Partial Exemption VAT — A Simple Explanation

The Accounted Tax Team·3 March 2026·8 min read

If your business makes both taxable and exempt supplies, welcome to the world of partial exemption. It sounds complicated — and honestly, it can be — but the underlying concept is quite logical once you understand it.

In essence, partial exemption is about working out how much of the VAT on your business expenses you're allowed to reclaim. Because some of your income is exempt from VAT, you can't reclaim all the input tax on your costs. You need to apportion it fairly.

This guide explains partial exemption in plain English, walks you through the standard method of calculating it, and covers the de minimis rules that might let you off the hook entirely.

What Are Exempt Supplies?

Before diving into partial exemption, let's clarify what exempt supplies actually are. VAT-exempt supplies are goods or services that don't have VAT charged on them at all — not even at 0%. They're completely outside the VAT charging system.

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Common exempt supplies include:

Financial services — insurance, banking, loans, credit
Education — provided by eligible bodies (schools, universities, and some private providers)
Health and medical services — by registered practitioners
Burial and cremation services
Certain land and property transactions — rental of residential property, sale of existing commercial property (unless you've opted to tax)
Subscriptions to professional bodies and trade unions
Betting, gaming, and lotteries
Postal services provided by Royal Mail

Exempt supplies are different from zero-rated supplies. Zero-rated goods (like most food, children's clothes, and books) are technically taxable supplies — they're just taxed at 0%. This distinction matters enormously because if you only make zero-rated and standard-rated supplies, you're fully taxable and can reclaim all your input tax. It's only when exempt supplies enter the picture that partial exemption kicks in.

Why Partial Exemption Matters

The basic principle of VAT is that you can reclaim the VAT on purchases (input tax) that relate to making taxable supplies. If all your supplies are taxable, you reclaim everything. Simple.

But if some of your supplies are exempt, HMRC says you can't reclaim the input tax on costs that relate to those exempt supplies. After all, you're not charging VAT on that income, so it wouldn't be fair to reclaim VAT on the associated costs.

The tricky bit is that many of your business costs don't neatly relate to either taxable or exempt supplies — they relate to both. Your office rent, your phone bill, your accountancy fees — they support your entire business, not just one type of supply.

That's where the partial exemption calculation comes in.

The Three Categories of Input Tax

Under partial exemption, you need to split your input tax into three categories:

1. Directly Attributable to Taxable Supplies

VAT on purchases that relate wholly to your taxable activities. You can reclaim this in full.

Example: If you're a landlord who rents out both residential property (exempt) and commercial property (taxable because you've opted to tax), the cost of repairing the commercial building relates directly to taxable supplies. You can reclaim all the VAT on those repairs.

2. Directly Attributable to Exempt Supplies

VAT on purchases that relate wholly to your exempt activities. You generally cannot reclaim this at all (unless you qualify under the de minimis rules).

Example: The cost of repairing the residential building in the above scenario relates directly to exempt supplies. No input tax recovery.

3. Residual Input Tax (Non-Attributable)

VAT on purchases that relate to both taxable and exempt supplies — your general overheads. This is the pot that needs to be apportioned.

Example: Your accountancy fees, office supplies, marketing costs, phone bills, and similar general expenses that support your whole business.

The Standard Method

HMRC's standard method for apportioning residual input tax is based on the ratio of your taxable turnover to your total turnover. Here's how it works:

Step 1: Calculate Your Recovery Percentage

Take your taxable turnover (including zero-rated supplies) and divide it by your total turnover (taxable plus exempt). Multiply by 100 to get a percentage. Round up to the nearest whole percentage point.

Formula:

Recovery percentage = (Taxable turnover / Total turnover) × 100

Example:

Taxable turnover: £80,000
Exempt turnover: £20,000
Total turnover: £100,000
Recovery percentage: (£80,000 / £100,000) × 100 = 80%

Step 2: Apply the Percentage to Residual Input Tax

Multiply your residual input tax by the recovery percentage.

