Partial Exemption Explained: Methods, De Minimis & Annual Adjustments

Quick answer: If your business makes both taxable and exempt supplies, you are partly exempt — and you cannot reclaim all the VAT on your purchases. Input VAT used only for taxable sales is fully recoverable; input VAT used only for exempt sales is not. VAT on shared costs (residual input tax) is split using a partial exemption method — usually the standard method, which recovers the same percentage as your taxable share of total sales. If the VAT tied to your exempt supplies is small enough, the de minimis rule lets you reclaim everything anyway. Every figure claimed during the year is provisional and is finalised by an annual adjustment.

What partial exemption actually is

Most VAT-registered businesses only make taxable supplies — sales charged at 20%, 5% or 0% — so they reclaim all their input VAT. Partial exemption bites when a business also makes exempt supplies: sales that carry no VAT at all and give no right to reclaim the VAT on the costs behind them.

Common exempt supplies include residential letting, most financial services such as lending and arranging insurance, education and training by eligible bodies, health services, betting and gaming, and the Royal Mail's universal postal service. Businesses that commonly land in partial exemption include landlords with mixed commercial and residential property, financial advisers who also sell taxable consultancy, training providers with commercial arms, and charities with trading income.

Two points catch people out early: if you make only exempt supplies, you cannot register for VAT at all, and exempt sales do not count towards the £90,000 VAT registration threshold, which measures taxable turnover only. Our when to register for VAT guide covers the threshold tests.

The three steps, every VAT period

HMRC's calculation has three steps — the first two on every return, the third at year-end:

1. Direct attribution. Sort each purchase by use: exclusively for taxable supplies, exclusively for exempt supplies, or for both.
2. Apportionment of residual input tax. Split the shared-cost VAT between taxable and exempt use using your partial exemption method.
3. Annual adjustment. At the end of your longer period — normally your VAT tax year — redo the calculation on full-year figures and correct any over- or under-recovery.

Before any of that, strip out blocked input tax. VAT on business entertaining (other than for staff or overseas customers) and on most cars is never recoverable, whatever your method says, and it is excluded from the de minimis tests. VAT on purchases used partly for non-business or private purposes must first be apportioned for business use; only the business share enters the calculation.

Step 1: direct attribution

Direct attribution is done on the basis of use or intended use at the time you receive the purchase. A landlord's example makes it concrete:

• VAT on repairs to a commercial unit let at 20% VAT: directly attributable to taxable supplies, fully recoverable.
• VAT on repairs to a residential flat let exempt: directly attributable to exempt supplies, not recoverable (unless de minimis saves it).
• VAT on the accountant's fee, office rent and business insurance: used for the business as a whole, so residual — it goes into the pot for step 2.

The most common and expensive mistake in partial exemption is skipping this step and throwing everything into the residual pot. Directly attributable exempt input tax counts in full against the de minimis limit, while residual input tax only counts in its exempt proportion — lumping costs together understates your exempt input tax and overclaims recovery.

Step 2: the standard method

Unless HMRC has approved a special method for you, you must use the standard method. It is written into the VAT Regulations, needs no approval, and suits most smaller businesses. The formula is:

Value of taxable supplies in the period (excluding VAT) ÷ total value of supplies in the period (excluding VAT) × 100 = recoverable percentage of residual input tax

Apply that percentage to your residual input tax for the period. The result is rounded up to the next whole number — so 67.5% becomes 68% — unless you incur more than £400,000 of residual input tax per month on average, in which case you round to two decimal places.

Worked example: the standard method

A consultancy and training business in one quarter makes £67,500 of taxable supplies and £32,500 of exempt supplies (£100,000 total, excluding VAT). Its residual input tax for the quarter is £15,000.

• Recovery percentage: £67,500 ÷ £100,000 × 100 = 67.5%, rounded up to 68%
• Recoverable residual input tax: £15,000 × 68% = £10,200
• The remaining £4,800 is not recoverable — unless the de minimis rule applies (see below).

