It’s common practice for solicitors to hold money on behalf of their clients. These funds must be held separately from the firm’s own bank account and may be held in either a bank account which is designated for a particular client or in a general, undesignated client account. This article relates primarily to undesignated client accounts.
Up until a few years ago, the interest received on client accounts was generally low and had minimal VAT implications. However, rising interest rates over the course of the last few years has meant that significantly larger amounts of interest are now being earned by solicitors. In some cases, this may result in a restriction on how much VAT a law firm may recover on its costs.
In this blog, we explore the VAT implications of increased interest earned on client accounts and what this means for law firms.
What is the issue
The receipt of bank interest represents payment for a VAT exempt supply by the account holder (i.e. the law firm) to the bank. In other words, the account holder is treated as making a VAT exempt supply of credit, in return for which it receives payment in the form of interest.
While HMRC accept that most business bank account income is ‘incidental’ income which does not affect the business’s VAT position, they may not in many cases take this approach when it comes to interest which is earned on solicitors’ client accounts.
Where a business makes both taxable and VAT exempt supplies, it may be required to restrict some of the input VAT it recovers on its costs under the rules of ‘partial exemption’. Under these rules, VAT incurred on costs which are directly attributable to taxable supplies is recoverable in full and VAT which is directly attributable to exempt supplies is irrecoverable. Residual VAT such as that incurred on general overheads, which is not directly attributable to either taxable or exempt supplies must be apportioned.
Broadly, the standard method of partial exemption requires that the value of the business’s taxable income should be divided by total income. The resulting percentage is rounded up to the nearest whole percentage, which represents the amount of residual input VAT which is attributable to taxable supplies and therefore may be recovered. The remainder is treated as relating to exempt supplies and is therefore not recoverable, subject to certain de minimis provisions (not covered in this article).
How have things changed
Prior to the recent changes in interest rates, the exempt interest received by law firms on client accounts was typically less than 1% of total income. In cases where, for example, taxable income divided by total income resulted in a VAT recovery percentage of 99.2%, this would be rounded up to the nearest whole percentage, thereby resulting in 100% VAT recovery, i.e. no restriction.
However, in recent years, interest rate rises have meant that in some cases, the interest earned by law firms on their client accounts may be more than 1% of total income. As a result, firms may no longer be entitled to recover all the residual VAT they incur on their overheads and other general business costs. Where VAT has been over-recovered, it’s worth noting that HMRC can assess going back up to four years.
How can we help
The Lubbock Fine VAT team can help law firms by reviewing your VAT position and considering the effect of any client account interest received. We can perform partial exemption calculations and consider the effects of the partial exemption de minimis provisions. We can help you to set your VAT affairs in order and deal with making any necessary disclosures to HMRC. Where an unprompted disclosure is made to HMRC, we have a good success record in getting HMRC to mitigate penalties.
For a confidential discussion regarding the above, please get in touch with our VAT director, Sharon Parker (sharonparker@lubbockfine.co.uk).
