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Most VAT-registered businesses can reclaim VAT on purchases used to make taxable supplies. If your business makes both taxable and exempt supplies, however, you may not be able to recover all of your input VAT.
This is known as partial exemption.
Santa from AccountingPreneur says “The rules are designed to separate VAT relating to taxable activities from VAT connected with exempt activities. For businesses involved in areas such as finance, insurance, property, education or healthcare, getting this calculation wrong can lead to overclaimed VAT, interest and penalties.”
This guide explains the standard method, direct attribution, residual input VAT, de minimis limits and the annual adjustment.
What Is Partial Exemption VAT?
A VAT-registered business is partly exempt when it makes both taxable and exempt supplies and incurs VAT on costs relating to those activities.
Taxable supplies include standard-rated, reduced-rated and zero-rated sales.
Exempt supplies can include certain:
- Financial and credit services
- Insurance activities
- Land and property transactions
- Education services
- Healthcare services
Input VAT associated with taxable supplies is generally recoverable. Input VAT associated solely with exempt supplies is normally blocked.
Where a cost supports both activities, the VAT has to be apportioned.
Separate Non-Business Activity First
Partial exemption applies to business activity. Non-business or private activity needs to be separated before you perform the partial exemption calculation.
VAT on purchases used entirely for non-business purposes cannot be recovered.
Where a purchase has both business and non-business use, divide the VAT using a fair and reasonable method. Only the business element then enters your partial exemption calculation.
This distinction matters particularly for charities, membership organisations and businesses receiving grants where some activities may fall outside the scope of VAT.
Step One: Directly Attribute Input VAT
The first stage is to look at each cost and ask what activity it supports.
VAT on a purchase used exclusively for taxable supplies is normally recoverable in full.
VAT on a purchase used exclusively for exempt supplies is normally not recoverable.
For example, imagine a business provides taxable consultancy alongside exempt financial services.
Software used solely by the consultancy department would normally be directly attributable to taxable supplies.
Marketing material produced solely for the exempt financial service would normally be directly attributable to exempt supplies.
Anything that cannot be directly allocated to one side becomes residual input VAT.
Step Two: Apportion Residual Input VAT
Residual input VAT arises on shared costs such as:
- Office rent
- Utilities
- Accountancy fees
- General software
- Management costs
- Shared equipment
Under HMRC’s standard method, the recoverable percentage is broadly:
Taxable supplies ÷ total taxable and exempt supplies × 100
You then apply that percentage to your residual input VAT.
Certain transactions are excluded from the calculation where including them would distort the result, including some capital asset sales and incidental financial or property transactions.
How Does the Standard Method Work?
Suppose a business has:
- £300,000 taxable supplies
- £100,000 exempt supplies
- £5,000 residual input VAT
Its taxable proportion is:
£300,000 ÷ £400,000 = 75%
The business can therefore provisionally recover:
£5,000 × 75% = £3,750
The remaining £1,250 is treated as exempt input VAT.
The standard method percentage is normally rounded up to the next whole percentage point where average residual input VAT does not exceed £400,000 per month. Businesses above that level generally calculate to two decimal places.
The De Minimis Rule
Partial exemption does not always mean losing VAT.
HMRC allows businesses to recover exempt input VAT where the amount is sufficiently small.
Under the original de minimis test, exempt input VAT must be:
- No more than £625 per month on average, and
- No more than 50% of total input VAT
Both conditions must be met.
For a quarterly return, £625 per month is equivalent to £1,875 for the quarter.
Using our example, assume the business also has £2,000 of VAT directly attributable to exempt supplies.
Its total exempt input VAT would be:
£2,000 + £1,250 = £3,250
That exceeds £1,875 for the quarter, so it fails the de minimis test and cannot recover that exempt VAT.
HMRC also provides two simplified de minimis tests which can save smaller businesses from carrying out the full partial exemption calculation each period. Eligible businesses that were de minimis in the previous year may also be able to use the annual test, although the position must still be reviewed at year end.
