Value added tax: Partial exemptions for solicitors

Professional service firms often manage client funds as part of their business operations, whether they are legal firms holding escrow funds, accountants managing trusts, or consultants overseeing project disbursements.

A frequently overlooked aspect of this practice is the treatment of interest earned on these funds for value added tax (VAT) purposes. The intricacies surrounding VAT obligations can lead to compliance issues, tax inefficiencies, and reputational risks if not addressed correctly. 

There are two ways in which a client’s monies could be held: 

• in designated client account, or 

• in general client account 

When money belonging to a particular client is deposited in a separate designated account, the client is usually entitled to the interest earned on that account.  

When a professional service firm, such as a solicitor practice, holds client money in a general client account, it is customary for the practice to retain interest earned from the bank (which should always be paid into the firm’s office account), after accounting to clients for a ‘fair and reasonable sum’ in line with rule 7.1 of the SRA Accounts Rules. It is at the discretion of individual law firms to determine what they consider to be a ‘fair sum of interest’, as there is no further definition within the Accounts Rules. Many firms adopt a de minimis level approach, below which interest will not be accounted for to clients. The SRA require any de minimis levels to be regularly reviewed to ensure they remain reasonable in light of current interest rates.

VAT treatment

The VAT treatment on the interest payment will depend on what type of account is being used and how the interest is being passed on.  Considering these in turn: 

Designated account:  Where the funds are held in a designated account and all the monies are passed onto your client including the interest, then for VAT purposes this would be considered outside the scope of UK VAT.   

This would not be consideration for a supply and therefore no VAT would be due. 

General account: When funds are held in a general account then not all interest may be passed on to clients, as it may be below the de minimis for instance. Where not all interest is passed on to your clients, there will be interest income received by the practice as a result of holding client monies in the general account, which would be exempt for VAT purposes. 

Any interest kept or passed on to your clients would be considered a supply of services to the bank, an exempt supply for VAT purposes.  Therefore, the gross interest received would need to be considered for the business’s partial exemption calculations.  Where large amounts of client funds are held, it may cause a distortion in the recovery of the business’ input tax and lead to an over-restriction, which may be considered unfair based on the supplies made. 

Any business receiving exempt income will need to apportion its VAT recovery. Where the amounts are minimal the business could be considered de minimis and be able to recover all input tax.  However, this needs to be calculated every quarter to confirm that this is the case.  If a business does not restrict its VAT recovery, then it may be liable for penalties and interest due on the over-recovered VAT. 

As such, professional service firms that deal with mixed supplies, those that are both taxable and exempt, may wish to consider and apply for a Partial Exemption Special Method (PESM) to provide a fairer VAT recovery on overheads.  A PESM will allow businesses to agree with HMRC a different method for apportioning the recovery of VAT, and you may wish to consider if there is a method which will provide a fairer result and apply for a PESM. 

We have seen that recently HMRC has been more stringent when considering applications and rejecting those which cannot be audited properly.  It is therefore important to ensure that any PESM applications are considered in full and whether HMRC will agree them.  Where HMRC reject a PESM application a business may need to submit a brand-new application as HMRC will not work with the business to rework the PESM application.  

If you want to consider a PESM or want some advice to ensure that your business is accounting for VAT correctly, then please contact a member of our VAT team who would be happy to help.