VAT Partial Exemption: Mixed Supply Rules

What Is Partial Exemption?

Most VAT-registered businesses make only taxable supplies (standard-rated, reduced-rate, or zero-rated) and can reclaim all their input VAT. But if your business also makes exempt supplies, you're partially exempt, and your ability to reclaim input VAT is restricted.

Common exempt supplies include:

• Insurance
• Financial services (including loans and credit)
• Education and training (by eligible bodies)
• Health and medical services
• Land and property transactions (unless you've opted to tax)
• Burial and cremation services
• Subscriptions to certain membership organisations

How Partial Exemption Works

When you're partially exempt, your input VAT falls into three categories:

1. Directly Attributable to Taxable Supplies

Input VAT on purchases used exclusively for making taxable supplies is fully reclaimable. Example: raw materials used to manufacture standard-rated products.

2. Directly Attributable to Exempt Supplies

Input VAT on purchases used exclusively for making exempt supplies is not reclaimable. Example: marketing costs specifically promoting an exempt financial service.

3. Residual (Non-Attributable) Input VAT

Input VAT on overhead costs used for both taxable and exempt activities — rent, utilities, general admin — must be apportioned. Only the proportion relating to taxable supplies can be reclaimed.

The Standard Method

The default apportionment method is the standard method:

Reclaimable proportion = Value of taxable supplies / Total value of all supplies

Example: Your total sales for the period are £100,000, of which £80,000 is taxable and £20,000 is exempt.

• Reclaimable proportion: £80,000 / £100,000 = 80%
• If your residual input VAT is £5,000, you can reclaim 80% = £4,000

Round the percentage up to the nearest whole number. If the calculation gives you 79.1%, round up to 80%.

The De Minimis Test

Even if you're partially exempt, you can reclaim all your input VAT if the exempt input tax is below certain limits:

• It's £625 or less per month on average (£7,500 per year), AND
• It's 50% or less of your total input VAT

If both conditions are met, the exempt portion is de minimis and you can reclaim everything. This is very helpful for businesses that make only small amounts of exempt supplies.

If you fail the de minimis test, you cannot reclaim any of the exempt input tax. It's an all-or-nothing test.

Special Methods

If the standard method doesn't produce a fair result for your business, you can apply to HMRC for a special method — a bespoke calculation that better reflects how your costs relate to your supplies. Common approaches include:

• Headcount-based apportionment
• Floor area-based apportionment
• Transaction count methods
• Sector-specific methods
• Combination methods using different approaches for different cost categories

You must get HMRC's agreement before using a special method. Once agreed, you must use it consistently unless circumstances change.

Annual Adjustment

Partial exemption calculations are done provisionally each quarter and then adjusted at year-end through the annual adjustment. The annual adjustment ensures the total input VAT claimed for the year matches the correct annual proportion.

The annual adjustment exists because quarterly figures can be skewed by seasonal patterns or one-off transactions. The annual calculation smooths these out and ensures your recovery reflects the full year's trading position.

Practical Examples

Example 1: Property Landlord

Sarah owns two commercial properties (opted to tax, generating standard-rated rental income of £60,000) and three residential flats (exempt rental income of £36,000).

• Directly attributable to commercial (taxable): £3,000 (fully reclaimable)
• Directly attributable to residential (exempt): £1,500 (not reclaimable)
• Residual (overheads): £2,000

Recoverable percentage of residual: £60,000 / £96,000 = 62.5%, rounded to 63%. Reclaimable residual: 63% x £2,000 = £1,260.

De minimis test: Exempt input tax = £1,500 + £740 = £2,240. Monthly average = £187. Under £625 and less than 50% of total input tax. Sarah passes the de minimis test and can reclaim all her input VAT.

Example 2: Financial Services

Tom's IFA practice generates £200,000 of exempt financial advice income and £50,000 of taxable consultancy income.

• Directly attributable to taxable: £2,000 (reclaimable)
• Directly attributable to exempt: £8,000 (not reclaimable)
• Residual: £6,000

Recoverable percentage: £50,000 / £250,000 = 20%. Reclaimable residual: 20% x £6,000 = £1,200.

De minimis test: Exempt input tax = £8,000 + £4,800 = £12,800. Monthly average = £1,067. Exceeds £625 per month — fails de minimis.

Total reclaimable: £2,000 + £1,200 = £3,200 out of £16,000. Tom loses £12,800 in VAT recovery.

Common Mistakes

Not identifying partial exemption. Some businesses don't realise they make exempt supplies and reclaim all input VAT. Retrospective corrections can be costly.

Poor cost attribution. Be rigorous about which costs are directly attributable and which are genuinely residual.

Forgetting the annual adjustment. The quarterly calculations are provisional. The annual adjustment is mandatory.

Not considering a special method. If the standard method produces unfair results, explore alternatives with HMRC.

With Accounted, Penny tracks your taxable and exempt supplies, attributes input VAT correctly, and prepares the annual adjustment calculation automatically.

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