Partial Exemption VAT: A Practical Guide for UK Businesses

If you’ve ever tried to claim back VAT and been told you can only recover part of it, you’ve likely crossed paths with Partial Exemption VAT. For many business owners, this is the moment where VAT suddenly feels less like a straightforward tax and more like a puzzle with missing pieces.

The truth is, Partial Exemption VAT doesn’t exist to make life harder — it’s about fairness. If some of your sales are exempt from VAT, HMRC believes it wouldn’t be right for you to reclaim all the VAT you’ve paid on the expenses that helped make those exempt sales happen. But while the rules sound strict, there’s room for strategy, and with the right approach you could keep more VAT than you expect.

This guide breaks it down, with real-life examples and even a mini case study to show exactly how the process works in action.

Understanding the Basics

Most VAT-registered businesses reclaim the VAT they’ve paid on their purchases. The catch comes when a business makes both taxable and exempt sales. “Exempt” means you don’t charge VAT to your customers — think rental income from certain properties, specific types of education and training, financial services, or some charitable activities.

If you have both taxable and exempt income, you’re in “partial exemption” territory. The rules say you can only reclaim the VAT that directly relates to your taxable sales. The rest is off limits — unless you can use a calculation to split your costs fairly between the two types of activity.

Why the Rule Exists

Imagine two companies: one sells high-end home décor with VAT on every sale, the other sells the same décor but all of its sales are exempt. If both could reclaim all the VAT they paid on their stock and overheads, the exempt seller would get a tax advantage without collecting VAT for the government. That’s the imbalance Partial Exemption VAT aims to prevent.

A Day-to-Day Example

Consider a community arts centre. On one side, they rent their event hall for weddings and corporate meetings — these are taxable services, and they charge VAT. On the other side, they run free educational workshops funded by a charity grant — these are VAT-exempt.

The monthly electricity bill keeps the lights on for both the weddings and the workshops. Because the bill benefits both taxable and exempt activities, the VAT on it can’t be reclaimed in full. The arts centre has to work out the proportion that relates to taxable use and reclaim only that amount. This, in a nutshell, is how Partial Exemption VAT works in real life.

Sorting Your Costs

When businesses apply the rules, they usually think in three categories:

Taxable-only costs

Fully recoverable VAT (e.g., stock bought for resale with VAT added).

Exempt-only costs

No VAT recovery allowed (e.g., marketing for an exempt property rental).

Shared costs

Part recoverable, part not, based on a fair calculation (e.g., rent, electricity, admin software).

Most start with the “standard method” — working out the percentage of taxable sales compared to total sales, then applying that percentage to shared costs. It’s not perfect, but it’s HMRC’s default approach.

The De Minimis Rule: A Hidden Opportunity

One of the most overlooked parts of Partial Exemption VAT is the de minimis rule. This rule says that if the amount of VAT you can’t reclaim is small enough, you can ignore the restriction and recover it all anyway.

You qualify if:

• The VAT you can’t reclaim is less than £625 per month on average, and
• It’s also less than 50% of the VAT on all your purchases.

For small businesses, this can be a game-changer. For example, a yoga studio with a small café might find its unrecoverable VAT under the threshold, meaning it can reclaim 100% of its VAT despite having exempt sales.

At WellTax, we support businesses in navigating VAT rules and identifying opportunities to improve their overall tax efficiency.

Mini Case Study: How a Boutique Hotel Handles Partial Exemption VAT

Imagine running a cozy boutique hotel called The Willow House in Bath. You love welcoming guests, hosting spa days, and even turning your rooftop garden into a dreamy wedding venue. But here’s the catch — not all your activities are taxed the same way. Some are standard VAT, and some are exempt. This is where Partial Exemption VAT comes into play.

Let’s break it down:

Hotel Stays & Spa Treatments

Standard VAT — every pound earned here allows The Willow House to reclaim VAT on costs directly related to these services.

Wedding Venue Rental

Exempt from VAT — any costs used solely for weddings cannot be reclaimed.

Now, let’s look at shared costs, like electricity, cleaning, or staff wages, which support both taxable and exempt activities.

At the end of the month, the hotel reviews its sales:

• Taxable sales: £70,000
• Exempt sales: £30,000
• Total shared costs (with VAT included): £10,000

1. Calculate the proportion of taxable sales: £70,000/£100,000=70%
2. Apply this percentage to shared costs:70%*£10,000=£7,000

So, the hotel can reclaim £7,000 of VAT on shared costs. The remaining £3,000 is linked to exempt activities and cannot be recovered.

Tailored Methods: A Fairer Approach

While the standard method is the default, it doesn’t always give a fair outcome. That’s where special or tailored methods come in. Instead of relying on sales values alone, a business can agree a method with HMRC based on more accurate measures — such as floor space, staff hours, or actual use of costs.

Take an accounting firm as an example. Most of its income comes from VAT-taxable services like bookkeeping, payroll, and advisory work, but it also earns some VAT-exempt income from arranging client loans. Under the standard method, the exempt commission might appear large compared to taxable fees, meaning the firm can only reclaim, say, 80% of VAT on shared costs. But if staff records show that less than 15% of employee time is spent on the exempt loan work, a staff-hours based tailored method could push recovery up to around 85–87% — a truer reflection of how the costs are really used.

Annual Adjustments and Why They Matter

Partial exemption isn’t a “set it and forget it” exercise. At the end of your VAT year, you have to do an annual adjustment to compare your estimates with your actual figures.

This step is crucial because:

• If you’ve reclaimed too much VAT, you must repay it to HMRC.
• If you’ve reclaimed too little, you can claim it back.
• Missing this step can lead to penalties and interest charges.

For more information on VAT penalties, including the new penalty point system introduced on 1 January 2023, visit our guide on VAT Penalty Points Systems

Real-Life Wins

• A property developer selling zero-rated houses and renting exempt commercial units kept more VAT than expected by applying a tailored method and de minimis in certain quarters.
• A charity café increased its VAT recovery in a year after rethinking cost allocation and applying the de minimis threshold.

Common Pitfalls to Avoid

Many businesses run into trouble with Partial Exemption VAT because they confuse exempt sales with zero-rated ones — a costly mistake, as zero-rated sales still allow full VAT recovery. Others stick rigidly to the standard calculation method even when a special method would be fairer and potentially more profitable. On top of that, poor record keeping can make it harder to justify your VAT claims, which may lead to a lower recovery rate and unwanted attention from HMRC.

Final Thoughts

Partial Exemption VAT might not be the most glamorous subject, but it can have a big impact on your cash flow. With the right calculation method, clear records, and awareness of the de minimis rule, you can maximise your VAT recovery and avoid HMRC headaches.

Whether you’re a small yoga studio, a busy charity café, or a complex property business, understanding how these rules apply to you is worth the effort — because every pound of VAT you reclaim is money back into your business.