Partial Exemption VAT for UK Small Firms: Six Steps to Recover Tax
If your business makes both taxable and exempt supplies, you can only recover the VAT that relates to your taxable activity, and you must use the standard method unless HMRC has approved a fairer special method for you. A limited de minimis rule can let you recover everything despite some exempt use. The worked example below shows exactly how the sums work.
TL;DR:
Classify input tax first: taxable costs are recoverable, exempt costs are normally blocked, and shared costs use taxable supplies divided by total supplies, excluding VAT.
After calculating, full recovery applies only if exempt input tax averages at most £625 monthly and is no more than half of total input tax.
A special method needs HMRC approval, historical figures from completed accounts, and auditable allocation drivers that reflect actual cost use better than turnover.
Quarterly recovery figures are provisional; recalculate them using full year figures in the annual adjustment, especially if seasonal turnover changes the taxable share.
Track qualifying capital assets separately: the Capital Goods Scheme can require annual VAT adjustments for five or ten years when taxable and exempt use changes.
Table of Contents
What partial exemption means and where the rules come from
You are “partly exempt” for VAT purposes when your business makes both taxable supplies (standard, reduced or zero-rated) and exempt supplies, such as certain insurance, finance, or land and property transactions. Once that happens, the VAT you pay on purchases splits into three categories, and only some of it comes back to you.
The starting point, set out in VAT Notice 706, is a three-way sort of your input tax:
Input tax directly attributable to taxable supplies, which is fully recoverable.
Input tax directly attributable to exempt supplies, which is normally irrecoverable.
Residual (or “non-attributable”) input tax, used for both activities, such as rent, accountancy fees or general overheads, which needs apportionment.
That third category is where partial exemption calculations actually happen. According to the same HMRC guidance, a business must use the standard method of apportionment for this residual tax unless HMRC has approved a special method tailored to its circumstances. Many small and growing businesses never check which category their overheads fall into, and end up either overclaiming VAT they shouldn’t, or underclaiming VAT they are entitled to. Getting this sorting step right before you touch a formula saves a lot of rework later.
The standard method: formula, sequence and rounding
The standard method apportions residual input tax using your turnover, on the basis that the split between taxable and exempt sales is a reasonable proxy for how shared costs were actually used. HMRC’s internal guidance sets out the formula precisely:
Recoverable proportion = (value of taxable supplies ÷ value of all supplies) × 100
Both figures exclude VAT, and “all supplies” means taxable plus exempt supplies together. The resulting percentage is applied to your residual input tax to find how much of it you can recover.
In practice, you work through the calculation in a fixed sequence:
Choose your tax period (normally your VAT return period, with an annual adjustment at the end of your longer period).
Separate input tax into the three categories above: directly attributable taxable, directly attributable exempt, and residual.
Calculate the value of taxable supplies and the value of all supplies for the period, excluding VAT.
Divide taxable supplies by total supplies and multiply by 100 to get your recovery percentage.
Apply that percentage to the residual input tax figure to find the recoverable amount.
Add the recoverable residual amount to the input tax directly attributable to taxable supplies. That total is your recoverable VAT for the period.
Rounding matters more than it looks. Under PE30500, the recovery percentage is normally rounded up to a whole number, but where residual input tax is substantial, HMRC expects a more precise calculation, typically to two decimal places rather than the nearest whole percentage. The threshold most practitioners work to is where average monthly residual input tax exceeds a high value, a point at which rounding to a whole number can distort recovery by a material sum over a year.
A single rounding error in a monthly return, repeated for twelve months, can shift annual recoverable VAT by a noticeable amount once residual input tax is large, which is exactly why HMRC tightens the rounding rule at higher values (PE30500).
Two things can take you off the standard method track. First, if your business structure or cost base makes turnover a poor proxy for actual use, you may want to apply for a special method, covered below. Second, HMRC can require a standard-method override where the result produced by turnover would distort recovery significantly, usually where residual input tax is high and the standard method and an alternative “use-based” calculation would give materially different answers. We cover the override in more detail later in this guide.
De minimis: when you can recover everything anyway
Even if you are partly exempt, you might still recover all your input tax, including the exempt element, if you fall within the de minimis limits. HMRC’s guidance on de minimis sets out two tests that both need to be met:
Your exempt input tax averages no more than £625 per month.
That exempt input tax is no more than 50% of your total input tax for the period.
Both conditions have to be satisfied together, and the test is applied only after you have completed the full partial exemption calculation, direct attribution and all. De minimis is not a shortcut you reach for instead of doing the sums; it is the final check once the sums are done.
If you fail either test, none of the de minimis relief applies and you fall back to the standard method result.
