Registration and the threshold

A law firm must register for VAT once its taxable turnover exceeds £90,000 in any rolling twelve-month period (the current registration threshold from 2024). Most firms providing legal services pass this threshold quickly: legal services are standard-rated supplies at 20%, so all fee income counts toward the threshold.

Once registered, the firm charges VAT on its taxable supplies, reclaims input VAT on costs it incurs for the purposes of the business, and accounts to HMRC quarterly. The main complication for law firms is that the line between the firm's own supplies and costs it incurs as agent for clients is not always obvious. Getting that line wrong in either direction creates a VAT liability or an incorrect reclaim.

Disbursements versus rechargeable costs: the core distinction

This is the most important VAT question for most law firms. The distinction turns on whether the firm is acting as principal or as agent when it incurs a cost.

A true disbursement is a cost the firm incurs as agent for the client. The client is the customer of the third-party supplier; the firm is simply passing money through. Because the client is the true customer, the supply is to the client from the supplier directly, and the firm neither charges VAT on the recharge nor reclaims input VAT on the original invoice. The amount recharged to the client is outside the scope of VAT.

HMRC's guidance and the leading case of Brabners LLP v HMRC [2017] UKFTT 0666 (TC) set out the conditions that must be met for a cost to be treated as a disbursement:

  • The client authorised the firm to incur the expense on their behalf
  • The client knew the expense was to be incurred as a separate supply to them (not wrapped into the firm's overall service)
  • The cost was actually paid to the third party by the firm acting as agent (not as principal)
  • The firm accounts to the client for the actual amount paid, not a marked-up version
  • The cost cannot be reclaimed by the firm as input VAT (because the supply is to the client, not the firm)

If all conditions are met, the recharge is a disbursement and no VAT is added. If any condition fails, the recharge is a rechargeable cost (sometimes called an "out-of-pocket expense") and VAT must be charged at the same rate as the underlying supply.

Rechargeable costs are costs the firm incurs as principal and then passes on to the client as part of its own service. The firm is the customer of the supplier. The recharge to the client is part of the firm's own supply and is VATable if the firm's service is VATable.

Counsel fees

The VAT treatment of counsel fees depends on who is the client's counterparty in the barrister relationship.

If the client contracts directly with the barrister (the barrister is instructed by the client, with the firm acting as intermediary), the fee is a true disbursement. The firm passes the fee through at cost, adds no VAT, and reclaims no input VAT. The barrister invoices the client (via the firm as agent), and any VAT on the barrister's invoice is the client's to deal with.

If the firm contracts with the barrister directly (the firm instructs and is responsible for the barrister's fee, irrespective of the outcome of the matter), the fee is a rechargeable cost. The firm pays the barrister (and reclaims the input VAT if the firm's own supply is VATable), then recharges the fee to the client as part of its overall service, adding VAT.

In practice, the second scenario is more common in litigation: the firm is typically the barrister's client for contractual purposes, even if the underlying matter belongs to the solicitor's client. Review your standard retainer terms to confirm which arrangement applies, and make sure the billing treatment matches the contractual reality.

There is a long-standing HMRC concession that many firms rely on in place of the strict contractual analysis. Under it, counsel's fees can be treated as a disbursement even where the firm instructed counsel: the firm re-addresses counsel's receipted fee note to the client (crossing out the firm's name and inserting the client's, with the firm's name preceded by "per"), so the supply is treated as made direct to the client. The client, if VAT-registered, reclaims the VAT; the firm keeps no VAT record for the fee. HMRC confirmed this concession survives the 2020 withdrawal of the postal search concession, though it remains under review. If you use it, apply it consistently and keep the amended fee notes on file.

Search fees: Land Registry, local authority and environmental

Search fees are the area where firms most often get the disbursement treatment wrong. The instinct is to treat every search passed on to a client as a disbursement, but that is not the position HMRC takes. The distinction is whether the search result is simply passed through to the client unamended, or whether the firm uses it as an input to its own advice.

This was the central point in Brabners LLP v HMRC. The firm obtained electronic property searches through an online search agency and treated the fees as disbursements. The tribunal held they were not: because the firm used the search results as part and parcel of its own service (interpreting them and advising the client on what they meant), the fees were a cost component of the firm's standard-rated supply and VAT should have been charged. HMRC confirmed and generalised this position in Revenue and Customs Brief 6 (2020): where the firm uses a search to inform the advice it gives, the fee is part of the firm's supply and is VATable, whether the search was obtained electronically or by post.

