Inter-Partes Costs Recovery: VAT Treatment for UK Law Firms

The One Rule That Governs VAT on Recovered Costs

If you take one thing from this guide, take this: you claim VAT from the other side only to the extent your own client cannot recover it as input tax. That single rule decides the VAT treatment of every inter-partes (party-and-party) costs recovery.

It resolves into two cases. If your client is VAT-registered and using the legal services for its taxable business, your client recovers the VAT on your invoice as input tax, so the costs are claimed net of VAT and the paying party pays no VAT. If your client cannot recover the VAT, a private individual, a non-registered party, or a matter that is not for a taxable business purpose, the costs are claimed inclusive of VAT, and the paying party bears it. This flows from the indemnity principle (you can recover only what your client is actually out of pocket for) and from a long-standing agreement between HMRC and the Law Society's Revenue Law Committee. Throughout, the firm invoices its own client for VAT and never issues a tax invoice to the paying party. This guide sets out the rule, the agreement, and the accounting, with an England and Wales focus (an SRA-regulated firm, the Senior Courts Costs Office and the Civil Procedure Rules).

The Supply Is to Your Client, Not the Paying Party

The whole position rests on identifying who receives the supply. The firm supplies legal services to its own client. That supply is standard-rated at 20 per cent (the rate since 4 January 2011), and the firm accounts for output VAT on its bill to its own client. The paying party never receives a supply from the receiving party's solicitor. When the paying party meets a costs order, it is reimbursing the receiving party under an indemnity, not buying a supply.

That distinction is not a technicality. It is why a tax invoice goes to the firm's own client and never to the paying party, and why the paying party can never reclaim the VAT it pays. There was only ever one supply, from the firm to its client, and only that client can have an input-tax position on it. Hold this foundation and the rest of the rules follow naturally.

The Indemnity Principle

The indemnity principle is the bedrock of inter-partes costs. A party may recover from the other side only the costs it is itself liable to bear. A costs order indemnifies the receiving party against its own liability; it does not enrich it. You cannot recover from the loser a sum the receiving party never has to pay.

Applied to VAT, the logic is clean. If your client is VAT-registered and reclaims the VAT on your fee as input tax, your client is not out of pocket on the VAT, so the VAT cannot be recovered inter partes; the costs are claimed net. If your client cannot reclaim the VAT, your client genuinely bears it, so it is a real cost the loser must indemnify; the costs are claimed inclusive. The VAT treatment is therefore not the firm's choice. It is dictated by whether the receiving party actually carries the VAT burden.

The HMRC and Law Society Revenue Law Committee Agreement (VATSC11534)

The authority for all of this is HMRC's internal manual at VATSC11534, recording the agreement with the Law Society's Revenue Law Committee on VAT in respect of third-party cost payments. It states the position in terms.

Where the receiving party's client is a VAT-registered, fully taxable person obtaining the legal services for its business and recovers the VAT, the indemnifying party need only pay the costs exclusive of VAT. Where the client is not registered, or otherwise cannot recover the VAT, the indemnifying party is liable to pay the costs and the VAT as well; however, the indemnifying party cannot recover that VAT. On invoicing, the manual is equally direct: the solicitor whose costs are to be paid should deliver a tax invoice to its own client, and in no circumstances may a tax invoice be issued by the client's solicitor to the paying party, who is not in law entitled to receive an input tax credit because the services have not been rendered to it. The paying party receives only a note of the costs.

This is the settled, agreed position. When you draw a bill net or inclusive, you are applying VATSC11534, not exercising a discretion.

Case 1: Receiving Party Is VAT-Registered and Recovers Input Tax (Costs Claimed Net)

Where your client is VAT-registered and recovers the input tax on your fee, the bill of costs against the other side is drawn net of VAT. The paying party pays the net costs. Your own client reclaims the VAT on your invoice through its own VAT return. The VAT never enters the recoverable figure, because your client is not out of pocket on it.

The practical question is how you know your client recovers. The answer turns on the client's own VAT status and the purpose of the matter. A VAT-registered trading company instructing the firm on a dispute connected to its taxable business will, in the ordinary case, recover the firm's VAT in full as input tax. That recovery is what removes the VAT from the recoverable costs. It is not enough that the client is registered in the abstract; the legal services must be a cost component of the client's own taxable activity, so that the input tax is attributable to taxable supplies the client makes. Establish this at the outset, because it dictates how the entire bill of costs is drawn.

