How does bank interest on client accounts affect VAT recovery for law firms?

The services of solicitors are usually liable to VAT, which allows law firms to recover input VAT paid on related expenses. But with higher bank interest rates and more money being received from client accounts, things have changed considerably recently. This has forced law firms to contemplate issues around the vague definition of "incidental income" for partial exemption purposes as well as the fair distribution of interest to their clients. 

Recognising bank interest as unexpected revenue 

Bank interest is classified as exempt from VAT. This means that receipt of interest could bring a law firm into the realms of being partially exempt for VAT recovery purposes.  

However, it’s permissible to ignore income that is “incidental” from any partial exemption calculations. This could bring law firms back into being able to fully recover the VAT incurred on costs.  

The definition of what is “incidental” is not defined in legislation and is open to interpretation. HM Revenue & Customs provide their interpretation within guidance available online. Broadly, interest that is passively received, such as from deposit accounts, and is not reported on by auditors, can be treated as incidental and disregarded for partial exemption purposes. 

However, there’s an example in case law where interest from client accounts was rejected as incidental. This was a CJEU (Court of Justice of the European Union) case concerning a property management company that was allowed to retain interest earned on client monies it held awaiting transactions. Because the business was required to hold the funds as a “direct, necessary and permanent” extension of its normal activities, the interest earned could not be disregarded for VAT. 

With the significant rise in interest rates, this issue has been brought into sharp focus for many firms that face a potential reduction in the amount of input VAT that they can claim.

Things to think about 

There’s a risk that solicitors could become partially exempt due to the spike in interest earnings, which would limit their capacity to recover residual VAT. If it’s apparent that not all interest received is “incidental”, law firms will need to make  regular partial exemption calculations to determine their VAT recovery position. 

Happily, even if interest can’t be treated as incidental, many law firms will still able to recover all of their input VAT under the de minimis rules. These rules permit you to receive a relatively low level of exempt income before any restriction to VAT recovery. However, to support that this is your VAT profile, the calculations need to be undertaken for each VAT return period affected. 

What do you need to do?

Consider your sources of interest (client account vs. own account) and reach a position on whether each of these is capable of being treated as incidental or not. If not, undertake partial exemption calculations to determine whether your VAT recovery is restricted or whether you’re within the permitted de minimis limits.

Whatever the outcome, it’s clear that some action needs to be taken in this area and you’ll need to document your calculations and the decisions you’ve reached.

Please get in touch with our specialist Legal or VAT team for further information and advice. You can find contact details on the Our People section of the website. Alternatively, call 033 024 0888 or email enquiry@larking-gowen.co.uk.

Lisa Grovesmith