A search fee can still be a genuine disbursement, but only where the firm does no more than obtain the search and pass the result to the client without using it in its own advice (for example, a personal search a client asks the firm to procure and hand over unamended). Where the firm interprets the search and reports on it, treat the fee as part of the firm's VATable service. If in doubt, charge VAT: this is the treatment HMRC now expects for the typical conveyancing search.

Court fees paid on behalf of clients remain in a different position: the court is dealing with the client's case and the firm acts as agent, so these are typically disbursements outside the scope of VAT on recharge. HMRC generally accepts court fees as outside the scope of VAT on recharge.

Partial exemption

Most legal services are standard-rated. However, some supplies connected to financial services can be exempt from VAT under Group 5 of Schedule 9 VATA 1994. A firm that arranges financial products, provides certain regulated credit or carries out activities that straddle the financial services exemption may have a partial exemption position.

Partial exemption means the firm makes both taxable and exempt supplies. It can recover input VAT attributable to taxable supplies in full, cannot recover input VAT attributable to exempt supplies, and must apportion input VAT on costs that relate to both (residual input tax). The apportionment uses either the standard method (turnover-based) or a special method agreed with HMRC.

The de minimis rules allow firms to ignore the restriction on exempt input tax if the monthly average is below £625 and below 50% of total input tax. Many smaller firms with incidental exempt income fall within de minimis. Review your position if exempt income is growing: partial exemption compliance becomes material once de minimis is lost.

The cash accounting scheme

Under standard VAT accounting, a firm accounts for output VAT when it raises an invoice and reclaims input VAT when it receives one. This means the firm must pay VAT to HMRC on fees it has billed but not yet collected.

The cash accounting scheme changes the trigger: output VAT is accounted for when payment is received, and input VAT is reclaimed when payment is made. For a firm with slow-paying clients and significant lock-up, this can improve cash flow materially: you are not paying VAT to HMRC before the client has paid you.

Eligibility requires taxable turnover below £1.35 million. If turnover is above that, the firm must use standard accounting and plan the quarterly VAT outflow explicitly.

Making Tax Digital for VAT

All VAT-registered businesses must keep digital VAT records and submit returns using Making Tax Digital (MTD)-compatible software. For most law firms this is met by using a practice management system or accounting software (such as Xero, Sage or QuickBooks) that links to the HMRC MTD API.

The digital link requirement means there must be no manual re-keying of figures from the accounting records into the VAT return: the figures must flow through digital links from the original record to the return submission. Bridging software or spreadsheet-based returns are acceptable only if the digital link is preserved throughout.

Input VAT recovery on mixed supplies

A fully taxable firm recovers all input VAT on costs that have a direct and immediate link to its taxable supplies. The practical list includes: professional indemnity insurance, office rent, IT systems, accounting software, training and CPD, stationery and general overheads.

Costs with no business purpose cannot be recovered. Costs with both business and personal elements (a mobile phone used for both purposes, for example) must be apportioned. HMRC accepts a reasonable basis for the apportionment; it does not need to be precise, but it must be documented and applied consistently.

The flat rate scheme

The flat rate scheme simplifies accounting by replacing the standard input/output calculation with a single percentage applied to gross VAT-inclusive income. The flat rate for legal services is 14.5%.

For most law firms, the flat rate scheme is not beneficial. A firm charging 20% output VAT but paying only 14.5% under the flat rate keeps the 5.5% difference, but it cannot reclaim any input VAT on costs (other than capital expenditure over £2,000). Law firms typically have significant VATable input costs (rent, IT, insurance, counsel fees where rechargeable), and losing the ability to reclaim input VAT on those costs usually outweighs the benefit of the flat rate margin. The scheme is worth modelling if the firm has very low input costs, but the standard position for established firms is that standard accounting is more beneficial.

Common VAT errors in law firms

The errors that most commonly trigger HMRC enquiries in legal practices are:

  • Treating rechargeable costs as disbursements (and failing to charge VAT on recharges that should be VATable)
  • Reclaiming input VAT on costs incurred as agent (which must not be reclaimed because the supply is to the client)
  • Inconsistent treatment of the same cost type across different matters (treating Land Registry fees as a disbursement for some clients and as a rechargeable cost for others, without a principled basis)
  • Not registering until turnover has exceeded the threshold for a significant period
  • Failing to apportion residual input tax under partial exemption once de minimis is lost

If you are uncertain about the VAT treatment of a specific cost type, the safest approach is to treat it as part of the firm's own supply (VATable) rather than as a disbursement. Over-charging VAT is correctable; under-charging creates a liability that the firm must usually absorb.