VAT Partial Exemption: A Plain-English Guide for 2026/27
How VAT partial exemption works in 2026/27: the standard method, de minimis limits, the annual adjustment, and how to recover input VAT correctly.
Quick answer
VAT partial exemption is the set of rules that decide how much input VAT a business can reclaim when it makes both taxable supplies (at 20%, the reduced rate, or zero-rated) and exempt supplies. You recover input tax linked to taxable activity, you cannot recover input tax linked to exempt activity, and you apportion the shared overhead tax in between. A de minimis test may still let you recover everything if the exempt amount is small.
What partial exemption actually means
Most small businesses are fully taxable: everything they sell carries VAT (even if some of it is zero-rated), so they reclaim all their input VAT subject to the usual rules. Partial exemption only arrives when you make exempt supplies as well.
The crucial distinction is between zero-rated and exempt:
- Zero-rated supplies are taxable supplies charged at 0%. You still recover the input VAT on costs that support them.
- Exempt supplies are outside the scope of VAT recovery. You charge no VAT on them, and you cannot reclaim the input VAT on costs used to make them.
Common exempt categories include certain financial services, insurance, most residential property lettings, some education, and some health and welfare. The exact liability of any supply is detailed and full of exceptions, so confirm yours on gov.uk rather than assuming.
The three pots of input VAT
Under the standard method you sort every pound of input VAT into one of three pots.
| Pot | What it covers | Recoverable? |
|---|---|---|
| Directly attributable to taxable supplies | Costs used only to make taxable sales | Yes, in full |
| Directly attributable to exempt supplies | Costs used only to make exempt sales | No |
| Residual (overhead) | Costs used for both, such as rent and software | Apportioned |
The first two pots are about direct attribution: you trace the cost to the type of supply it supports. The third pot, residual input tax, is the part that needs a recovery percentage, because those overheads keep the whole business running.
How the standard method splits residual VAT
The standard method recovers residual input tax in proportion to taxable turnover. The headline formula is:
Recovery percentage = taxable supplies / total supplies
You take the value of your taxable supplies (including zero-rated) as a percentage of all your supplies (taxable plus exempt), and for most smaller businesses you round that percentage up to the next whole number. You then apply it to the residual pot.
A simple worked example for one VAT period:
| Item | Amount |
|---|---|
| Input VAT directly attributable to taxable supplies | GBP 4,000 |
| Input VAT directly attributable to exempt supplies | GBP 1,000 |
| Residual input VAT | GBP 2,000 |
| Taxable turnover | GBP 180,000 |
| Total turnover | GBP 240,000 |
The recovery percentage is 180,000 / 240,000 = 75%. So you recover 75% of the GBP 2,000 residual pot, which is GBP 1,500. Add the GBP 4,000 of directly attributable taxable input tax and your provisional recoverable input VAT is GBP 5,500. The GBP 1,000 exempt-attributable tax and the GBP 500 unrecovered residual tax are the exempt input tax, GBP 1,500 in total -- and that is the figure the de minimis test looks at next.
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The de minimis rules exist so that businesses with only a small slice of exempt activity are not punished with lost VAT. If your exempt input tax is small enough, you recover all of it.
Broadly, you pass the test in a VAT period when both of these hold:
- Your total exempt input tax is below a set monthly average money limit, and
- Your exempt input tax is less than half of your total input tax.
If you pass both, you treat the exempt input tax as recoverable for that period -- so in the example above you might recover the full GBP 1,500 rather than writing it off. The specific monthly money limit is set by HMRC and is a figure I will not quote from memory; confirm the current de minimis limit on gov.uk before you rely on it. The "less than half of total input tax" half of the test is the structural part that does not change.
The annual adjustment
Calculating partial exemption every VAT period is sensible for cash flow, but quarterly figures get distorted by timing. A large one-off exempt sale, or a seasonal swing, can push a single period above or below de minimis unfairly.
That is why the rules require an annual adjustment. After the tax year ends, you:
- Recalculate the recoverable input VAT using full-year figures.
- Compare that annual figure with the total you actually reclaimed across the four periods.
- Post the difference -- a top-up or a clawback -- on a nominated return.
The annual adjustment also re-runs the de minimis test on a whole-year basis, which can rescue recovery for a business that failed in one quarter but is comfortably under the limit across the year. Keep a clean record of both the period calculations and the annual reconciliation.
When the standard method is not fair
The standard method is turnover-based, and turnover is not always a fair proxy for how costs are actually used. A business with high-value, low-cost exempt transactions, or a property portfolio where floor space matters more than rental income, may find the standard method over- or under-recovers.
The standard method needs no approval and uses turnover, which is simple and predictable but can distort recovery where exempt supplies are unusually high or low value.
A partial exemption special method must be approved by HMRC in writing before use, but it can apportion residual VAT on a basis that better reflects reality -- such as floor space, headcount, or transaction counts.
If you propose a special method you must set out how you will attribute and apportion input tax, and you cannot use it until HMRC agrees in writing. There is also a "standard method override" that can apply where the standard method produces a result that differs substantially from use-based recovery; if that risk applies to you, take professional advice.
Records, MTD and the wider VAT picture
You must keep enough records to evidence your split between taxable, exempt and residual input tax, the recovery percentage for each period, and the annual adjustment. Under Making Tax Digital you keep these digitally and file through compatible software, with a clear digital audit trail from invoice to return.
