Retained Interest on client account and Partial Exemption
Glyn Edwards · Posted on: April 23rd 2025 · read
At the start of 2024 we commented on the risk faced by legal practices following a sustained rise in interest rates and the potential for this to create a partial exemption problem by increasing the value of exempt supplies made, via the interest earned on client accounts balances.
We are now starting to understand more about HMRC’s approach to this question and that knowledge may influence practices’ decisions on how to address the risk.
HMRC’s Views
We understand that HMRC are taking a tough stance on many aspects of this question. Anecdotally their unpublished views seem to be:
- Retained interest earned on client account balances cannot be excluded from partial exemption calculations when using the ‘standard [income based] method’ to apportion VAT incurred on general overheads. They do not accept the argument that this can be treated as relating to excludable ‘incidental financial transactions’.
- No netting off of this income is permitted i.e. they do not agree that interest which is disbursed to clients can be excluded from this calculation. This is about more than just retained interest.
- Special methods may be agreed but would have to demonstrably fairer than the standard method. Methods based on staff time are unlikely to be approved.
- In at least one case, HMRC have taken the view that fee earners contribute to the generation of VAT exempt interest….because they generate bankable income.
In the light of such views, how can practices best deal with this issue?
The ‘Do Nothing’ Option
This stance has been taken by many practices. There is a fileable position which treats client bank account interest as incidental and which therefore can be excluded from partial exemption calculations. That view might be more likely to succeed in practices which make no effort to improve returns and simply deposit moneys in one general client account and passively receive interest. The chief risk is that HMRC will take a different view, and penalties may apply to any assessment following an enquiry.
Undertake Partial Exemption Calculations
If it is accepted that interest is not incidental, then calculations should be carried out to determine whether VAT on expenses relating to that income exceeds the partial exemption de minimis limits. A controversial part of this calculation will be to determine what expenses should be treated as residual by a practice whose only exempt income is bank interest. A narrow view would look only at overheads in the office from which interest is managed e.g. the seat of any designated treasury function. HMRC may challenge that, given the comments above about the role of ‘fee earners’. There will therefore be some risk, even if initial calculations suggest no restriction is required.
We are aware that some practices are preparing worst case scenario calculations to gauge the level of risk, but are not disclosing the VAT that those calculations suggest should be disallowed to HMRC. The benefit in identifying a reserve to cover a future liability needs to be weighed against the likelihood that HMRC would take a harsher view on penalties if they become aware of those calculations. They may regard them as evidence that the practice knew the rules and simply chose not to make correct declarations.
Our expert's final thoughts
"We are now starting to understand more about HMRC’s approach to this question and that knowledge may influence practices’ decisions on how to address the risk.
The benefit in identifying a reserve to cover a future liability needs to be weighed against the likelihood that HMRC would take a harsher view on penalties if they become aware of those calculations."
Contact HMRC
A cards on the table approach of contacting HMRC reduces future risk and ensures the lowest level of penalties. However, a practice which takes this route must be alive to the likely outcome, and decide in advance whether they are ready to enter into a dispute with HMRC if that outcome appears patently unfair.
As the position of each firm is unique, and in view of tax and reputational risks, practices should seek a review and advice from specialists. This will help in defence against penalties if HMRC decide to make an enquiry; and is especially important if the preference is to contact HMRC to resolve the matter.
