplies

VAT attributed to taxable business activities is recoverable under section 26(2)(a) of the VAT Act 1994. VAT attributed to exempt business supplies is irrecoverable.

Directly attribute VAT on costs that are used, or to be used, wholly in making non-business supplies

Non-business VAT that is covered by one of the COS headings (COS VAT) should be dealt with under section 41(3) of the VAT Act 1994. Non-business VAT that is not covered by one of the COS headings is not recoverable nor can it be dealt with under section 41(3).

VAT that cannot be directly attributed is your residual VAT and relates to costs for mixed-use

This mixed-use VAT, will include VAT incurred on costs used to perform both business and non-business activities which needs apportioned. Within the business portion, there may be both taxable and exempt use, where the exempt portion is irrecoverable.

The non-business portion will only be refundable if the cost the VAT was incurred on fell under a COS heading (non-attributable COS VAT). VAT incurred on goods, certain utilities, or any other service not under a COS heading, which relates to both business and non-business activity will be within this pot of mixed-use VAT will not be refundable under section 41(3) of the VAT Act 1994.

You may wish to identify non-attributable COS VAT and carry out the business/non-business apportionment on that separately, rather than on the whole of the mixed-use VAT. Read the direct attribution of VAT incurred section of this guidance for more information.

Step 1

To calculate the business proportion of mixed-use VAT, multiply your mixed-use VAT by the following ratio (expressed as a percentage):

Taxable and exempt supplies divided by (total taxable and exempt supplies and non-business income)

The proportion of VAT identified from the calculation relates to business activities, that is, the making of taxable and exempt supplies. This VAT is residual or non-attributable input tax and is dealt with in step 2.

The remaining proportion of VAT identified from the calculation relates to non-business activities and is irrecoverable unless it relates to services falling under the contracting out direction (COS).

It’s only attributable to COS if it’s allocated to a COS heading based on how it’s used or intended to be used to undertake non-business activities. Any VAT identified as falling under a COS heading should be dealt with under section 41(3) of the VAT Act 1994. The remaining VAT is not recoverable under the COS refund scheme nor as input tax.

Step 2

To identify the recoverable element that is attributable to taxable supplies, multiply the business proportion of mixed-use VAT by the following ratio (expressed as a percentage rounded up to 2 decimal places). This VAT is recoverable as input tax under section 26(2)(a) of the VAT Act 1994.

Taxable supplies divided by taxable and exempt supplies.

The remaining proportion of mixed-use VAT is attributable to exempt supplies and is irrecoverable.

The precise activity which certain costs are used for will vary across the government department sector, a cost may be directly attributable for one government department, but may fall into mixed-use VAT for another. This will apply to costs which fall under a COS heading as well. It’s therefore important to not assume that a cost which falls under a COS heading is wholly attributable to non-business activities.

For example, a government department may incur £1 million on computer services under COS heading 14. These services may be used to support most of the non-business activity of a government department, however the government department may use it for business too, for example, they may use it to make an onward taxable supply to an arm’s length body. This means that the cost will be mixed-use.

The mixed-use VAT is apportioned using a fair and reasonable apportionment method. It’s only the non-business element of this cost which may be refunded under section 41(3) of the VAT Act 1994.

There are various ways of working out the non-business portion. One way of doing this is with an income based method as per the worked example. If you work out that 90% of the use of this is non-business, then £900,000 of it can be refunded under section 41(3). The remaining £100,000 which relates to business activity must then have a partial exemption calculation carried out on it to work out how much of it relates to taxable activity which may be recovered.

If, for example you work out that 80% of this activity is used for taxable activity, then £80,000 can be recovered. This leaves £20,000 which relates to exempt activity which is irrecoverable. As with a non-business apportionment method, there are various ways of calculating the apportionment but it must generate a fair and reasonable result.

Worked example of a combined method and calculation for government departments

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Checklist for HMRC approval

This checklist identifies what you should consider when making an application to seek HMRC’s approval of a method.

Seeking approval for a VAT recovery method

Check you’ve taken reasonable steps

The person making a statutory declaration that a proposed VAT recovery method gives a fair and reasonable attribution of input tax has to state that they have taken reasonable steps to ensure they have all relevant information relating to the proposed method. If you have to make a declaration, check that you’ve covered the following points.

Consider whether your method needs sectors

You should consider a sector if:

  • an activity is subject to segmental accounting and uses taxed costs in a different way to that suggested by the result of a single calculation covering all of the trust’s activities
  • the result of a single calculation covering all of the trust’s activities is materially different from the result of an attribution which represents the extent to which the goods and services are used, or will be used by you, in making taxable supplies while performing that activity

Prepare a worked example of your proposed method

To accompany the explanatory narrative of how the method works, HMRC needs to receive a worked example of how the method will work in practice, using actual figures. The worked example should clearly show how the total amount of VAT incurred is allocated to business and non-business activities, and how the business VAT is apportioned between taxable and exempt supplies.

An explanation of why you feel your proposed method gives a fair and reasonable result should be given. If there’s no worked example, it may create uncertainty about the methodology. HMRC cannot give approval for a proposed method if there’s uncertainty or ambiguity.

