Could a special method increase your profits?

Basic principles

If your business has any exempt sales, you must apportion your input tax claims so that VAT is only claimed on costs that relate to your taxable sales. In other words, sales where you charge VAT at either 0%, 5% or 20%.

Exempt input tax. No input tax can be claimed on expenses that directly relate to your exempt sales.

Taxable input tax. All VAT incurred on costs that are directly linked to your taxable sales can be claimed, subject to the normal rules.

Residual input tax. A proportion of VAT can be claimed on mixed costs and general overheads.

It is the latter expenses, also known as “non-attributable input tax” or “the pot” which give you scope to consider if a different method might be more suitable for your business.

Standard method

The default position is that any partially exempt entity must adopt the standard method, where all input tax on mixed costs and overheads is apportioned according to turnover splits, i.e. the proportion of taxable sales to total taxable plus exempt sales, excluding VAT.

If the total VAT paid on your mixed costs and overheads is less than £400,000 per month on average, almost certainly the case, you can round up your percentage to the nearest whole number. You will do the calculation at the end of each VAT period but must always do an annual adjustment at the end of each tax year, which supersedes the monthly or quarterly calculations. The tax year ends on 31 March, 30 April or 31 May, depending on your periods; it is 31 March if you submit monthly returns.

What is a special method?

A special method is any method that is not the standard method; even a small variation from the standard is a special method. It must be approved by HMRC in writing and you can only adopt it for current and future periods and not retrospectively. Common methods include:

• square footage, which might work well for your business if you carry out exempt and taxable activities in distinct parts of your office or trading premises
• staff numbers, or staff hours if you have a mixture of full and part-time staff
• inputs, i.e. an apportionment based on total expenditure and its link to taxable or exempt supplies; or
• number of transactions, e.g. the number of sales invoices issued for your taxable and exempt activities each period.

Even if your special method gives a distortive result in some periods, perhaps because of seasonal trading, an annual adjustment is compulsory for all special methods and will even out any fluctuations.

Fair and reasonable declaration

When you seek HMRC’s written approval to adopt a special method, you must declare that your method is fair and reasonable in terms of input tax recovery, i.e. it will not produce a distortive result that gives an excessive claim. If it does, an officer can issue a “best judgement” assessment going back up to four years.

Example. A method based on staff numbers would produce a distortive result if all staff employed by the exempt part of a business worked full time but the taxable staff only worked part time. A method based on staff hours would be fairer here.