What Is the Annual Adjustment?
Partial exemption calculations made during the year are provisional.
At the end of your partial exemption year, you normally perform an annual adjustment using figures for the whole longer period.
This helps smooth out temporary distortions caused by seasonality or unusually high costs in an individual quarter.
You recalculate:
- Directly attributable input VAT
- Residual input VAT
- The taxable recovery percentage
- Your de minimis position
You then compare the result with the VAT already reclaimed during the year.
If you recovered too much, VAT is repaid to HMRC. If you recovered too little, you can normally reclaim the difference.
HMRC normally expects the adjustment on the VAT return immediately following the end of the longer period, although businesses can in some circumstances include it in the final return of that period.
What Is the Standard Method Override?
The standard method works well for many businesses, but turnover does not always reflect how shared costs are actually used.
The standard method override can apply where the standard calculation produces a substantially different result from a fair and reasonable use-based calculation.
It is not triggered simply because the figures differ.
The business must generally:
- Be partly exempt and using the standard method
- Have residual input VAT above £50,000 a year
- Have a standard-method result that does not fairly reflect actual or intended use
A difference is considered substantial where it exceeds £50,000, or where it exceeds 50% of residual input VAT and is at least £25,000.
If the override applies repeatedly, that may indicate that the standard method is not suitable.
Partial Exemption Special Methods
A business can apply to HMRC for a Partial Exemption Special Method where the standard method does not provide a fair result.
A special method might apportion shared costs according to:
- Staff numbers
- Floor space
- Transaction volumes
- Time spent
- Different business divisions
You cannot simply choose an alternative method yourself. HMRC normally needs to approve it before use.
The method should reflect how purchases are actually used in making taxable and exempt supplies.
If an approved method later becomes unfair, either HMRC or the business can initiate a special method override process, but a notice served by the business must be approved by HMRC.
Foreign and Specified Supplies
Some supplies made outside the UK still carry a right to recover input VAT.
These can include certain financial and insurance services supplied to customers outside the UK.
Although those supplies might have been exempt if made domestically, HMRC treats some of them as specified supplies, meaning related input VAT can still be recoverable.
Cross-border activity therefore needs to be classified carefully rather than automatically treating every exempt-looking transaction as restricting VAT recovery.
Partial Exemption and the Capital Goods Scheme
Jasper’s draft is outdated here.
From 29 July 2026, computers and computer equipment are no longer new Capital Goods Scheme items.
The threshold for land, buildings and civil engineering works has also increased from £250,000 to £600,000 excluding VAT.
Aircraft, ships, boats and other vessels remain subject to the existing £50,000 threshold.
Assets that entered the scheme under the old rules before 29 July 2026 remain in it for the rest of their normal adjustment period.
The Capital Goods Scheme matters to partly exempt businesses because VAT recovery can be adjusted over several years if the proportion of taxable use changes.
Keep Clear Partial Exemption Records
Your VAT records should show how you arrived at each recovery figure.
Keep:
- Direct attribution workings
- Residual VAT calculations
- Standard or special method calculations
- De minimis tests
- Annual adjustments
- Evidence supporting any special method
- Capital Goods Scheme records where relevant
Review your method when your business changes significantly. A calculation that was fair when the business was smaller may no longer reflect how costs are actually used.
Final Thoughts
Partial exemption is essentially about matching VAT recovery to the activities that generate it.
Start by separating non-business costs. Directly attribute VAT wherever possible, apportion shared costs using the appropriate method and check the de minimis rules before blocking exempt VAT.
Then perform the annual adjustment and consider whether the standard method still gives a fair reflection of the business.
The rules become more important when exempt income grows, property or financial transactions become significant, or high-value capital assets are involved. In those situations, professional VAT advice can help prevent both overclaims and missed recovery opportunities.