When investigations are underway, especially with VAT, it is often forgotten to do the VAT annual adjustment. Partly exempt businesses are required to review the VAT paid over the previous 12 months and make an annual adjustment.

So, what should you be doing to maximise your claim?

One of the basic VAT rules is that you can’t reclaim VAT on purchases which you use to make exempt sales. But some expenses, essentially overheads such as premises and IT costs, may be used in the process of making exempt and vatable sales. This is known as residual VAT and you are entitled to reclaim a portion of it.

HMRC’s standard method for working out reclaimable residual VAT involves comparing the value of your exempt and vatable sales in each VAT period. For example, if your vatable sales for a quarter were £200,000 and your exempt sales were £50,000 then you are entitled to reclaim 20% of the residual VAT.

Having made a quarterly calculation of the residual VAT you can reclaim, you’re not quite out of the woods. Remember that for the return period which includes 31st March you are required to repeat the calculation for a 12 month period. If this shows a difference compared with the VAT you actually reclaimed, which will almost always be the case, you will have to account for it in your next VAT return. This might mean paying or reclaiming more VAT – either way the annual adjustment must be made.

Tip of the day

To avoid the need to relatively small adjustments the rules including a de minimis limit. If the total VAT in the period that relates to exempt supplies (including the claimable proportion of the residual tax) is less than £625 per month on average, and not more than 50% of the total VAT you paid on purchases, you can reclaim it in full.

Don’t forget to check for excluded transactions. Some should be excluded from your calculations of reclaimable residual VAT. These are easily overlooked in your quarterly returns so make sure you pick them up when calculating your annual adjustment.

So, when working out the value of your exempt and vatable supplies leave out the following:

  1. Sales of capital items – for example vans, cars and other machinery – unless your business is of course selling them.
  2. Some types of incidental supplies such as those relating to the sale of land or financial services transactions.

Making your annual adjustments calculation is the perfect time to consider whether using a so called special method, instead of the standard method, which might allow you to reclaim more residual VAT. A special method can use any formula to work out the reclaimable residual VAT as long as it produces a fair and reasonable result.

Hope you find this useful when you next deal with your VAT as this is one of the things that HMRC pick up on very early in the investigation.

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