One nuance to flag here is partial exemption. If your client is partially exempt and cannot fully recover the input VAT, the irrecoverable proportion can be claimed inter partes, because the client genuinely bears that part; the recoverable proportion cannot. The bill and the VAT statement should reflect only the irrecoverable slice, expressed as the client's residual recovery rate applied to the VAT on the firm's fee. A common error is to treat a partially exempt client as if it recovered nothing (claiming the full VAT) or as if it recovered everything (claiming none); the correct figure is the genuinely irrecoverable percentage, and that percentage must be evidenced. For how a firm's own partial-exemption position works, see our guide to law firm partial exemption and client-account interest.

Case 2: Receiving Party Cannot Recover (Costs Claimed VAT-Inclusive)

Where your client cannot recover the VAT, a private individual, a non-registered party, or a matter not for a taxable business purpose, the bill of costs is drawn VAT-inclusive. The paying party reimburses the VAT-inclusive figure, because under the indemnity principle the client genuinely bears the VAT and is entitled to be indemnified for it.

The paying party cannot reclaim that VAT. No supply was made to it, so it has no input-tax credit; it simply meets a higher indemnity. This is the case most people picture when they think of costs recovery, the winning individual claimant recovering inclusive costs from a losing defendant, and it is exactly the situation in which VAT is properly added to the recoverable sum.

The same logic catches a non-recovering body that is not a private individual: a charity or other organisation whose activities are exempt or non-business, or a registered person instructing the firm on a matter outside its taxable business, may equally be unable to recover the input tax. In each of these cases the test is identical. Ask whether the receiving party genuinely bears the VAT. If it does, the bill is drawn inclusive and the loser indemnifies the VAT-inclusive figure. The label attached to the client (individual, company, charity) is not the deciding factor; the deciding factor is whether the client can offset the VAT as input tax against its own taxable supplies.

The Statement in the Bill of Costs (CPR PD 44)

The net-versus-inclusive rule is operationalised through the bill of costs itself. CPR Practice Direction 44 requires a statement in the bill as to the receiving party's VAT position, whether the receiving party can recover VAT and, where relevant, its input-tax recovery rate. The costs draftsman certifies that position.

This is the procedural hook that tells the assessing court and the paying party whether VAT is properly claimed and at what level. It is also where partial-exemption clients are dealt with, by stating the irrecoverable proportion. Treat the VAT statement as a substantive decision made at the outset of drawing the bill, not a box to tick at the end, because it determines whether VAT is added to the recoverable costs at all.

No Tax Invoice to the Paying Party

This bears repeating because it is the discipline firms most often get wrong. The firm must not issue a VAT invoice or tax invoice to the paying party. The paying party did not receive the supply and is not entitled to an input-tax credit. The firm delivers its tax invoice to its own client, and the paying party receives only a note or copy of the costs.

Issuing a tax invoice to the other side is not a harmless courtesy. It wrongly represents that the paying party received a supply and could reclaim the VAT, which is exactly what VATSC11534 forbids. Keep the invoicing clean: tax invoice to your client, note of costs to the payer.

Accounting for It in the Firm's Books

Output VAT is accounted on the firm's bill to its own client at the tax point under VATA 1994 s.6: the basic tax point on performance, overridden by the earlier of a VAT invoice or payment, plus the 14-day rule. That is true regardless of when, or whether, the paying party meets the costs order. A late-paying or non-paying loser does not move your VAT tax point.

Recovered costs received from the other side are receipts against your fees (or into client account where appropriate), not a separate VAT event. There was one supply, to your client, and the VAT on it crystallised on your bill. The recovery is a reimbursement of that bill, not a new taxable transaction. For the time-of-supply mechanics across interim and final billing, see our guide to the VAT tax point and time of supply for law firm billing. Where costs are received into client account, the SRA client-money rules apply to how that money is held and transferred; see our overview of client money accounting for solicitors.

It is worth being explicit about what does not happen in the books, because the misconceptions here are persistent. You do not raise a sales invoice to the paying party, and you do not post the recovered VAT as a fresh output-tax liability when the loser pays. The output VAT was already accounted on the bill to your own client. If you were to treat the recovery as a second taxable event you would double-count the output tax. Equally, the receiving client does not get a second input-tax claim out of the recovery; its input tax (if any) arose on your invoice to it, and the recovery from the other side simply reduces the net cost the client has borne. Keep one supply, one tax point, one output-VAT entry, and treat the inter-partes recovery as cash against the matter.

Two further points smooth the bookkeeping. First, where the matter is settled rather than assessed, the same analysis applies: a global settlement figure for costs still rests on costs the receiving party is liable to bear, so the net-versus-inclusive distinction still drives what VAT, if any, is built into the settlement. Second, where the firm has rendered interim statute bills during a long matter, the tax points on those bills have already arisen, and the eventual costs recovery does not reopen them. Reconcile recovered costs to the bills already rendered, not to a notional fresh charge.