Design your method using the framework and HMRC guidance

If your proposal is not based on the VAT recovery method in this framework HMRC will give it due consideration, without preconceptions, over its acceptability. However, you should expect more detailed enquiries will be made and the proposal fully tested.

Make your declaration

You’ll need to make a statutory declaration in accordance with the law (set out in regulation 102(9), of SI 1995/2518). You should be able to do this if you’ve taken the reasonable steps described to ensure your proposed method gives a fair and reasonable result. The declaration must clearly identify the document containing the proposal. This is usually the letter setting out the stages of the method.

Templates

You can use the following templates to help you explain your chosen method to HMRC. Although the templates are addressed to the taxpayer from HMRC, this is the format that HMRC routinely receives from other businesses. This means HMRC can simply reissue the letter to the taxpayer to approve the method.

Template for partial exemption special method

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Template for business/non-business and partial exemption special method (combined method)

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Glossary

Allocation

Some special methods have different sectors where the recoverable element of residual input tax is different. Allocation is the means by which residual input tax is distributed to specific sectors within a method. For the purposes of the Executive, each department could be treated as a sector within a special or combined method.

Annual Adjustment

At the end of the tax year the partial exemption calculation is recalculated using annual figures. It reconsiders your use of goods and services over the longer period. It reviews how VAT was allocated and attributed to business (taxable and exempt supplies) and non-business activities for each VAT return period and makes adjustments if the use of the underlying cost during the longer period was different from the outcome of the provisional quarterly calculations undertaken.

Apportionment

Residual input tax must be apportioned to reflect the extent to which the purchases on which is it incurred are used in making onward taxable supplies. The partial exemption method carries out this function. Mixed use VAT bearing costs must be apportioned between business and non-business activities initially.

Business activities

Activities which are not carried out under any statutory requirement or where the activity may be defined as a business activity in accordance with section 41A of the VAT Act 1994. This may result in supplies that are taxable or exempt and attributable VAT costs will be deductible subject to the normal partial exemption rules.

Combined method

HMRC can approve a partial exemption method covering business and non-business calculations. This is a single agreement covering both activities and is known as a combined method.

De minimis tests

Tests designed to allow recovery of minimal amounts of exempt input tax. A combined method does not provide for recovery under these tests.

Direct attribution

The identification of input tax on supplies that are wholly used, or to be wholly used, in making taxable supplies or are wholly used or to be used in making exempt supplies. This also applies to VAT bearing costs that are exclusively used, or intended to be used, for non-business activities.

Exempt input tax

Input tax incurred on purchases which are used or to be used in making exempt supplies. It comprises input tax directly attributable to exempt supplies and, after the partial exemption method has been applied, the exempt element of residual input tax identified by the partial exemption method.

Exempt supplies

Supplies made by a business, which are listed in schedule 9 of the VAT Act 1994. VAT incurred in making exempt supplies is non-recoverable, unless they are specified supplies.

Input tax

VAT incurred by a VAT registered entity on goods and services purchased for the purposes of a business.

Mixed-use VAT-bearing costs

This means VAT on a supply, which is used, or to be used, to make both business supplies and in undertaking non-business activities. A combined method will prescribe how the VAT should be apportioned between business and non-business activities.

Non-business activities

The principal activities of government departments are predominantly undertaken for no consideration and are carried out under statutory regulation to deliver public services. These activities are non-business and are therefore outside the scope of VAT. VAT costs attributable to non-business activities are irrecoverable.

Provisional recovery

This can be included as part of a special or combined method agreement. The previous year’s recovery can be applied in all tax periods during the current tax year. The provisional recovery is adjusted at the time of the annual adjustment using the recovery percentage for the current tax year.

Residual input tax

Input tax which is used, or to be used, to make both taxable and exempt supplies. It’s apportioned between taxable and exempt supplies by the partial exemption method. Residual input tax is commonly referred to as non-attributable input tax or the pot.

Sectors

Sectors are used within a PESM to subdivide a single calculation into different business areas, this enables different parts or divisions of a government department to adopt a separate calculation appropriate to its circumstances.

Special method

Any partial exemption method, other than the standard method, used to identify the taxable element of input tax incurred. Special methods require prior approval from HMRC.

Specified supplies

Supplies specified by Treasury Order which are not taxable supplies, but which carry the right to recover input tax incurred in making them. An example is exempt supplies made to businesses outside the UK.

Standard method

This is the default partial exemption method. Further information on the standard method is detailed in VAT Notice 706 (partial exemption). For larger and complex entities a special or combined method is typically used to ensure the method is fair and reasonable and produces an accurate result.

Taxable input tax

Input tax incurred on purchases of goods and services which are used, or are to be used, in making taxable supplies and other supplies which carry the right to deduct.

Taxable supplies

Supplies made by a business, which are either standard, reduced or zero-rated. Input tax incurred in making supplies is deductible.

Tax year

Every VAT registered business has a tax year. The tax year is a period of 12 calendar months and normally ends on 31 March, 30 April or 31 May depending on your tax periods. However, using the special or combined method means the tax year can align with the executive accounting reporting year of December.

Published 29 March 2023
Last updated 29 March 2023 + show all updates

  1. To make the information accessible, this page has been published in HTML format to replace the original PDF. It has also been updated to remove outdated EU references as a result of the UK leaving the EU. The other content of this document has not changed.

  2. First published.

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