Partial Exemption and Client Account Interest: A VAT Risk for UK Law Firms

The Hidden VAT Risk Most Firms Miss

Almost every law firm treats itself as fully taxable for VAT. Legal services (advice, conveyancing, litigation, drafting) are standard-rated at 20%, a rate in force since 4 January 2011, so firms reasonably assume they recover all the input VAT on their costs. For the overwhelming majority that assumption is correct. But there is a quieter category of income that behaves very differently for VAT: interest.

Interest a firm earns on its own deposits, and the interest it retains on client-account and designated-deposit balances, is an exempt supply of finance. Exempt income can, in principle, make a firm partially exempt, and a partially exempt business cannot automatically recover all of its input VAT. With interest rates elevated since 2022, the sums involved have grown large enough that advisers across the legal sector flagged this as a live issue through early 2026. The natural worry is that a firm earning meaningful interest has quietly lost some of its recovery on rent, IT and other overheads.

The honest answer is reassuring but it requires a check rather than an assumption. There is a strong safety net (the de minimis test) and, above it, an even more important rule: HMRC treats genuinely incidental interest as excluded from the calculation altogether. The result is that most firms are not restricted at all. This guide walks from the legal starting point (why interest is exempt) through the mechanics (the standard method, the de minimis limits, the annual adjustment) to the crux (when interest is incidental and when it is not), so you can confirm where your firm sits.

Why Interest Is an Exempt Supply (Schedule 9 Group 5)

The legal anchor is VATA 1994 Schedule 9 Group 5 (Finance). This group exempts the core financial activities, including the issue, transfer or receipt of, or any dealing with, money (Item 1), the making of any advance or the granting of any credit (Item 2), and the operation of any current, deposit or savings account (Item 8). Interest a firm earns is consideration for a supply that falls squarely within this exempt group. The firm charges no VAT on it, and it sits outside the standard-rated stream that legal fees occupy.

It is worth drawing one careful distinction at the outset. This is the firm's own exempt income. It is separate from client money, which the firm merely holds and which is never the firm's income at all. Money held on account of costs, or held for a client pending a transaction, does not become the firm's turnover and does not feature in the firm's VAT supplies. What does feature is the slice of interest the firm is entitled to keep: the margin or retained interest on general client account, and the interest the firm earns on its own office-account deposits. That retained interest is the exempt supply that can, in the wrong circumstances, trigger partial exemption.

A second distinction worth holding from the start is between an exempt supply and one that is outside the scope of VAT or zero-rated. Exempt supplies sit inside the VAT system but carry no output VAT and, importantly, can restrict input VAT recovery, which is exactly why they matter for partial exemption. Zero-rated supplies (taxed at 0%) are still taxable supplies and do not restrict recovery; out-of-scope receipts are outside the system entirely. Interest sits in the first category: a genuine exempt supply of finance. That is why the question for a firm is never "do I charge VAT on interest" (you do not) but "does this exempt income reduce what I can reclaim on my costs", which is the partial-exemption question this guide answers.

The Client Account Interest Angle

This is where the topic becomes specifically a law-firm issue rather than a generic one. Under the SRA Accounts Rules 2019, Rule 7 requires a firm to account to its client (or the relevant third party) for a fair sum of interest on client money it holds. The fairness test looks at the amount held and the period it is held for, and a contrary written agreement is permitted. The practical consequence is that the bank pays interest on the pooled client-account balances, the firm pays a fair sum across to clients, and the firm may retain a margin.

That retained margin is the firm's own income, and being interest, it is exempt for VAT. So the very money flow that the SRA fairness duty governs is the same money flow that can produce a firm's exempt income for VAT purposes. The two regimes sit side by side: one (the SRA rule) is about treating the client fairly, the other (VAT) is about how the firm's retained share is categorised. Our guide on handling client money interest under the SRA rules covers the regulatory side in full; here the point is simply that the SRA-driven interest the firm keeps is the exempt supply that can put partial exemption on the table.

For completeness, it helps to be clear about what counts as client money for a UK solicitor, because only the firm's retained interest (not the client money itself, and not interest paid across to clients) is the firm's exempt income.

It is also worth separating the regulatory point from the tax point, because they are easily conflated. The SRA Rule 7 duty is about fairness: it tells the firm how much interest it must pay the client and obliges it to have a clear, defensible interest policy. It says nothing about VAT. The VAT analysis runs alongside it and asks a different question: of the interest the bank pays into the firm's accounts, how much does the firm keep for itself, and what does that retained amount do to the firm's VAT recovery. A firm can have an impeccable Rule 7 interest policy and still need to think about VAT, because the two regimes are measuring different things. The connection is simply that the same flow of bank interest feeds both, and the slice the firm retains is the slice that is relevant to VAT.

One further nuance on the source of the interest. The interest a firm earns falls into two practical buckets: interest on its own office-account or treasury deposits (plainly the firm's income), and the retained portion of interest on pooled general client account and on designated deposit accounts opened for individual matters. For the VAT analysis both are simply interest, and both are exempt; the firm's task is to identify, across all of it, how much it has retained as its own income in the period. That retained total is the figure that feeds everything that follows.

