Possible VAT impact of increased bank interest earned from client accounts

The recent welcome increase in Bank and savings interest rates can unfortunately have a negative consequence for certain VAT registered businesses, mostly legal firms, but potentially other businesses also.

If a solicitor for example holds client funds before a transaction is complete and is entitled to retain some or all of the interest earned, the VAT liability of the interest is exempt.  

As the earned interest is part of the business model of the solicitor, the business must perform a “partial exemption” calculation. Recently the very low bank interest rates usually meant that total interest in the year was less than 1% of turnover, so the business was “fully taxable” under the rounding up rules. Once the interest exceeds 1% of total turnover, the business may have to restrict VAT recovery on overhead costs (termed residual input tax) such as office rent, light and heat, audit fees, IT costs etc. 

In an example where client account bank interest is between 1% and 2% of turnover, then only if the 1% value of residual/overhead VAT exceeds £7,500 VAT in a year, does it become irrecoverable. If this amount is less than £7,500 in a year, it is below the VAT partial exemption de-minimis limit.

HMRC determine that if bank interest is “incidental”, the above calculation is not required. There is no formal legal definition of the term “incidental” but interest earned from a businesses own bank account is very likely to be incidental. 

If you require further advice or practical assistance calculating whether any VAT has to be restricted, please contact the Indirect Tax Services team at James Cowper Kreston.