Remember the boundaries of the regime. The VAT registration threshold is GBP 90,000 of taxable turnover -- exempt supplies do not count toward it, so a mostly-exempt business may not need to register at all. Standard VAT remains 20%. Partial exemption is only about input tax recovery; your output tax on taxable sales is calculated separately. If you want to model the VAT on your sales while you work through recovery, a calculator helps:
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Open VAT calculatorIf your business is a limited company, the irrecoverable input VAT becomes part of your deductible costs for Corporation Tax purposes, which at small-profit level is charged at 19% on profits up to GBP 50,000 and 25% above GBP 250,000 with marginal relief between. You can sketch that impact too:
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Open Corporation Tax calculatorCommon mistakes to avoid
- Treating exempt supplies as zero-rated, or vice versa, and recovering the wrong input VAT.
- Forgetting the de minimis test and writing off recoverable exempt input tax.
- Skipping the annual adjustment, which HMRC expects every year.
- Using a special method without written approval.
- Failing to keep a clear audit trail for the attribution and apportionment.
Bottom line
Partial exemption is mechanical once you internalise the three pots and the order of operations: attribute directly first, apportion the residual with your recovery percentage, run the de minimis test, then reconcile with the annual adjustment. Use the standard method unless you can show it is unfair, keep tidy digital records, and confirm the current de minimis money limit and the precise liability of your supplies on gov.uk -- those are the two areas where details change and mistakes get expensive.
Frequently asked questions
What is VAT partial exemption?
Partial exemption applies when a VAT-registered business makes both taxable supplies (standard, reduced or zero-rated) and exempt supplies (such as certain financial services, insurance or residential lettings). Because you cannot reclaim input VAT that relates to exempt activity, you must split your input tax between recoverable and non-recoverable. The rules tell you how to make that split fairly, and a de minimis test may let you recover the exempt portion anyway if it is small enough.
Who has to use partial exemption rules?
Any VAT-registered business that incurs input VAT on costs used to make exempt supplies, or used for a mix of taxable and exempt supplies. If everything you sell is taxable you are fully taxable and recover all input VAT subject to normal rules. If you make some exempt supplies, you fall within the partial exemption regime and must apply the standard method or an agreed special method to work out what you can reclaim.
What is the standard method?
The standard method splits input VAT into three pots: tax directly attributable to taxable supplies (fully recoverable), tax directly attributable to exempt supplies (not recoverable), and residual or overhead tax used for both. You recover the residual tax in proportion to your taxable turnover as a percentage of total turnover, rounded up to the next whole percent for most smaller businesses. It is the default unless HMRC approves a special method.
What is the de minimis limit?
The de minimis rules let you recover all your input VAT, including the exempt-related part, if the exempt input tax is small. Broadly, the exempt input tax must be below a monthly average money limit and also be less than half of your total input tax. If you pass both tests in a VAT period you treat exempt input tax as recoverable. The exact money limits are set by HMRC, so confirm the current figures on gov.uk before relying on them.
How does the annual adjustment work?
Partial exemption is calculated each VAT period, but those period figures can be distorted by timing. So you also perform an annual adjustment covering the whole tax year. You recalculate recoverable input VAT using full-year figures, compare it with what you reclaimed across the periods, and post the difference on a nominated return. This smooths out seasonal swings and gives a fairer annual recovery percentage.
Can I recover VAT on overheads like rent and software?
Overheads such as rent, accountancy, software and utilities usually count as residual input tax because they support the whole business, including any exempt supplies. You cannot recover all of it automatically. Instead you apply your recovery percentage from the standard or special method to the residual pot. If you pass the de minimis test, the unrecovered residual amount becomes recoverable in full for that period.
What counts as an exempt supply?
Common VAT-exempt supplies include certain financial services, insurance, most residential property lettings, some education and training, and some health and welfare services. Exempt is different from zero-rated: zero-rated supplies are taxable at 0% and still allow full input VAT recovery, whereas exempt supplies block recovery. Check the specific liability of your supplies on gov.uk, because the categories are detailed and have exceptions.
Do I need HMRC approval for a special method?
Yes. The standard method is the default and needs no approval. If it does not give a fair and reasonable result for your business, you can propose a partial exemption special method, but you must get written approval from HMRC before using it. The proposal sets out how you will attribute and apportion input tax. Many businesses base a special method on floor space, headcount, or transaction counts rather than turnover.
How does partial exemption interact with the VAT registration threshold?
The VAT registration threshold is GBP 90,000 of taxable turnover. Exempt supplies do not count toward that threshold, so a business making mostly exempt supplies might not need to register at all. Once registered, though, partial exemption applies to the input VAT on your costs. Standard VAT is charged at 20% on taxable supplies. Use a VAT calculator to model the output tax on your taxable sales while you assess input recovery separately.
What records do I need to keep?
You must keep enough records to show how you split input VAT between taxable, exempt and residual, the calculations behind your recovery percentage each period, and the annual adjustment. Keep invoices, the basis for any direct attribution, and a clear audit trail for the method used. Under Making Tax Digital you keep digital records and file through compatible software. Good records protect you if HMRC reviews your recovery.
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