Example:

Total residual input tax for the quarter: £2,000
Recovery percentage: 80%
Reclaimable residual input tax: £2,000 × 80% = £1,600

Step 3: Add It Up

Your total reclaimable input tax for the quarter is:

Input tax directly attributable to taxable supplies (100% recoverable)
Plus reclaimable portion of residual input tax (from Step 2)
Minus input tax directly attributable to exempt supplies (0% recoverable, subject to de minimis)

This is the figure that goes on your VAT return.

The De Minimis Rules

Here's where it gets a bit more cheerful. If your exempt input tax is small enough, you can treat it as if it were fully recoverable and reclaim the lot. These are the de minimis rules.

You pass the de minimis test if your total exempt input tax (both directly attributable and the non-recoverable portion of residual) is:

£625 or less per month on average (£1,875 per quarter), AND
50% or less of your total input tax

Both conditions must be met. If you pass, you can reclaim all your input tax as if you were fully taxable. If you fail either test, you can only reclaim the taxable portion.

Why This Matters

For many businesses with only minor exempt supplies, the de minimis rules are a lifesaver. If you're, say, a consultant who also earns a small amount of exempt insurance commission, your exempt input tax might be well within the de minimis limit — meaning you don't need to worry about partial exemption at all.

It's still worth doing the calculation each quarter to check, but in practice, many partly exempt businesses fall within the de minimis limits and can simply reclaim all their input tax.

The Annual Adjustment

Partial exemption isn't just a quarterly exercise. At the end of each VAT year (which may or may not align with your financial year), you need to do an annual adjustment.

This involves recalculating your recovery percentage using the figures for the full year, then comparing the result with what you actually reclaimed during the year. If the annual calculation gives a higher recovery percentage, you get a refund. If it gives a lower one, you owe HMRC the difference.

The annual adjustment goes on the VAT return for the period that includes the end of your VAT year. It's an important step that catches any distortions caused by unusual quarters — for example, if you made an unusually large exempt supply in one quarter that skewed your recovery percentage.

If you're tracking your VAT with Penny in Accounted, the annual figures are easy to pull together from your records. But it's still a calculation that benefits from careful attention.

Special Methods

The standard method (based on turnover ratios) doesn't suit every business. If it produces results that don't fairly reflect the use of your purchases, you can apply to HMRC for a special method.

Common special methods include:

Floor-space basis — useful if you have premises used partly for taxable and partly for exempt activities, and the split can be measured by physical space
Headcount basis — apportioning by the number of staff working on taxable versus exempt activities
Transaction count — useful if your individual transactions are of roughly equal value
Sector-based methods — some industries have their own agreed approaches

To use a special method, you need HMRC's prior approval. You'll need to demonstrate that the standard method doesn't give a fair result and that your proposed method does. Once agreed, you must use it consistently.

Practical Tips

Keep Good Records

You need to be able to demonstrate which of your purchases relate to taxable supplies, which to exempt supplies, and which are residual. Code your expenses carefully in your accounting software so you can run the partial exemption calculation without tearing your hair out each quarter.

Review Your Position Regularly

Your business mix might change over time. If your exempt supplies grow as a proportion of your turnover, your recovery percentage will drop and you might fall outside the de minimis limits. Conversely, if exempt supplies shrink, you might start recovering more input tax.

Consider the Option to Tax

For property businesses, the option to tax can convert what would be exempt rental income into taxable supplies. This can simplify your partial exemption position significantly — but it has its own implications that need careful thought.

Don't Forget Capital Goods

The Capital Goods Scheme applies to certain high-value assets (land and buildings over £250,000, computers and other equipment over £50,000). If you have assets under this scheme, you'll need to adjust the input tax recovery over several years as your partial exemption position changes.

When to Get Help

Partial exemption is one of the more technical areas of VAT, and the stakes can be high — get the calculation wrong and you could be paying HMRC too much or too little, with penalties in the latter case.

If your exempt supplies are small and clearly within the de minimis limits, you can probably manage this yourself with a bit of care. But if your business has a complex mix of taxable and exempt activities, or if significant sums are involved, it's worth getting specialist VAT advice.

The input tax recovery rules are worth understanding in detail alongside partial exemption, as they interact closely.

Accounted helps UK sole traders stay on top of their bookkeeping and tax. Start your free 30-day trial at getaccounted.co.uk

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