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Law firms could lose out on VAT recovery due to high interest rates

| Christine Newitt | 14 February 2024

With the Bank of England base rate having skyrocketed from 0.1% in 2021 up to 5.25% today, many law firms are earning proportionally higher amounts of interest from funds they hold on behalf of clients on undesignated client accounts.

Regulation by the Solicitors Regulation Authority (SRA) will often dictate that some of this interest is paid out to clients and legal firms will be well aware of these rules. However, this does not assist in the matter of VAT recovery.

The increased income received by way of interest may cause firms to lose some of the VAT incurred on overhead expenditure that they have previously been able to recover. Does this apply to you?

Let’s explore the problem in more depth - and decipher whether your income from interest is a cause for concern…

Is interest from client funds impacting your VAT recovery?

While law firms make a profit by charging clients for their time, they also generate income from funds they hold for them in the form of interest. Typically, this interest has been insignificant in comparison to other trading income.

However, with interest rates being the highest they have been since the 2008 financial crisis and holding steady at 5.25%, the income generated from client funds is radically higher than previously seen figures.

Presently, if interest earned from a deposit of client funds exceeds 1% of the total sales income of the firm then recovery of VAT on overhead costs of the business may not be fully recoverable. The practice may also have other exempt sources of income which then adds further complexity to the calculation of how much VAT can be recovered.

Client accounts versus holding account

A key factor in determining the amount of exempt interest earned is the location of the funds in question. If the money is in a client-holding account from which the client and the client alone receives the interest, this is entirely beyond the scope of VAT - so you (or rather, your accountants) can breathe a sigh of relief. No further consideration of this interest is required as it is not income belonging to the law firm.

However, if the funds generating interest are being held in a general account for which the practice itself retains the interest (albeit that they may be required to or choose to pay some of this to clients), then this is problematic. It is a requirement that businesses receiving any exempt income undertake what is known as a partial exemption calculation to determine their VAT recovery position. The gross interest gained plus any other exempt income must stay below the 1% threshold of your overall sales for VAT to be recovered in full on general business expenditure.

Unfortunately, if it exceeds this - which is increasingly possible as interest accrues in line with historically soaring interest rates - then VAT recovery may be restricted unless the interest can be considered ‘incidental’. Legal precedence, however, dictates that you are unlikely to be afforded an ‘incidental’ exemption. Why is this?

Citing a Case Law precedent: interest is not ‘incidental’

There is some case law precedent relevant to professional firms, although to date the matter has not been tested in the courts in relation to law firms. Law firms may therefore experience growing problems as deposit funds generate higher interest.

The most relevant case law concerns a property management company.

In 1996, the European Court of Justice ruled in this case against Regie Dauphinoise. The property management company held funds on behalf of clients in its own general account, for which it generated interest. The ECJ determined that interest earned on these monies were not incidental because the receipt of the interest was a ‘direct, permanent and necessary extension of the taxable activity of property management’.

It is therefore likely that a similar fact pattern can be established for law firms holding deposits in relation to transactions on which they are earning professional fees.

What does this mean for my firm in 2024?

Essentially, if you are holding funds in a general account from which the practice gains any interest, you need to consider whether or not you should be recovering all of your business VAT. It is possible (especially where this is likely to be a significant cost to the law firm) to agree a special method with HMRC that produces a more fair and reasonable result. This must though be agreed in advance of operating any new method by HMRC.

If you are concerned about this increasingly relevant issue and require expert advice, get in touch with our specialist team today.


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