VAT Partial Exemption Explained

A business that makes both taxable and exempt supplies is partly exempt, so it cannot recover all of its input VAT. Tax on costs used for taxable supplies is recoverable, tax on costs used for exempt supplies is not, and shared overhead tax is split using a partial exemption method. There is relief: if your exempt input tax averages no more than £625 a month and is no more than 50% of your total input tax, you can recover all of it under the de minimis rule.

What is partial exemption?

Most VAT registered businesses make taxable supplies, which means the goods or services they sell carry VAT at the standard, reduced or zero rate. Some businesses also make exempt supplies, such as certain financial services, insurance, and the letting of property. Exempt supplies do not carry VAT, and the trade off is that you cannot normally reclaim the VAT you paid on costs used to make them.

A business that makes both kinds of supply is described as partly exempt. Partial exemption is simply the set of rules that decides how much of your input VAT you are allowed to recover. It matters because getting it wrong in either direction causes problems: reclaim too much and HMRC can assess the difference with interest, reclaim too little and you are needlessly out of pocket. If you are still deciding whether you need to register at all, start with our guide to the VAT registration threshold.

How do you attribute input tax?

The starting point is to sort your input tax into three pots. This exercise is called attribution.

• Input tax directly attributable to taxable supplies. This is recoverable in full.
• Input tax directly attributable to exempt supplies. This is not recoverable, unless the de minimis rule below rescues it.
• Residual input tax, sometimes called overhead or pot three tax. This covers costs used for the business as a whole, such as rent, accountancy, heating and general office expenses, where the VAT cannot be pinned to taxable or exempt work alone.

The first two pots are straightforward once you have good records. The residual pot is where the real work of partial exemption happens, because that VAT has to be apportioned between the recoverable and non-recoverable sides of the business.

What is the standard method?

The default way to split residual input tax is the standard method, which is based on turnover. You take the value of your taxable supplies in the period, divide it by the value of all your supplies in the period, and turn that into a percentage. Both figures exclude VAT itself. The formula is:

taxable supplies (excluding VAT) divided by total supplies (excluding VAT), multiplied by 100.

That percentage is then applied to your residual input tax to work out how much of it you can recover. A helpful quirk of the rules is that the recoverable percentage is rounded up to the next whole number, so a calculation of 82.1% becomes 83%. Rounding up only applies below certain high value thresholds, but for the vast majority of small and medium businesses the whole number rule is what you will use. If the standard method gives an unfair result for how your costs are actually used, you can ask HMRC to approve a special method instead.

What is the de minimis rule?

The de minimis rule is the piece of good news in partial exemption. If your exempt input tax is small enough, you are treated as fully taxable and can recover all of it, including the part that would otherwise be blocked. Two conditions must both be met in the period:

• Your total exempt input tax is no more than £625 a month on average, which works out at £7,500 across a full year.
• Your total exempt input tax is no more than 50% of your total input tax.

Both tests have to be passed. If your exempt input tax is under £625 a month on average but makes up more than half of all your input tax, you fail, and the same is true the other way round. HMRC also publishes simplified de minimis tests that let some businesses reach the same answer with a quicker calculation, which is worth knowing if your figures are always comfortably inside the limits.

Partial exemption sits alongside the other VAT choices you make. It works differently from the VAT flat rate scheme, and if you are weighing up how the schemes interact it is worth reading around them before you commit. Whatever method you use, your figures still have to be filed digitally under Making Tax Digital for VAT.

What is the annual adjustment?

Partial exemption is calculated period by period through the year, usually every quarter, but those in year sums are only provisional. At the end of your partial exemption year you have to carry out an annual adjustment. This recalculates recovery over the whole year in one go, which smooths out the seasonal ups and downs that a single quarter can distort.

The annual adjustment does two things. It confirms how much residual input tax you were really entitled to recover across the year, and it rechecks whether you passed the de minimis limits over the full twelve months rather than just in each quarter. The difference between the provisional figures and the annual result is then paid to, or reclaimed from, HMRC on the appropriate return. It is a step that is easy to overlook, and a missed annual adjustment is a common reason for an unexpected VAT correction later on.

Keeping your VAT position safe

Partial exemption is one of the areas HMRC looks at closely, because the calculations are easy to get slightly wrong and the amounts add up over time. Even a careful business can face an enquiry, and the professional time spent answering HMRC can be considerable. Solar Protect tax investigation insurance covers up to £100,000 of your accountant’s fees, with no excess, if your VAT affairs are investigated, so a routine review does not turn into a large bill. You can get a quote in a couple of minutes.

For how partial exemption fits with the rest of your obligations, our accountancy and tax guide brings the main topics together in one place.

Related Accountapedia entries

• Partial exemption standard method override

Reviewed by Matthew Bartlett, Director, Solar Protect. This guide is general information, not personalised tax or financial advice. Figures are correct for the 2025/26 and 2026/27 UK tax years at the time of writing.