Solicitor client account interest and hidden VAT issues

As they say, every silver lining has a black cloud. After well over a decade, interest rates have risen to what could be thought of as ‘normal’ rates. This has caught the attention of HMRC, with potential issues being raised for certain sectors. The most obvious area affected is in respect of issues with VAT recovery on overheads for solicitors.

The potential problem

In principle VAT cannot be reclaimed on purchases used to make exempt supplies. The receipt of bank interest is effectively payment for an exempt supply of credit by the account holder to the bank.

HMRC guidance suggests interest on a bank account can be seen to be an incidental financial transaction which means it can effectively be ignored and should not have an impact on VAT recovery. The reasoning behind this appears to be that the income is received passively. However, there are some areas HMRC may take a different approach to, such as interest earned on client funds held by, for example, solicitors and there is some, albeit old, caselaw that could support their position. It is a worrying development and could cause issues for businesses that for whatever reason earn a reasonable amount of interest on their client accounts.

Who may be affected

If exempt income is minimal, certainly under 1% of income, it is unlikely to be an issue.

However, where solicitor firms receive meaningful interest income, it may be harder to argue this is incidental, particularly where firms negotiate bank terms or proactively manage interest flows.

As HMRC scrutiny seems to have increased it would be worth considering the potential implications of bank interest.

Action points for firms:

• Review your potential partial exemption position to identify the scale of any potential issue. HMRC can go back up to four years to correct an overclaimed input VAT.
• Maintain clear records to support passive treatment where appropriate.
• Be prepared to defend your approach if interest income becomes more central.
• Speak to our team.

Every firm’s position is unique. Our dedicated team can review your position, guide you through partial exemption complexities, consider special partial exemption methods and ensure your VAT strategy remains robust.