Partial exemption standard method override

The standard method override forces a partly exempt business to correct its input tax recovery where the standard method, which splits residual VAT by the value of taxable and exempt sales, gives a result that is substantially different from how the costs are actually used. It only applies if residual input tax is more than £50,000 a year (£25,000 for certain group undertakings), and an adjustment is needed only where the difference exceeds £50,000, or exceeds 50% of residual input tax and is at least £25,000. The rules are in regulations 107A to 107E of the VAT Regulations 1995 and section 5 of VAT Notice 706.

What problem does the override solve?

Under the partial exemption standard method, VAT on shared costs (residual input tax) is recovered in proportion to the value of taxable supplies against all supplies. That is quick, but values are not always a good guide to how overheads are used. HMRC’s Partial Exemption Guidance manual at PE32500 explains that the override was announced in the Budget on 17 April 2002 and took effect the next day, mainly to stop avoidance built around the standard method, but also to deal with cases where the method simply breaks down.

The manual is clear that very few businesses outside avoidance schemes are affected, and that those that are can be just as likely to gain as to lose. The override works both ways: if the standard method under recovers compared with use, the adjustment is in your favour.

Which businesses does it apply to?

Notice 706 paragraph 5.4 says you are only subject to the override if all three of the following are true:

1. you are partly exempt and use the standard method
2. your residual input tax is more than £50,000 a year, or more than £25,000 a year if you are a group undertaking whose fellow group companies are not in the same VAT group, with both limits reduced in proportion for periods under 12 months
3. the standard method does not give a fair and reasonable reflection of use

The limits come from regulation 107E, which takes the meaning of group undertaking from section 1161 of the Companies Act 2006. Businesses with an approved special method are outside the standard method override, though a separate special method override notice can apply to them.

The override also does not apply if you carried out your annual adjustment on the basis of use, or to input tax you were already required to attribute on the basis of use. PE32500 adds that it ignores directly attributable input tax, so misallocation of directly attributable costs is a separate error, and that input tax relating to the financial instruments in items 1 and 6 of Group 5, Schedule 9 is ring fenced and recovered on use without the override.

What counts as a substantial difference?

Regulation 107C says a difference is substantial if it exceeds either:

• £50,000, or
• 50% of the residual input tax for the period, provided the difference is not less than £25,000.

The difference is between the input tax deducted under the standard method and the amount deductible based on the use or intended use of the purchases. Regulations 107A and 107B also count use by a successor who takes over the assets on a transfer of a going concern, as defined in regulation 107D.

When does the standard method fail to reflect use?

PE32500 says the standard method gives a fair result, at least for inputs actually used, where residual costs are used to make supplies in the same period they are incurred, in proportion to the values of supplies made, and to make all of the supplies counted in the calculation. Notice 706 paragraph 5.5 lists situations where that breaks down:

• costs incurred in one year that will not produce supplies until a later year
• high value transactions that do not consume inputs much more than lower value ones
• different business units making different supplies and using costs in different ways
• costs for an intended supply that never happens

A common case is a business that spends heavily on refurbishing a building it will let on exempt leases next year, while this year’s turnover is almost entirely taxable. The values say high recovery; the use says low.

The manual also notes a common misconception: you do not have to prepare a full use based calculation to prove no adjustment is needed. You should first consider whether the conditions above are met. If they are, the standard method already reflects use for inputs actually used.

How is the adjustment calculated and reported?

Notice 706 paragraph 5.6 requires you to calculate the difference between the standard method deduction and the deduction according to use, and account for it in the same VAT period as your annual adjustment. Under regulation 107B that is the return for the first period after the longer period, or the last return in the longer period if you bring the annual adjustment forward.

Two special cases apply. If you first become partly exempt in the last period of a tax year, so there is no annual adjustment, regulation 107A requires the override adjustment on the next return. If your registration is cancelled, it goes on the final return.

Any fair and reasonable calculation of use is acceptable. Paragraph 5.7 suggests the easiest approach is to work out why the standard method breaks down and correct for that, dealing separately with any costs that are not used in proportion to the values of supplies. Paragraph 5.8 says that if, after the adjustment, exempt input tax falls within the de minimis limits, you can recover all input tax for the period.

How do the thresholds work in practice?

Illustration only. Three partly exempt businesses using the standard method, each with a full 12 month longer period:

	Business A	Business B	Business C
Residual input tax	£200,000	£80,000	£60,000
Recovered under standard method	£160,000	£56,000	£54,000
Recoverable based on use	£100,000	£36,000	£22,000
Difference	£60,000	£20,000	£32,000
Substantial?	Yes, over £50,000	No	Yes, over £30,000 (50%) and at least £25,000

Business A repays £60,000 with its annual adjustment. Business B’s difference is below £50,000 and below 50% of its residual input tax (£40,000), so no adjustment is required, though it may want to consider a special method. Business C’s difference is over half its residual input tax and above £25,000, so it repays £32,000. Had any of them had residual input tax of £50,000 or less, the override would not apply at all.

What about capital items, records and repeated adjustments?

Input tax on items within the Capital Goods Scheme incurred in the period counts when testing the override, and the use of the capital item is considered. Capital Goods Scheme adjustments themselves are not counted as input tax for the test (Notice 706 paragraph 5.11).

You must keep evidence supporting any override adjustment, and where you decide no adjustment is needed, you should keep the calculations that support that view (paragraph 5.9).

The onus is on the business. PE32500 tells HMRC officers to raise an assessment where an adjustment was needed and not made, after consulting a regional partial exemption specialist. If you find you missed one, correct it under the error rules; see correcting VAT errors.

If you need the override year after year, paragraph 5.13 and PE32500 both point towards applying for a special method, which can reflect use directly and remove the annual comparison.

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Related Accountapedia entries

• When to apply for a partial exemption special method
• VAT Partial Exemption Explained
• The partial exemption annual adjustment
• Standard costing
• Partial exemption de minimis limits

Sources

• GOV.UK: Partial exemption vat notice 706
• legislation.gov.uk: SI 1995/2518, regulation 107C
• legislation.gov.uk: SI 1995/2518, regulation 107E
• GOV.UK: Manual page PE32500
• legislation.gov.uk: SI 1995/2518, regulation 107B
• legislation.gov.uk: SI 1995/2518, regulation 107A
• legislation.gov.uk: SI 1995/2518, regulation 107D

Reviewed by Christine Anderson, Broker, Solar Protect. Last reviewed 24 October 2026. Part of Accountapedia, the Solar Protect guide to UK tax and accounting. This page is general information, not personalised advice.