What Partially Exempt Actually Means

A business that makes both taxable and exempt supplies is partially exempt. It cannot automatically recover all of its input VAT, because some of that input VAT relates to making the exempt supplies, and input VAT on exempt supplies is in principle irrecoverable. To apply the rules, the firm sorts its input VAT into three categories:

• Directly attributable to taxable supplies. Input VAT on costs used wholly to make standard-rated legal services. This is fully recoverable.
• Directly attributable to exempt supplies. Input VAT on costs used wholly to make the exempt supply (the interest activity). This is not recoverable, subject to the de minimis test below. For a firm passively earning interest, this category is usually tiny or nil, because there are no dedicated staff, systems or bought-in services generating the interest.
• Residual (overhead) input VAT. Input VAT on costs used for the business as a whole: rent, utilities, IT and software, professional fees, general office costs. This cannot be attributed wholly to either stream, so it is apportioned.

The mechanics that follow (the standard method, the de minimis test, the annual adjustment) come from the VAT Regulations 1995 (SI 1995/2518), regulations 99 to 111, with VAT Notice 706 as the accessible statement of HMRC's approach.

The Standard Method

Residual input VAT is apportioned using the standard method. The recoverable percentage is the value of taxable supplies (excluding VAT) divided by the total value of all supplies (excluding VAT), multiplied by 100. That percentage is then applied to the residual input VAT to give the recoverable amount.

Two rounding rules matter. The percentage must be rounded up to the next whole number, which works in the taxpayer's favour. The exception is for large businesses: where residual input tax exceeds £400,000 a month on average, the percentage is taken to two decimal places instead. Very few law firms approach that residual-input-tax level, so for a typical firm the round-up to the next whole percent applies. The standard method is the default; a firm can apply to HMRC for a special method if the standard one produces a distortive result, but that needs HMRC approval and is the exception rather than the rule.

The De Minimis Test: The Safety Net

This is the reassuring section, and the figures are exact. A partially exempt firm is treated as fully taxable, and recovers all of its input VAT (including the exempt-related part), if its exempt input tax is both:

• no more than £625 per month on average (HMRC states this as £1,875 for a quarter and £7,500 for an annual calculation); and
• no more than 50% of total input tax in the period.

Both limbs must be satisfied (figures current for 2026). HMRC also provides two simplified checks that let many businesses confirm de minimis without a full attribution exercise. Test One: total input tax is no more than £625 a month on average and exempt supplies are no more than 50% of all supplies. Test Two: total input tax less the input tax directly attributable to taxable supplies is no more than £625 a month on average, and exempt supplies are no more than 50% of all supplies. Passing any one of the three tests (the original test or Test One or Test Two) means the firm is de minimis and recovers everything for that period.

The reason most firms sail under de minimis is straightforward: the input VAT actually attributable to passively earning interest is usually negligible. There is rarely any bought-in cost dedicated to it. So even the firm's exempt-related slice of residual overhead VAT tends to be small in absolute terms, well below £625 a month and far below half of total input tax.

Is Interest Incidental? The Crux

Above the de minimis safety net sits a more fundamental rule, and it is the single most important point on this page. VAT Notice 706 directs that incidental financial transactions, for instance interest received on a bank account, are excluded from the standard-method calculation, because their inclusion would be distortive. If a firm's interest is genuinely incidental, it does not enter the recovery fraction at all, and so it cannot restrict recovery in any amount.

What makes interest incidental? The term is not defined in statute, so it is a question of facts and degree. The factors that point towards incidental are: the interest arises passively as a consequence of normal business activity; the firm does not actively manage deposits as a business activity in its own right; little or no cost is incurred to generate it; and it is not a permanent or significant extension of what the firm does. For an ordinary firm earning interest on the cash it happens to hold, all of those factors are usually present, so the interest is incidental and is left out of the calculation.

Honesty requires the other side of the point. Because incidental is a facts-and-degree test, very large or actively managed interest may not qualify. A firm that holds substantial designated-deposit balances, deliberately places them to maximise retained interest, and treats that retained interest as a material, recurring income stream is in a different position: the incidental argument is harder, and the interest may have to be included. That is precisely the nuance that sector advisers and HMRC's partial-exemption guidance flag. The right approach is to reach a reasoned conclusion and document it, not to assume incidental in every case.

It helps to see the two protections as a sequence rather than alternatives. The incidental-exclusion rule is the first gate: if the interest is genuinely incidental, it never enters the standard-method fraction, so there is nothing to apportion and no exempt input tax to test. The de minimis test is the second gate, and it catches the cases where some exempt input tax does fall to be considered (because the interest is included, or because there is some directly attributable exempt cost): even then, if that exempt input tax is small enough, the firm still recovers everything. A firm passes if it clears either gate. Most firms clear the first; nearly all of the rest clear the second. Only a firm that fails both, non-incidental interest and exempt input tax above the de minimis limits, suffers an actual restriction.

