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HMRC internal manual

VAT Partial Exemption Guidance

Partial Exemption basics: EU law


EU Law

This section will go through how partial exemption arises from, and fits into, the basic system of VAT, that is universal to all EU countries, as underpinned by EU law.

The VAT system

The basic shape of VAT, with each business declaring output tax net of their claim for input tax through a chain of supply until tax finally sticks with the end consumer, is set out in the principal VAT Directive (2006/112/EC) [Formerly the First and Sixth VAT Directives (Directives 67/227&77/388)].

Article 1(2) (formerly Article 2) says:

“On each transaction, value added tax…shall be chargeable after deduction of the amount of value added tax borne directly by the various cost components”.

This introduces the ideas of input tax and deductibility.

The various articles of the principal VAT Directive (2006/112/EC) define how this system will work in practice.


Title IX, Chapters 1 to 10, Articles 131 to 166 (Formerly Articles 13 to 16, Dir 77/388), set out which transactions will be exempt from VAT. However the European legislation uses “exempt” in a wider context than the UK legislation. It concentrates on whether or not there is a right to deduct, so for example:

Exempt… is translated into UK legislation as…
with the right to deduct either zero-rated or outside the scope with the right to deduct
without the right to deduct either exempt or outside the scope without the right to deduct.

In general, transactions with the UK definition as being exempt from VAT, being outside the VAT system, are not eligible for deduction of input tax borne on their cost components. The business making the exempt supply effectively becomes the final consumer.


Title X, Chapter 1, Articles 167 to 172 of the principal VAT Directive (2006/112/EC) (Formerly Article 17, Dir. 77/388) set out when the right to deduct input tax arises, both in terms of the output transactions that carry this right for their associated cost components and in terms of the time that this right is acquired.

Article 167 (Formerly Article 17(1), Dir. 77/388) states that any right arises at the time when the business incurs the input tax.

Article 168 (Formerly Article 17(2), Dir. 77/388) states that taxable transactions carry the right to deduct input tax on their cost components.

Article 169 (Formerly Article 17(3), Dir. 77/388) states that some transactions that are not taxable will also carry the right to deduct input tax on their cost components. These include supplies made outside the UK that would have been taxable if they had been made in the UK and financial or insurance supplies made outside the EU.

Article 173 (Formerly Article 17(5), Dir. 77/388) addresses how input tax on business costs, that are partly cost components of supplies carrying the right to deduct and partly cost components of supplies not carrying such a right, is to be treated. It states that it will be deductible only to the extent that it is attributable to the former. It also sets out a basic rule, and some alternative options, of how calculations leading to this attribution shall be carried out.

Article 173(2)(e) also includes a provision that member states may allow businesses to deduct input tax on supplies that do not carry the right to deduct as long as the amount is insignificant.

Article 173 introduces Article 174 & 175 (Formerly Article 19, Dir. 77/388) as the method by which the extent of taxable use of the residual costs is to be ascertained. However, it allows Member States to adopt any of sub-paragraphs (a) to (e) of that Article, rather than Articles 174 & 175. The UK has taken this option and our regualtions are based on the article 173 alternatives.

Adjustments to deductions

Title X, Chapter 5, Articles 184 to 192 (Formerly Article 20, Dir. 77/388) allows for adjustments to how much input tax was initially deducted in certain circumstances. Attribution of input tax under Article 173 is an annual process so adjustments within the year are possible. Other than this, adjustments are only possible within the limits provided for in Articles 184 to 192.

Translation into UK law

Member states are required to enact national law to bring into effect the provisions of EU directives in their country. PE11500 - UK partial exemption law - goes through how the above has been implemented in UK partial exemption law.