When the standard method breaks: the override

Turnover is only a proxy for use, and sometimes a bad one — for example where large costs are incurred in one year for supplies made in a later year, or where one high-value transaction consumes almost no inputs. The standard method override corrects this. You are only in scope if you use the standard method and your residual input tax exceeds £50,000 a year (£25,000 for group undertakings not in the same VAT group). You must then adjust if the standard method result differs from a use-based result by more than £50,000 and more than 50% of the residual input tax. Applying the override regularly is HMRC's signal to apply for a special method instead.

Special methods: when turnover does not reflect use

A special method is any calculation other than the standard method that fairly reflects how your purchases are actually used to make taxable supplies. Common bases include floor area (natural for property businesses), staff numbers or staff time, number of transactions, input costs, or management accounts. Large businesses often use a sectorised method, with a separate recovery rate for each discrete part of the business.

The hard rule: you must not use or change a special method without HMRC's written approval, applied for through the online service. Until approval arrives, you stay on your current method. Your application must include a declaration that the method is fair from its effective date and for the foreseeable future; if HMRC later finds that declaration was wrong and you knew or ought to have known, it can serve a special method override notice and rewrite your recovery from the effective date. Special method percentages are calculated to two decimal places.

The de minimis rule: small exempt VAT is fully recoverable

This is the rule that saves most small partly exempt businesses from any restriction at all. You may recover all of your input tax — including the part tied to exempt supplies — if your exempt input tax passes the de minimis test. The original test has two conditions, and both must be met:

1. Exempt input tax is no more than £625 per month on average — £1,875 for a quarterly return, £7,500 for a full year.
2. Exempt input tax is no more than 50% of all input tax incurred in the period.

There are also two simplified tests, and passing any one of the three is enough:

• Test One: total input tax is no more than £625 per month on average, and exempt supplies are no more than 50% of the value of all supplies.
• Test Two: total input tax minus input tax directly attributable to taxable supplies is no more than £625 per month on average, and exempt supplies are no more than 50% of the value of all supplies.

Worked example: de minimis passes — and fails

A small landlord files quarterly. In one quarter total input tax is £9,000, of which £1,400 is attributable to exempt supplies.

• £1,400 is less than the £1,875 quarterly limit, and £1,400 ÷ £9,000 = 15.6%, well under 50%. Both conditions pass, so the landlord recovers the full £9,000.

Change one number: if exempt input tax were £2,000 instead, the first condition fails (£2,000 > £1,875) even though 22.2% is still under 50%. Because both conditions must be met, the landlord recovers only the taxable share that quarter. Note the part-year trap: if exempt supplies only start mid-year, only a pro-rata slice of the £7,500 annual limit is available.

Step 3: the annual adjustment

Everything claimed during the year is provisional. At the end of your longer period — normally your VAT tax year — you recalculate recovery on the full-year figures, re-test de minimis, and account for the difference, normally on the first return after the longer period ends (HMRC also allows it on the final return of the period itself, an early annual adjustment).

Worked example: the annual adjustment

A property company makes taxable commercial rents and exempt residential rents. Provisionally, each quarter, it recovers 80% of its residual input tax. Over the year its residual input tax totals £40,000, so it has claimed £32,000.

At year-end the actual figures are £420,000 of taxable supplies and £520,000 of total supplies:

• Final recovery percentage: £420,000 ÷ £520,000 × 100 = 80.77%, rounded up to 81%
• Final recoverable residual input tax: £40,000 × 81% = £32,400
• Adjustment: £32,400 − £32,000 = £400 of extra input tax recovered on the adjustment return.

The adjustment also corrects attribution: a cost provisionally treated as taxable that turned out to be used for exempt supplies (or vice versa) is fixed here. But it cannot correct return errors — a wrong figure in an earlier period must be corrected under the normal error-correction rules. And if a business first becomes partly exempt in the last period of its tax year, with no exempt input tax in the preceding year, there is no longer period adjustment for that year.

Frequently asked questions

Educational information and estimates. These tools do not submit VAT returns or determine the treatment of a specific transaction.