A common misconception is that the size of the interest income itself decides the question. It does not, at least not directly. What the partial-exemption rules restrict is input tax, not income. A firm could earn a large headline interest figure and still have almost no exempt input tax, because passively earning interest consumes very little in the way of VAT-bearing costs. The interest figure is relevant to the incidental judgment (scale is one of the factors) and to one limb of the de minimis tests (exempt supplies as a proportion of all supplies), but the restriction itself bites on the input VAT attributable to the exempt activity, which for a typical firm is the small number, not the large one.

The Annual Adjustment

Partial-exemption recovery in each VAT period is provisional. At the end of the longer period (normally the firm's VAT year) the firm must carry out an annual adjustment. It recalculates recovery using the full-year figures, re-tests de minimis on the annual numbers, and corrects the difference between the provisional quarterly figures and the final annual figure on the next return (or by error correction if needed).

The annual adjustment matters because the quarterly and annual positions can diverge. A firm might be de minimis in each individual quarter but breach the limits when the year is totalled, or the reverse. The year-end calculation is the one that settles the position, so a firm that tracks its exempt input tax through the year is rarely surprised at the adjustment. These rules are current for 2026.

Worked Example: The Firm That Is Comfortably De Minimis

The following is an illustrative sketch to show the mechanics, not advice, and the figures are invented.

A VAT-registered firm earns a modest amount of retained interest across the year on its general client account and its office-account deposits. It has no staff or systems dedicated to generating that interest; it simply earns it on cash it holds in the ordinary course. The firm's total input VAT for the year is, say, £60,000, almost all of it on costs used for its standard-rated legal work and on general overheads (rent, IT, professional fees).

First, the incidental question. The interest arises passively, no material cost is incurred to earn it, and it is not a business activity in its own right. The firm concludes the interest is incidental and documents the reasoning. On that basis the interest is excluded from the standard-method calculation entirely, and there is no restriction to compute. The firm recovers its input VAT in full.

Second, the belt-and-braces check. Suppose the firm did not rely on the incidental exclusion and instead ran the de minimis test. The input VAT directly attributable to the interest is effectively nil, and even the exempt-related share of residual overhead VAT is, say, only a few hundred pounds across the whole year, far below £7,500 for the year (the annual equivalent of £625 a month) and nowhere near 50% of the £60,000 total input tax. The firm passes the de minimis test comfortably, so once again it recovers everything, including the overhead VAT.

The takeaway: for most firms the incidental exclusion and the de minimis safety net mean there is no actual restriction. The discipline is to test the position and keep the working, not to assume it.

When a Firm Should Actually Worry

The live risk arises in a narrow set of circumstances, and it is worth naming them so that the firms genuinely affected can spot themselves. Concern increases where the firm holds very large designated-deposit or client-account balances; where it actively manages placement to maximise the interest it retains; where the retained interest is a significant and recurring income stream rather than an incidental by-product; or where the firm has other material exempt income alongside interest.

In those cases the incidental argument weakens, the interest may have to be brought into the calculation, the exempt input tax can exceed the de minimis limits, and a slice of the firm's overhead input VAT becomes irrecoverable, confirmed at the annual adjustment. None of that is fatal; it simply means the firm carries a modest, quantifiable VAT cost that it should plan for. The error to avoid is at the other extreme: assuming the restriction bites for every firm with a healthy interest line. It usually does not.

Practical Mitigation and Record-Keeping

A short, structured review keeps a firm on the right side of this:

• Test whether the interest is incidental, and document the reasoning. Record that it is passive, the (minimal) cost of generating it, its scale relative to the firm, and the absence of active management. That note is the firm's defence if HMRC ever asks.
• Track exempt input tax against the de minimis limits. Do it each VAT period and again at the year end via the annual adjustment, so the position is never a surprise.
• Identify any genuinely attributable cost. For most firms this is nil; if a firm does buy in services to manage deposits, capture that input VAT as directly attributable to the exempt activity.
• Stay on the standard method unless a special method is clearly better. A special method needs HMRC approval and is rarely necessary for a firm whose only exempt income is incidental interest.
• Do not confuse this with the Flat Rate Scheme. The Flat Rate Scheme applies a flat percentage to VAT-inclusive turnover and does not work the same way; our guide to the VAT Flat Rate Scheme for UK solicitors sets out that regime, and partial exemption does not apply within it in the same form.

For the broader picture of how VAT works across the firm, see our guides to VAT on legal services and solicitor VAT accounting, and if you are buying or refurbishing premises, the partial-exemption recovery rate discussed here feeds directly into the Capital Goods Scheme covered in our guide to the option to tax and the Capital Goods Scheme on law-firm premises. The timing of when output VAT falls due on your fees is a separate question, addressed in our guide to the VAT tax point and time of supply for law-firm billing.

Speak to a Specialist

Partial exemption looks alarming and turns out, for most firms, to be a clean review with a reassuring conclusion: incidental interest is excluded, the de minimis safety net preserves full recovery, and nothing is restricted. The firms that need to look harder are the minority with large, actively managed or otherwise non-incidental exempt income. Either way, the value is in confirming the position with a clear, documented calculation rather than guessing. If your firm's interest income has grown and you want certainty on your VAT recovery, speak to a legal-sector-specialist accountant who can run the de minimis test, assess whether your interest is incidental, and document the result.