VAT in the financial sector: partial exemption
March 2017 | EXPERT BRIEFING | CORPORATE TAX
As the VAT year-end is fast approaching for most businesses, it is an opportune time for businesses to take stock of their VAT position.
The majority of businesses in the financial sector will be partly exempt, which means that they are not entitled to reclaim the full amount of VAT that they incur on costs. Given this is one of the most complicated areas of VAT, we often find many businesses are not minimising their VAT costs as much as they could, and are not aware of the requirements around their VAT year-end.
What does not help matters is that the rules governing VAT are continually changing as a result of new legislation, updates in HMRC’s guidance, and various case law precedents and decisions being released over time.
Who is subject to partial exemption?
Businesses within the financial services sector are often not fully aware of the VAT exemptions that apply to many financial services. For example, fees for arranging any corporate finance transactions will be exempt as they are typically intermediary services for arranging a transaction in securities. The VAT treatment of the intermediary service mirrors the VAT treatment of that transaction being arranged.
If you are involved in arranging any of the following transactions it is likely that exemption should apply to your services (even if they are called advisory services): (i) debt and equity private placements; (ii) mergers and acquisitions; (iii) debt restructuring; (iv) divestments; (v) rights issues; (vi) listings; and (vii) IPOs.
How to make sure you get it right
It is not practical for businesses to continually solicit professional advice in respect of each and every service and transaction that they carry out on an ongoing basis. However, as all partly exempt businesses must carry out an annual adjustment at the end of each VAT year, this is an ideal opportunity to review the year’s activities. The annual adjustment can be calculated externally as part of a review process.
Many businesses simply fail to carry out an annual adjustment, or just get the calculations wrong which can lead to not optimising the VAT reclaimable and being penalised by HMRC, so it is important to check you are doing it correctly and have applied an annual adjustment for each of the last four years (HMRC can go back and penalise businesses for the last four years).
What is an annual adjustment?
Annual adjustments require you to apply the normal VAT recovery method using annual data, rather than on a quarter-by-quarter basis. The difference between what can be reclaimed on an annual basis, compared to what was claimable in the individual VAT return periods, then forms the annual adjustment.
These adjustments are mandatory and must be carried out by all partly exempt businesses.
Capital goods scheme adjustment
If you are partly exempt there is an additional adjustment required for the VAT recovery claimed on expenditure relating to capital assets. This is dependent on the change in annual adjustment recovery rate (from the annual adjustment calculations noted above) from the rate applied to the original year of purchase and use of the asset to the rate calculated in each subsequent adjustment year for a period of 10 years (in most cases).
For VAT purposes, capital assets include any commercial property (purchase or refurbishment) costing over £250,000 and computer hardware costing over £50,000 (although in practice it is unlikely that computer hardware would be purchased for this amount anymore). An adjustment period of 10 years is applied for all commercial property capital assets. If an asset is disposed of within the 10 year adjustment period, the remaining adjustment periods will be calculated based on the VAT treatment applied to the disposal.
Beware of HMRC
In the current climate, with the need to increase tax revenues, the corporate finance sector in particular is an area that could easily be targeted by HMRC. A simple error, such as treating the VAT treatment of a transaction incorrectly, can have knock on effects on your VAT recovery and your annual adjustment figures, compounding the error, which can lead to a significant amount of VAT being at stake over a four year period.
In addition to the VAT due, HMRC will seek to charge penalties and interest. The amount of the penalty will range from 15 percent to 30 percent of the VAT owed for a ‘careless’ error identified by HMRC. Deliberate or concealed errors will attract even higher penalties. The actual penalty amount is subject to HMRC’s assessment of whether the business took ‘reasonable care’ or not in making the error.
Improving your VAT recovery
The VAT year-end is an opportune time to review your VAT recovery position. It may be possible to improve recovery by considering the use of a different partial exemption method, given many are still using the standard method.
This is especially true given that many exempt fees tend to be as a result of a transaction taking place where the fees are based on the realised value of the transaction, which does not reflect the costs used to generate the fees. Many businesses in this sector will benefit from a special method based on the number of projects or transactions being worked on, rather than the standard method based on turnover. Although it can be difficult and sometimes time consuming to agree a special method with HMRC, the benefits can be significant.
Even if you have agreed a special method with HMRC, it can often be worth reviewing the application of the method and whether it is still fair and reasonable for the business. The method may have been agreed with HMRC some time ago, after which business operations may have changed and improvements to VAT recovery can be made.
It is crucial to keep on top of your VAT position, with regular annual reviews, as failure to do so can leave the business at a disadvantage. We would encourage all partly exempt businesses to seek specialist advice to ensure that they not only avoid the pitfalls, but also take advantage of potential improvements to their VAT recovery position.
VAT is not straightforward, especially in the financial sector, and the complexities of the VAT rules mean that continuous monitoring and review is recommended as best practice. The regular reviewing of your VAT position by external advisers also demonstrates, if any errors do arise, that ‘reasonable care’ is being taken by the business, which will help mitigate and reduce any penalties that HMRC may seek to apply.
Kamlesh Chauhan is a senior VAT manager at haysmacintyre. He can be contacted on +44 20 7969 5584 or by email: firstname.lastname@example.org.
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