Rising interest rates and the implications for the legal sector

Over the course of 2023 we have seen interest rates increase significantly. This has had a number of implications for the legal sector, but has also afforded law firms the opportunity to earn additional interest revenue on client funds.

Interest rates have been rising consistently since the end of 2021. The Bank of England have started to hold the base rate in recent months, and while many are predicting that interest rates will fall over the next 12 months to December 2024, in November, the Bank of England stated that interest rates would ‘have to remain where they are now for an extended period’.

With interest rates having risen so substantially, we would advise solicitor practices to be proactive and negotiate with banks to find the best rates, as well as shopping around, to ensure that they maximise their interest earning potential on client funds. There is also the possibility of utilising fixed term deposit accounts, provided that firms remain compliant with respect to accounts requirements, for instance ensuring that the account is of a permitted type, the funds can be accessed immediately, and that adequate funds are held in the general client account. However, firms need to be mindful of the potential consequences of rising interest rates on their policies for paying interest to clients, compliance with the accounts rules, and VAT partial exemption issues.

Under the current accounts rules, interest earned on client account balances must be paid into the practice’s business account. Firms are then required to comply with rule 7.1 of the accounts rules, whereby they must ‘account to clients or third parties for a fair sum of interest on any client money held by you on their behalf’.

It is down to individual law firms to carefully consider what constitutes a ‘fair sum of interest’ as there is no further definition. Solicitor practices have varying levels of detailed interest policies, with many adopting a de minimis, below which interest will not be accounted for to clients. The SRA guidance states that such a de minimis must be ‘set at a reasonable level and regularly reviewed in the light of the current interest rates’.

With interest rates having been low for so long, many have not reviewed their interest policy or de minimis levels, which could be as low as £20 in some cases. In view of recently rising interest rates, this could see a lot more interest payments being required to clients in order to comply with firms’ policies and terms, which could mean increased administrative burdens on firms in paying out interest.

Now could therefore be a good time for firms to revisit their interest policies and consider the appropriate de minimis level given the current climate. We would advise firms to ensure that any changes are properly justified and documented, to show that they are complying with the code of conduct and acting in the best interests of each client. Care should also be taken to appropriately evidence the administrative burden (for example time costs of calculation and payment processing) of paying out interest below a certain level. That being said, many software packages have automated processes for calculating interest, which could ease administrative burdens here.

We would advise firms to review and renew their policies periodically, and even more frequently in times of economic instability. At a minimum, firms should be reviewing policies annually to ensure they remain relevant, compliant and reasonable. Once the policies have been reviewed, we would recommend that firms formally document their justifications and that policy papers are approved by the management board, prior to changes being implemented. Firms should then communicate their updated interest policies to clients, and at the outset of new engagements, and ensure the policy is applied accordingly and consistently to all matters meeting the relevant criteria.

Another key issue arising for firms here is that of VAT partial exemption. With interest rates rising, the amount of exempt income received by law firms could significantly increase. Under the standard calculation method for partial exemption, the increase in exempt income from the rise in bank interest could see firms suffering restrictions on VAT recovery in relation to their overheads.

However, HMRC do permit the use of a ‘special method’ which can allow firms to determine the percentage of VAT they can recover by reference to an alternative allocation or apportionment so long as it produces a ‘fair and reasonable attribution of input tax to taxable supplies’. We would therefore recommend that firms are mindful of their exempt income with reference to the ‘de minimis limit’ and consider revising their partial exemption calculation method. Any special method must be agreed in writing with HMRC prior to use.

The rise in interest rates has afforded solicitor practices the opportunity to earn more interest on client funds. However, we would urge law firms to be considering whether their policies for accounting for interest to clients (especially de minimis payment levels) remain appropriate, and to contemplate whether an increase in the de minimis for payment of interest would be fair and reasonable given the administrative burden. We would also advise firms to be mindful of their levels exempt income, and consider their partial exemption calculation method where relevant.

If you would like further guidance on this topic, contact us here.