The Bank of England’s decision to raise interest rates in the first half of 2023 might not have been well-received by those with mortgages or other debts, but it presents a beneficial situation for those accumulating interest in bank accounts.

This is particularly true for law firms, which often hold substantial client funds in interest-bearing accounts.

Funds in designated client accounts, including accrued interest, are considered the client’s property. Any movement of these funds and the interest they generate falls outside the VAT scope.

In contrast, when client money is kept in a general account and the law firm is entitled to the interest earned, this constitutes exempt income for the firm.

Law firms dealing with both taxable income (like client fees) and exempt income (such as interest on client funds) fall under the partly exempt category for VAT purposes.

They must calculate the proportion of VAT reclaimable from HMRC based on their costs. VAT linked directly to making taxable supplies (like fees) is fully recoverable. However, VAT incurred in earning exempt income (like client interest) is typically non-recoverable.

The VAT on general overhead costs will depend on the proportion of taxable income to total income, a method known as partial exemption calculation. Law firms can also negotiate a special method for this calculation with HMRC in writing.

For partial exemption calculations, financial transactions incidental to the main business activities are excluded from exempt income considerations.

However, HMRC views interest earned on client money held for ordinary business activities as non-incidental and includes it in these calculations.

If the interest earned is substantial, it could limit the VAT recoverable on a firm’s overhead costs. Given the rise in interest rates, law firms might consider negotiating a special method with HMRC or re-evaluating any existing agreements if the rate increase significantly impacts their business.

Act now

It is advisable to re-evaluate your current VAT partial exemption approach. An upswing in interest earned from client funds in general, undesignated, accounts could notably alter your VAT recovery stance.

The interest retained from these accounts is likely to be classified by HMRC as exempt income, not merely incidental.

This classification can lead to a reduced recovery percentage on overhead costs under any income-based VAT recovery method.

Previously, you might have qualified for full VAT recovery under the ‘de minimis limit’. This applies when the total VAT on costs linked to exempt activities is less than half of the total VAT incurred and is below £7,500 annually.

However, the spike in interest rates may push you past this threshold, potentially leading to the need to repay exempt input tax incurred over the year and in future tax returns.

Even if you have an existing special method agreed with HMRC in writing, remember that all such agreements contain a clause mandating a review in case of significant business changes.

If the increase in interest rates considerably affects your business, it’s crucial to consider reviewing and possibly renegotiating your method or documenting why the current method still ensures a fair and reasonable recovery of input tax.

To find out more about how this affects law firms and the actions they should take, please contact our dedicated tax team today.