One practical wrinkle catches people out: a business can be de minimis in a given VAT return period but fail the test once the annual adjustment recalculates figures over the longer period, or vice versa. Where you use a combined method, blending turnover-based and direct-use elements, the de minimis tests still apply to the totals produced, not to each component separately. Keep your working papers clear on which period each de minimis check relates to, since HMRC will ask to see both the monthly and annual positions if your figures sit close to the thresholds.
Special methods, HMRC approval and the standard-method override
The standard method works well for straightforward businesses, but turnover is a poor proxy for cost use in some sectors, property businesses with a handful of large exempt leases, or financial services firms with heavy transaction volumes but low turnover value, for example. In those cases, you can apply for a Partial Exemption Special Method (PESM).
HMRC’s test, set out in PE41000, is whether your proposed method gives a fairer and more accurate reflection of how costs were actually used than the standard turnover-based proxy. HMRC will not approve a special method simply because it recovers more VAT; the method has to be demonstrably more accurate, and it has to be auditable by a visiting officer.
What HMRC typically expects to see in a PESM proposal:
A worked example using real historical figures, ideally from at least one completed accounting year.
A method that can be reconciled to your management accounts or statutory accounts without adjustment.
Clear documentation of the allocation drivers used (floor space, staff time, transaction counts) and why they better reflect cost use than turnover.
A declaration that the proposal has not been designed principally to increase recovery.
Pro tip: Build your PESM proposal around figures an officer could trace straight back to your accounting software, not a one-off spreadsheet exercise; auditability is the single biggest reason HMRC rejects proposals.
Separately from PESM applications, HMRC retains a standard-method override. If the standard method’s turnover-based result is significantly distorted against the actual use of residual costs, and the amounts involved are material, HMRC can require you to adjust your recovery to the fairer figure, even without a formal special method in place. This is a safeguard against both unintentional distortion and deliberate manipulation of turnover mixes to inflate recovery, and it tends to come up most often where a business has a large one-off exempt transaction, such as a property disposal, that skews turnover for the year without reflecting genuine cost use.
How the Capital Goods Scheme interacts with partial exemption
Capital items above certain value thresholds, typically land, buildings and computer hardware, sit under a separate regime called the Capital Goods Scheme (CGS), rather than being dealt with purely through your normal partial exemption calculation in the year of purchase.
Under the CGS rules, you take an initial VAT deduction when you buy or build the asset, based on your use at that point. But CGS items are then tracked over an adjustment period, five or ten years depending on the asset type, with annual adjustments if the proportion of taxable versus exempt use changes.
This means your partial exemption workings and your CGS workings have to talk to each other. If a building you use mostly for taxable supplies starts being used more for an exempt activity (you sublet part of it under an exempt lease, for example), the CGS requires a staged correction to the original deduction, spread across the remaining years of the adjustment period rather than corrected all at once.
For asset-heavy startups and scaling businesses, this interaction is commonly missed entirely. A business might run its standard method calculation correctly every quarter and still get the VAT position wrong because nobody flagged that the office refurbishment from three years ago is still inside its CGS adjustment period. Keep a dedicated asset register noting the purchase date, VAT reclaimed, adjustment period and annual use split for every CGS item, separate from your general partial exemption working papers.
Choosing periods and keeping records HMRC will accept
Partial exemption calculations run on three overlapping timeframes: the VAT return period itself (the “prescribed accounting period”), a first interval if you have just become partly exempt partway through a longer period, and the annual adjustment at the end of your longer period, which recalculates the whole year using actual annual figures rather than the provisional quarterly estimates.
The annual adjustment matters because quarterly figures are provisional. Seasonal businesses in particular can see a very different recovery percentage once a full year’s turnover is used instead of a single quarter, so the catch-up (or clawback) on your next VAT return after the adjustment can be significant.
To stay audit-ready, keep:
A turnover schedule showing taxable and exempt supply values, excluding VAT, for each period and the annual total.
An allocation worksheet showing how you classified input tax as directly attributable taxable, directly attributable exempt, or residual.
Supplier invoices supporting the input tax figures used in the calculation.
A CGS asset register where relevant, cross-referenced to the capital items section above.
Any PESM approval letter and the worked example submitted to support it.
Pro tip: Post your annual adjustment on the VAT return covering the end of your longer period, and keep a one-page reconciliation showing how the quarterly provisional figures rolled up into the annual recalculation, since that single page is usually the first thing an inspecting officer asks for.
