Digitising partial exemption is a matter of transformation, not just automation

Partial exemption (both standard and special method) has a multitude of moving parts making it complex and challenging – which is why it was originally excluded from MTD for VAT.

However, with the recent increase in the VAT tax gap, and HMRC stating ‘using software for all your calculations will reduce the risk of errors in your returns’, we and many others expect partial exemption to come into the scope of MTD sooner rather than later.

What makes partial exemption so difficult?

There are a few factors that contribute to the difficulty of managing partial exemption in general, and partial exemption special method (PESM), in particular. Firstly, the partial exemption special method by its very nature is complicated as it is individually agreed with HMRC based on a business’ unique set-up. It is this individuality that requires businesses to demonstrate that the agreed PESM methodology has been followed, right down to the transaction level. Proving this compliance requires significant evidence gathering.

Secondly, many enterprise resource planning (ERP)/accounting systems simply struggle with partial exemption and so businesses end up having to do calculations outside of them. A perfect example of this is a reverse charge which, because it’s often a manual process, has been identified by accountancy firms as the number one area of risk with PESM. Organisations often fail to capture all their reverse charge transactions, with audits and reviews picking up missed reverse charges totalling well into the millions of pounds of undeclared VAT for prior years.

Several steps within the partial exemption process itself present challenges.

In our experience, attribution allocation is often the hardest stage to perform – it’s typically very manual with a sizable amount of estimation. Direct attribution is particularly time-intensive when thousands of transactions from across multiple data sources must be reviewed, allocated, corrected, or excluded and integrity checks performed before transactions can be correctly classified.

What are the implications of not digitising partial exemption?

By not automating partial exemption, you risk not maximising your recoverable VAT. This is because there tends to be a trade-off between keeping a method practicable and easy for the finance and tax team to operate, vs maximising recovery rates. For example, say a tax advisor develops two methods, in the case of option A the recovery rate is 75 percent but is relatively straightforward to implement, whereas option B has a recovery rate of 80 percent but is complex. Nine times out of ten companies operating a manual process will opt for option A because they can implement it more readily.

Reliance on spreadsheets and manual processes to calculate VAT increases the risk of errors. Partial exemption adds an additional layer of complexity with challenges relating to attribution allocations, sector information etc. This means there’s a greater potential for more mistakes and, with ever-increasing scrutiny, HMRC will spot them and either impose penalties or undertake a compliance investigation.

Finally, not digitising partial exemption can lead to companies being reluctant to evolve their partial exemption agreement as their business changes over time. The reason for this is two-fold.

Firstly, it takes significant time to gather the evidence manually to justify the change – and because it’s not in a digital format it can be harder to demonstrate how the method would work in relation to the current VAT Return, which extends the time HMRC takes to analyse and approve the change.

Secondly, once a new PESM has been agreed upon, there is the task of manually implementing those changes. But by rarely revisiting and updating your partial exemption method, the risk is you’ll potentially miss out on maximising recoverable VAT.

Choosing the right software

There are two main pitfalls to avoid when looking at VAT software.

Firstly, don’t select technology that simply automates and replicates the existing process – this will just bake in existing errors which means you’ll get to the wrong answer faster.

Secondly, don’t end up dependent on third parties for change management – this can make changes costly to implement and ultimately creates a change-averse finance function.

In contrast, purpose-built VAT software has the power to apply methods correctly, produce accurate calculations and deliver efficiency gains through automation. Partial exemption automation requires software with specific capabilities, so you should look out for:

  1. Ability to mirror the partial exemption agreement

It’s essential the software enables you to demonstrate easily, to HMRC that the agreed partial exemption method is being applied consistently and correctly.

This visibility will help you prove compliance and will reduce your evidence gathering burden. If you use the sectorised method, look for the ability to easily set up sectors, the associated recovery methods, how these apply to the sectors and finally the allocation steps. When it comes to confirming compliance to HMRC, you will be in a good position if you are armed with a full digital audit trail, a digitally linked process, and have a record of all the steps completed when following your partial exemption method.

  1. Ease of making changes

As your business activities evolve over time, you’ll want to easily reflect these changes in your partial exemption calculations. For example, the software should be flexible enough to handle additions to cost centres or changes in ERP reporting, as well as implement more complicated methods, without there being a costly or time-consuming IT project every time.

  1. Automation & repeatability

The goal should be to have an accurate, efficient and repeatable partial exemption method and process. Look into how the software will maximise the automation of each step, particularly manually intensive steps, such as cost allocations, as this will free-up time for reviews and value-add activities.

  1. Direct attribution

When allocating costs directly to sectors for input VAT recovery, the software should make it easy to identify the sector and criteria that ensure the right transactions are filtered into the sector. You should also be able to trace the transactions from sector to source.

  1. Indirect allocation

The indirect allocation process can be the most detailed part of a PESM. Each step in the allocation of residual input VAT to sectors must be itemised and the movement of residual VAT tracked throughout, as it is allocated from, for example, cost centres into sectors, and potentially reallocated between sectors. Being able to step through this process and review each stage is fundamental to ensuring the special method produces the expected results.

  1. Annual adjustment

The annual adjustment can be a laborious task requiring a lot of time and repetition of work. Therefore, the solution should utilise data and the set-up that has previously been provided. This ensures that the workload is focused solely on applying the relevant adjustments needed to arrive at the final input VAT position for the year.

  1. Analytics

Analytics should help you get the story out of the data. Hygiene factors will include the ability to track your recovery rates, conduct trend analysis and forecasting. Other areas to consider are how the analytics can support your partial exemption process, for example by giving visibility over movements in sectors and recovery methods.

AlphaVAT and partial exemption

AlphaVAT, Tax Systems’ specialist VAT automation platform, includes support for both partial exemption standard method and special method. It creates an accurate repeatable process proven to significantly reduce workloads.

For example, one of our clients who was using AlphaVAT to automate their manual process of mapping funds with cost centres and sectors removed three months’ worth of work. AlphaVAT also gives you the opportunity to maximise recovery rates through increased accuracy, such as calculating percentages direct from the source data, and through the flexibility to implement more complicated methods. Using AlphaVAT in this way, a financial services client recovered an additional £800,000 per annum.


To learn more about how you can overcome the challenges associated with automating partial exemption standard and special method, please download our Partial Exemption whitepaper.

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