About 20 law firms have so far signed up to a tribunal challenge to HM Revenue & Customs in a complex tax dispute that has dragged on for months.

The issue, which concerns the significant sums in interest on client money which firms have benefited from since rates began to rise in 2022, arose last year. Law firms are usually able to fully recover ‘input VAT’, the tax paid on goods and services bought for business use. However, client interest income is not subject to VAT and, depending on the sums involved, can restrict a firm’s ability to recover the input tax.

Before 2008, when law firms last booked significant amounts in client interest income, HMRC commonly granted partial exemptions enabling law firms to mitigate the restriction to input VAT recovery. This time around, however, HMRC has been denying all applications by law firms for such exemptions.

In an update circulated this week, Andrew Allen, partner and head of legal sector at accountants PKF-Francis Clark, said the group action was ‘gathering pace’. Stephen Morse of Temple Tax Chambers, a former tax and legal partner at PwC, is coordinating the challenge at a cost to the firms of £3,000-£5,000 each. The tax payments in dispute run to tens and in some cases hundreds of thousands of pounds per firm.

‘Many law firms are now in a position where they been preparing VAT Error Correction Notices to reflect the HMRC position on partial exemption,’ said Allen. ‘We are aware of discussions within HMRC that signal a potential change in stance on one part of the dispute, that being whether the full interest received is subject to the partial exemption calculation, or only the retained amount (after amounts paid to clients) as we have always asserted.

‘No definitive answer yet, but we are expecting some clarification on this point that may impact on the partial exemption calculations. For now, we continue to advise that firms consider submitting error corrections based upon the published position with the full interest paid to the account being used in the calculations.’

He added: 'Notwithstanding this point, we are encouraged that [Morse] has been successful in identifying a group of around 20 firms willing to commit a group action: it’s encouraging to see firms working together to address these challenges. As HMRC are not obliged to share the outcome from the VAT tribunal outside of the listed appellants, we suggest that to ensure you benefit from any positive outcome in tribunal proceedings, you consider joining this group. The more that join, the lower the contribution from each firm, likely to be £3-5k or less per firm for a direct engagement with Temple Tax.'

The Ministry of Justice consulted earlier this year on plans to seize 75% of interest on pooled client accounts and 50% on individual client accounts to help fund the justice system. No final decision has yet been announced.