Disbursements Within Recovered Costs and Counsel

Disbursements recovered inter partes follow the same eight-condition test as anywhere else (VAT Notice 700 section 25.1.1). A genuine disbursement, such as a court fee the client is liable for, is outside the scope of VAT and recharged with no VAT. An outlay the firm uses in its own service, or where any of the eight conditions fails, is part of the firm's standard-rated supply, and its VAT follows the firm's own position in the bill.

Counsel's fee is, by default, a supply to the firm, which the firm uses in making its onward supply to the client. So counsel's VAT follows the firm's own VAT position in the recovered bill: the firm recovers the input VAT and charges output VAT on its total fee, and the net-versus-inclusive analysis applies just as it does to the firm's own time. Counsel only counts as a disbursement in the rarer client-instructed case. For the detail see our guides to the VAT treatment of disbursements and counsel's fees and VAT, and for the foundational rule, VAT on legal services.

Common Mistakes on Recovered-Costs VAT

The same handful of errors recur, and each maps onto a point already made above. The first is adding VAT to a bill of costs against the other side when the receiving client is a fully taxable registered business that recovers its input tax. That over-claims, because the client is not out of pocket on the VAT, and it offends the indemnity principle. The second is the reverse: drawing a bill net of VAT for a private individual who cannot recover, which under-claims and leaves the client genuinely out of pocket on the VAT.

The third is issuing a tax invoice to the paying party. As VATSC11534 makes clear, the paying party never received a supply and is not entitled to an input-tax credit, so a tax invoice to it is wrong in principle; the payer gets a note of costs only. The fourth is treating a recovery from the loser as a fresh taxable event and accounting for output VAT a second time. The fifth, particular to partially exempt clients, is claiming either the whole VAT or none of it rather than the genuinely irrecoverable proportion. The sixth is failing to fix the receiving party's VAT-recovery position before the bill is drawn, so the CPR PD 44 statement is guessed at rather than evidenced. Each of these is avoidable by going back to the one rule: claim VAT against the other side only to the extent your own client cannot recover it.

A Worked Example: Registered Client, Private Client, and the Invoice Discipline

These examples are illustrative only and are not advice. First, a VAT-registered commercial client. A firm acts for a registered company in a commercial dispute, and the company recovers the firm's VAT as input tax. The bill of costs against the losing side is drawn net of VAT. The loser pays the net costs, and the firm's own client reclaims the VAT on the firm's invoice through its own return. The caption to remember: a registered client recovers the VAT, so the other side pays costs net of VAT.

Second, a private individual. The firm acts for a private claimant in a personal claim, and the client cannot recover VAT. The bill of costs is drawn VAT-inclusive. The losing side reimburses the VAT-inclusive costs and cannot reclaim that VAT, because no supply was made to it. The caption: a non-recovering client claims costs inclusive of VAT, and the loser bears it and cannot reclaim it.

Third, the invoice discipline that applies in both cases. The firm invoices its own client for VAT and delivers a tax invoice to that client only. The losing party gets a note or copy of the costs, never a tax invoice. The caption: you invoice your client, not the other side, and the other side has no input-tax claim.

Fourth, a partially exempt client. A partially exempt client recovers only part of the input VAT on the firm's fee. The irrecoverable proportion can be claimed inter partes; the recoverable proportion cannot. The caption: for a partially exempt client, claim only the VAT the client genuinely cannot recover.

Practical Checklist

For a litigation or costs team handling recovered-costs VAT:

• Establish the receiving party's VAT-recovery status at the outset of the matter, not when the bill is drawn.
• Draw the bill of costs net of VAT if your client recovers input tax, and inclusive of VAT if it does not.
• Include the CPR PD 44 VAT statement and certify the recovery position accurately.
• Invoice your own client for VAT, and never issue a tax invoice to the paying party (a note of costs only).
• Account for output VAT at the tax point on your own bill, regardless of when the loser pays.
• For a partially exempt client, claim only the irrecoverable proportion of the VAT inter partes.
• Treat recovered disbursements under the eight-condition test, and recovered counsel as a supply to the firm by default.

The Cluster B siblings cover the adjacent funding and costs questions: VAT on legal aid work and the LAA cash-flow lag, conditional fee agreement success fees and tax, and damages-based agreement accounting and tax.

Speak to a Specialist

The recovered-costs VAT rule is simple to state and easy to get wrong in practice: net if your client recovers, inclusive if it does not, invoice your own client only, and let the CPR PD 44 statement carry the position. The agreement and rules cited here (VATSC11534, CPR PD 44, VATA 1994 s.6) are stated as at 3 June 2026; confirm the current position before you rely on it. If your litigation or costs team wants to be sure its bills draw VAT correctly and its accounting follows VATSC11534, speak to a legal-sector-specialist accountant who can review your recovered-costs treatment against live matters.