How does the annual adjustment work?

Partial exemption - basic principles

If your business has both taxable and exempt income, you must restrict your input tax so that it is only claimed on expenses that relate to your taxable activities. You must split your expenses into three different categories:

Taxable input tax. Expenditure that wholly relates to your taxable sales (including zero-rated sales) - 100% input tax is claimed subject to normal rules.

Exempt input tax. Expenditure that wholly relates to your exempt sales - no input tax is claimed.

Residual input tax. Expenditure that has a link with both your taxable and exempt income, e.g. general overheads or mixed costs, so is partly claimed.

With the standard method, the default method for any business, your claim depends on the percentage of your taxable sales compared to your taxable plus exempt sales. Working out the residual input tax to claim with the standard method uses the formula:

Total residual tax x (taxable income (ex. VAT)/taxable income (ex. VAT) + exempt income

Tip. The T/T+E formula above is expressed as a percentage but always rounded up to the nearest whole number with both your quarterly and annual calculations.

What’s the annual adjustment?

Many businesses have seasonal trading which means that the amount of input tax claimed in a VAT quarter is often distorted, being either too high or too low. For example, a non-profit-making golf club usually receives all of its exempt playing subscriptions and joining fees in the first three months of a calendar year, which will produce a very low recovery percentage on its residual input tax. The annual adjustment will even out these variations.

The annual adjustment always supersedes the input tax claimed in the four quarters which make up your tax year. You carry out the same calculation as you do each quarter but include figures for all four quarters within the year. The net amount under or overpaid must be adjusted on either the return at the end of the year or the following period; you have the choice. If the annual adjustment produces a repayment, it makes sense to include it on the later return to help your cash flow.

What are the relevant dates?

Your partial exemption tax year ends on 31 March, 30 April or 31 May, depending on the VAT periods of your business. If you submit monthly returns, the relevant date is 31 March. With the annual adjustment, your claim percentage is also rounded up to the next whole number in the same way as the quarterly calculations, 56.1% means you will claim 57% of your residual input tax.

Error correction

The annual adjustment is compulsory for all partially exempt traders - including those that use a special method rather than the standard method - so you must treat the omission for the last three years as an error on your past returns. If the total amount under or overpaid when you have done the three calculations is less than £10,000 - or between £10,000 and £50,000 if this figure is also less than 1% of your outputs figure in Box 6 of your next return - then you can correct it on the next return that you submit to HMRC. Otherwise, you’ll need to notify using FormVAT652 .