Solicitors could reclaim overpaid VAT

We have had a number of situations recently where we have been able to save solicitor clients a considerable amount of tax. For one client this is £14,000 a year. It is possible to claim back overpaid tax for the previous three years, resulting in total savings of £42,000 for the client, in addition to the ongoing saving of £14,000 each year.

What is the issue? Recently we have encountered scenarios where solicitors have historically treated surplus interest on client money as ‘exempt’ income for VAT purposes. On occasions, this has been as a result of advice previously given by HM Revenue & Customs.

Treating the income as ‘exempt’ requires firms to carry out a ‘partial exemption’ calculation, or it could increase the exempt element for firms already required to carry out the calculation for other reasons. This can quite easily create an ‘irrecoverable VAT’ situation, where not all of the input VAT incurred by the firm on expenditure can be reclaimed from Revenue & Customs. This reduces profitability and hits the cashflow of the firm by the amount of the calculated irrecoverable VAT.

Who needs to know?

This could be an issue for any firm that holds client money. It is the element of interest retained by the firm and not paid on to clients, on money held in general client accounts, which could be required to be treated as ‘exempt’ income in certain circumstances.

It is therefore not an issue for firms that do not hold any client money, or for those that hold client money only in specifically designated client accounts, where all of the interest earned is paid directly to that client account.

This could also be a relevant issue for firms that have an asset or wealth management business. Usually this is carried out through a separate limited company, the shares of which may be owned by the partners. It may be more common for such businesses to hold investments on behalf of clients as shares, but money held after disposing of shares, awaiting reinvestment or repayment to the client, could also create an interest turn for the business that could be classed as ‘exempt’.

What is the issue?

As noted above, such interest income may have historically been treated as exempt income and indeed this was Revenue & Customs’ accepted view. However, a ruling in the European Court of Justice (ECJ) in 2005 considered the circumstances in which such income could be regarded as ‘incidental supplies’. Incidental supplies are defined as ‘any sum received in respect of certain financial transactions which are incidental to one or more business activities’. The significance of incidental supplies is that they should be excluded from the calculation of irrecoverable input VAT in partial exemption calculation. Therefore, if such income was the only exempt supply, the business would have no irrecoverable VAT.

The case of Empresa de Desenvolvimento Mineiro SGPS v Fazenda Publica involved a Portuguese company receiving interest on loans to subsidiaries which they claimed was incidental to their main business. The ECJ ruled that where the activity giving rise to the potentially exempt income had a link to the main activity of the entity (without forming part of it), and only required slight use of the business’s assets, then it should meet the definition of an incidental transaction.

Applying this principle to the circumstances of solicitors’ practices earning interest on client money that they hold, the holding of client money and consequent earning of interest on it is clearly linked to the main activity of providing legal services, since without this the client monies would not be held at all. In many cases the use of business assets will be small – even if the majority of the balance held is placed in overnight deposit, the time and resources involved in the making and execution of that decision are likely to be minimal in the context of the practice as a whole.

The facts will be different in every case, but where such interest is being treated as exempt in partial exemption calculations, based upon historical practice, it should be apparent from the above that the situation may not necessarily be as clear-cut as may have previously been believed.

What can be done?

The first thing to do is to review the firm’s VAT treatment of interest income and whether there is a partial exemption issue. If it appears there is, the next step is to seek advice from a tax specialist who can consider the firm’s specific circumstances and how they relate to the tests in the Empresa case.

If there is an argument that input VAT has been inappropriately disallowed, this should be reclaimed. This will usually require a voluntary disclosure to be made. There is a three-year cap on recovery of VAT, so it is important not to delay.

Moving forward, once Revenue & Customs have agreed the principle then the treatment can be correspondingly adjusted in the firm’s partial exemption calculations. The obvious financial benefit in terms of VAT savings is not the only advantage of this treatment – it will also simplify or even completely eliminate the need to perform partial exemption calculations, which are not usually straightforward.

Andy Poole is solicitor services manager at Hawsons. Brian Gooch, tax manager at Hawsons, also contributed to this article.