VAT and interest on client account funds

While many legal firms may already be familiar with the VAT issues associated with client account funds, a refresher can be invaluable. This article delves into the key points regarding the VAT implications of receiving interest on such accounts.

A lot of legal firms will be in the process of preparing their VAT returns for the quarterly period ending 30 June 2024 and as part of the VAT return calculations, a review of the VAT recovered in the period 1 April 2023 to 31 March 2024 should take place (known as a partial exemption annual adjustment).

Background

With the interest rate rises over the past year or so, many legal firms have received significant amounts of interest on their client account funds. The receipt of interest income is normally treated as an exempt supply for VAT purposes.

Where an organisation makes both supplies which are subject to VAT, known as taxable supplies, and exempt supplies there may be a restriction in the amount of VAT that it can recover on costs. The starting point is that VAT recovery on any costs which are not directly and immediately linked to taxable or exempt supplies is calculated using the partial exemption standard method (the “Standard Method”). VAT that is not directly attributable to a taxable or exempt supply is known as residual (or non-attributable). The Standard Method for recovery of residual VAT is an income-based methodology and the recovery of residual VAT is calculated broadly by calculating taxable income as a proportion of the total income.

Why now?

Historically, when interest rates were low, interest income on client account funds received by legal firms was small in value and consequently it didn’t have any impact on residual VAT recovery. This is due to the fact for many firms the interest income was less than 1% of total income and under Standard Method, usually the residual VAT recovery rate is rounded up to the next whole number hence firms had a 100% residual VAT recovery rates. Additionally, if a firm’s interest income was more than 1% of total income in many cases, it was possible to treat the residual input tax as fully recoverable because the partial exemption de minimis limit was not breached.

It’s important to note that although VAT law allows incidental finance income to be excluded from the Standard Method calculations, often HMRC do not treat interest received by legal firms as incidental income.

How we can help

Our VAT team can help you by:

• Determining the amount of interest that should be included as exempt income within the partial exemption calculations,
• Reviewing the attribution of input tax, and
• Considering if an alternative VAT recovery methodology could be used.

If you’d like to discuss this further, please get in touch with Callum Richards.