Another tax blow for law firms

There has been much debate about the extent to which law firms benefit from interest earned on client funds. 

There is another aspect to this income stream which is exercising law firms. The issue concerns the inability of a law firm to fully recover the VAT it suffers on its’ purchases (Input VAT) where the firm has a substantial amount of client interest income.

In a law firm almost all services they provide are subject to VAT (Vatable supplies). As a result of this, under VAT rules the law firm is usually able to fully recover the input VAT suffered on its purchases.

Client interest income however is not subject to VAT and is known as 'exempt income' under VAT rules.

Where exempt income arises (broadly) the ability to recover input VAT is restricted by the ratio of exempt to standard rates supplies i.e. the ratio of interest income to fees/disbursement income.

Consequently, when law firms earn client interest income this can restrict input VAT recovery which becomes a cost of earning the interest income.

Since 2022, when interest income returned to the law firm business model, this has been an issue for law firms to consider and for some firms the potential financial impact on the amounts of input VAT recoverable is material.

Some firms have been advised that client interest income is 'ancillary' and not relevant for partial exemption (meaning no input VAT restriction). However sustained correspondence from HMRC confirms this is not their view and in contrast client interest income in a law firm is relevant to be considered for partial exemption purposes.

Pre 2008, when law firms last earned client interest income, it was common for HMRC to grant Partial Exemption Special Methods (PESMs) to law firms. These allowed firms to calculate the input VAT restriction based on the proportion of time spent by a firm in managing client interest income rather the ratio of client interest income to fee income (known as the Standard Method).

These PESMs enabled law firms to mitigate the restriction to input VAT recovery; however at present HMRC are denying all applications by law firms for PESMs of this nature.

Practical issues for law firms here include:-

a) The profit reduction from the cost of the input VAT restriction

b) Potential exposure to interest charges & penalties for non-payment

c) Issues around when provisions are made in the financial accounts

d) Impact on partners joining and leaving firms

e) Four-year timeframe over which HMRC can potentially look back to seek recoupment

We have been discussing this issue with HMRC for nearly two years, whilst they have mooted issuing formal guidance to law firms, at this point they have not delivered this. However the consistent messaging from HMRC in formal responses is that:

a) Partial exemption rules apply to client interest income in law firms – it’s not 'ancillary'

b) The standard method to assess the level of input VAT restriction is fair

c) PESMs are unlikely to be agreed in this area

d) Restriction should be calculated based on gross client interest received before any deduction for amounts paid in lieu to clients under the requirements of the SRA Accounts Rules.

For many law firms there is a lack of clarity on this issue from HMRC, combined with contradictory advice from advisors.

For many law firms the amounts of potential input VAT at risk are significant – for example at the 2025 financial year-end the latent liability commonly ranged from £50,000 to £750,000.

We are in contact with a group of law firms who have reached an impasse with HMRC on this issue and the next step on their journey would be a tribunal hearing.

Given the risk and cost associated with such a move those firms are concluding that a sector wide approach on a group funded basis is likely to be the sensible next step. We are keen to coordinate this on behalf of the legal sector if there is sufficient appetite to take the matter forward.

Andrew Allen is a partner and head of legal sector at PKF-Francis Clark