Interest income is exempt from VAT, however, that in turn means that any business generating reasonable sums of bank interest and/or investment income will need to consider whether they are still able to recover all their VAT costs. Generally, any business that earns both taxable and exempt income is deemed to be partially exempt for VAT purposes and will need to calculate their VAT position to determine if there are any restrictions on their recovery.
Why is this important?
In the past, when interest rates were relatively low, any interest earned would have been relatively insignificant and unlikely to have any impact on the business’ VAT recovery. However, as these interest rates increase then the value of VAT exempt interest received will increase. With any business, an increase in exempt income may impact on its ability to recover all the VAT costs incurred.
To put this into perspective, if the exempt income generated from interest and investments exceeds 1% of turnover, then the residual VAT recovery can no longer be 100%, which means that there could be a reduction in the amount of VAT recovered.
In broad terms, VAT costs incurred wholly in relation to taxable supplies will still be recoverable in full. However, VAT costs on residual items, such as rent, light, utilities, professional fees etc. are all likely to be affected. Also, any direct costs incurred in generating exempt income will all contribute towards the total value of exempt VAT costs.
It should be noted that a partial exemption calculation should be carried out at the end of the partial exemption year, usually March, April or May, depending on the VAT return ‘stagger’ for the business. This calculation will determine whether there is a restriction on VAT recovery or not and more importantly, forms part of the business records to demonstrate to HMRC if required, why the business was deemed fully taxable or not.
The rules do allow for ‘incidental’ exempt income to be ignored when considering the VAT recovery. Typically, the phrase ‘incidental income’ is not defined in law. It seems likely that this relates to a business simply generating minor bank interest by way of using a bank account for their own funds and the interest is received because of using that account.
HMRC and existing case law suggests that where the income is anything other than ‘incidental’ it should be considered, and the following facts should be reflected on a case by case basis:
- How actively and/or frequently is the bank interest income being managed?
- What amount of staff time is used in managing this?
- What is the process for managing the bank interest earned?
- Does the activity use many inputs of the business?
- What is the relationship between the bank interest income and the activities of the organisation?
The final point is from an ECJ decision regarding a property management company. They held funds on behalf of their clients in their own bank account and retained the interest generated. The court determined that the income was a 'direct, permanent and necessary extension' of the business’ economic activity’. Therefore, it could not be seen to be incidental income.
When considering if your interest earned is incidental or not, this would be a good indicator and should be considered when determining your VAT position.