The Complete Guide to VAT Partial Exemption and the Capital Goods Scheme
Partial exemption and the Capital Goods Scheme (CGS) are two of the most technically complex areas of UK VAT. Businesses that make both taxable and exempt supplies often struggle with vat partial exemption rules, while property and high-value asset owners face long-term VAT adjustment obligations under capital goods scheme VAT legislation.
Errors in these areas frequently result in:
- Missed VAT refunds
- Large retrospective HMRC assessments
- Long-running compliance disputes
- Unexpected VAT liabilities years after asset purchase
In this complete guide, Audit Consulting Group – Accounting and Tax explains:
- How VAT partial exemption works
- How partial exemption calculation is performed
- What the de minimis rules mean
- How the Capital Goods Scheme (CGS) operates
- How CGS and partial exemption interact in practice
What Is VAT Partial Exemption?
Under UK VAT law, a business is partially exempt if it makes:
- Taxable supplies (standard-rated, reduced-rated, or zero-rated), and
- Exempt supplies (such as financial services, rent of residential property, education, insurance, and healthcare)
This is extremely common in sectors such as:
- Property and real estate
- Financial services and lending
- Healthcare and private clinics
- Education and training
- Insurance and brokerage
When a business is partially exempt, not all input VAT is automatically recoverable.
This is where vat partial exemption rules apply.
How VAT Partial Exemption Works in Practice
Input VAT is split into three main categories:
- VAT Directly Attributable to Taxable Supplies
Fully recoverable
Examples:
- VAT on materials for taxable construction work
- VAT on marketing purely for taxable services
- VAT Directly Attributable to Exempt Supplies
Fully blocked
Examples:
- VAT on costs linked solely to mortgage lending
- VAT on managing residential rental property
- Residual (Overhead) VAT
Partially recoverable using a partial exemption calculation
Examples:
- Office rent
- Admin salaries (if staff work across taxable and exempt areas)
- Software systems
- General professional fees
This category creates the most errors and HMRC disputes.
Partial Exemption Calculation Explained
The partial exemption calculation determines how much residual VAT you are allowed to reclaim.
Standard Method (Most Common)
The VAT recovery percentage is usually calculated as:
Taxable Turnover ÷ Total Turnover × Residual VAT
This gives the percentage of overhead VAT that can be reclaimed.
Example:
If taxable turnover is 60% of total turnover → you can reclaim 60% of residual VAT.
Annual Adjustment – A Major Risk Area
At the end of each VAT year, businesses must perform a partial exemption annual adjustment. This recalculates VAT recovery using full-year figures rather than quarterly estimates.
This adjustment may result in:
- Additional VAT refund
- Additional VAT payable to HMRC
Many businesses fail to complete this correctly, creating long-term compliance issues.
Partial Exemption De Minimis Rules
The partial exemption de minimis rule allows a business to recover all VAT, even if it makes exempt supplies.
To qualify, both of the following must be met:
- Exempt VAT is less than £625 per month on average, and
- Exempt VAT is less than 50% of total input VAT
If both conditions are met:
All VAT becomes fully recoverable
If not:
Partial recovery applies
This is often overlooked and can lead to missed VAT refunds.
Special Partial Exemption Methods
In some cases, the standard turnover-based method produces unfair or distorted results. HMRC may approve a Special Partial Exemption Method (SPEM) based on:
- Floor space usage
- Staff time
- Transaction volumes
- Cost drivers
These must be:
- Formally agreed with HMRC
- Applied consistently
- Reviewed as the business evolves
What Is the Capital Goods Scheme (CGS)?
The Capital Goods Scheme VAT is a long-term VAT adjustment system that applies to high-value assets, including:
- Land and buildings over £250,000
- Civil engineering works
- Certain large items of plant and machinery
Under CGS:
- VAT recovery is not final in the year of purchase
- The VAT position is reviewed and adjusted annually for:
- 10 years for land and buildings
- 5 years for equipment
How CGS Adjustment Works
Each year, businesses must review:
- How the asset is used
- Whether it supports taxable or exempt supplies
- Whether there has been a change of use
If the asset moves:
- From taxable → exempt use → VAT must be repaid
- From exempt → taxable use → VAT refund becomes available
This is called a CGS adjustment VAT.
CGS and Property: High-Value VAT Opportunities & Risks
For property businesses, CGS is especially powerful and dangerous.
Examples:
- A property originally used for residential letting (exempt)
- Later moved into taxable commercial leasing under the option to tax
- This can generate very large VAT refunds through CGS adjustments
However:
- Poor CGS tracking can trigger unexpected VAT bills years later
- Many businesses forget about CGS entirely after acquisition
HMRC treats CGS errors as high-risk compliance failures.
Interaction Between Partial Exemption and CGS
One of the most complex VAT areas occurs when:
- A business is partially exempt, and
- It holds CGS assets
In these cases:
- VAT recovery on the asset may change every year
- Partial exemption percentages directly affect CGS adjustments
- Errors get multiplied over a 10-year period
This creates a compounded risk of misstatements and penalties.
Common Partial Exemption & CGS Errors
Some of the most frequent HMRC findings include:
- Using the wrong turnover figures in the calculation
- Missing annual partial exemption adjustments
- Incorrect application of de minimis rules
- Failing to track CGS assets over multiple years
- Ignoring changes in property use
- Applying standard methods where a special method is required
These errors often result in:
- Multi-year VAT back payments
- Interest charges
- Penalties of up to 100%
Why Professional VAT Support Is Critical in These Areas
Partial exemption and CGS are not “set-and-forget” VAT areas. They require:
- Ongoing review
- Accurate forecasts
- Asset tracking
- Annual adjustments
- Strategic VAT planning
For many property, healthcare, education, and finance businesses, this is where professional VAT advisory support becomes essential.
How Audit Consulting Group Supports Partial Exemption & CGS
At Audit Consulting Group – Accounting and Tax, we provide:
✅ Partial exemption reviews and calculations
✅ Annual adjustment compliance
✅ Special method applications
✅ CGS asset tracking systems
✅ Property VAT structuring and option to tax advice
✅ Retrospective VAT refund claims
✅ HMRC VAT enquiry defence
We help clients:
- Recover the maximum lawful VAT
- Avoid hidden CGS liabilities
- Stay fully compliant with HMRC
Contact Audit Consulting Group
Audit Consulting Group – Accounting and Tax
+44 7386 212550
info@auditconsultinggroup.co.uk
If your business makes both exempt and taxable supplies or owns high-value property and assets, a VAT review could uncover significant refunds — while also protecting you from future HMRC assessments.