Worked example: a step-by-step calculation you can replicate
Say a small property and consultancy business has the following figures for a VAT quarter, all excluding VAT:
Taxable supplies (consultancy fees): £180,000
Exempt supplies (rental income from an exempt lease): £60,000
Total supplies: £240,000
Input tax directly attributable to taxable supplies: £9,000
Input tax directly attributable to exempt supplies: £1,400
Residual input tax (shared overheads, accountancy, general office costs): £4,000
Step one, calculate the recovery percentage: £180,000 ÷ £240,000 = 0.75, multiplied by 100 gives 75%.
Step two, apply that percentage to residual input tax: 75% of £4,000 is £3,000. That is the recoverable portion of the shared overheads.
Step three, add the directly attributable taxable input tax: £9,000 plus the £3,000 recovered residual figure gives £12,000 total recoverable VAT for the quarter.
Before finishing, run the de minimis check: this business’s exempt-attributable input tax is £1,400 plus £1,000 from residual, totaling £2,400 (PE24500). Averaged monthly that is £800, above the £625 monthly de minimis limit, so full recovery does not apply here and the business keeps the £12,000 figure calculated above.
Record each of these numbers in your allocation worksheet: the turnover split in your turnover schedule, the direct attributions with invoice references, and the residual calculation with the percentage shown explicitly so a reviewing officer can retrace every step without asking you to redo the sums.
Where founders and finance teams go wrong
The partial exemption mistakes we see most often are not complicated. They are usually a failure to separate directly attributable input tax from residual input tax at the point of entry, so everything ends up lumped into one bucket and apportioned when it shouldn’t be. Overheads get coded without thought to whether they touch exempt activity at all, and nobody revisits the turnover schedule until the annual adjustment forces the issue.
The second common error is treating de minimis as a target rather than a test, structuring invoicing or timing around staying under £625 a month instead of simply calculating the figures and seeing where they land. That approach tends to collapse the moment the annual adjustment recalculates using real figures.
The fix in both cases is unglamorous: a documented allocation rule applied consistently, a turnover schedule reconciled to your accounts every quarter, and a worked example you could hand to an HMRC officer without needing to explain it. Businesses that keep this discipline rarely have a difficult partial exemption conversation with HMRC, even when their figures sit close to the thresholds.
— Shoaib
How we can help with your partial exemption position
We can assist with VAT filing, partial exemption method design and bookkeeping that captures the right allocation drivers from day one, so your turnover schedule and allocation worksheet are already reconciled before a return is due.
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Where a standard method produces an unfair result for your business, a tailored special method proposal can be built and submitted to HMRC, backed by real figures from your own accounts rather than a generic template. If your business also handles marketplace sales, our bookkeeping can be set up to flag VAT on platform fees correctly alongside your partial exemption workings, a detail many founders miss when apportioning input tax, something our partners at Osellpa also flag for sellers managing fee reconciliation.
If you are not sure whether your current method is defensible, a review of your existing calculation and recordkeeping against HMRC’s expectations is available. Visit our accounting and VAT services page to see how our packages, from £99 to £199 per month, cover ongoing VAT filing alongside day-to-day bookkeeping and tax planning, and get in touch to arrange a diagnostic review of your partial exemption position.
This article is general information, not a substitute for advice from a qualified financial advisor. Consult a qualified financial professional about your own circumstances before acting on anything here.
FAQ
What are the rules for partial exemption from VAT?
You are partly exempt when you make both taxable and exempt supplies, and you must apportion residual input tax between the two using the standard method unless HMRC has approved a special method for you (VAT Notice 706). Input tax directly attributable to taxable supplies is fully recoverable, and input tax directly attributable to exempt supplies is normally irrecoverable.
Can you provide an example of how to calculate VAT partial exemption?
Divide the value of your taxable supplies by the value of all supplies, excluding VAT, and multiply by 100 to get your recovery percentage; apply that percentage to your residual input tax, then add it to input tax directly attributable to taxable supplies.
What are the rules for VAT exemption in the UK?
Certain supplies, including specific insurance, finance and land or property transactions, are exempt from VAT under UK law, meaning no VAT is charged on them and input tax relating to them is normally irrecoverable. VAT Notice 706 sets out how a business making both exempt and taxable supplies must apportion its input tax accordingly.
What are the new VAT rules for 2026 in the UK?
HMRC’s current partial exemption framework, including the standard method formula, the de minimis thresholds and the special method approval process, remains set out in VAT Notice 706 and the related internal manuals; no separate overhaul of partial exemption specifically has been published for 2026 at the time of writing. Businesses should check GOV.UK guidance directly for the current position before relying on older summaries.
How much does partial exemption VAT support cost?
Our VAT filing and partial exemption support is delivered through our flexible accounting packages, priced between £99 and £199 per month depending on the scope of work, with full details available on our services page. Bespoke special method design and PESM submission support are scoped individually once we understand your business.
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