Charities often carry out a mixture of activities that fall within and outside the scope of VAT, making accurate VAT recovery a recurring challenge.
To ensure compliance, HMRC requires charities to perform an “annual adjustment” to the input VAT reclaims made on quarterly or monthly returns made during the year. This must be calculated each year for both partial exemption and business/non‑business apportionments. This adjustment at the end of the year is essential because provisional recovery percentages used throughout the year are based on estimates that may not reflect the charity’s actual operations.
Partial exemption rules require charities to work out the proportion of VAT incurred that relates to taxable business activities compared with exempt business activities.
Similarly, business and non‑business calculations determine how much VAT on shared costs (such as overheads, facilities and staffing) relates to genuine business use rather than non‑business charitable purposes. Because these allocations rely on assumptions made during the year, the annual adjustment acts as a correction mechanism to ensure the final VAT position reflects the real usage.
While charities are normally familiar with the need for an annual adjustment in respect of partial exemption, the need for an additional year end adjustment in respect of business and non-business is often overlooked.
Charities must complete their annual adjustment following the end of their VAT year, typically on the first VAT return after the VAT year concludes. This is mandatory, and failure to perform it can result in incorrect VAT recovery, HMRC assessments to recover overclaimed VAT and / or unplanned liabilities.
It is also important to remember that while any actual adjustments to VAT due from the annual adjustment are made normally in the first return after the end of the financial year, for the purposes of annual accounts, this adjustment must be accrued at the end of financial year.
We've prepared a couple of examples to show this:
Example 1: partial exemption
A charity estimates that 60% of its overhead VAT relates to taxable business activities and recovers VAT on this basis. At year end, the annual calculation shows the true figure is 50%.
If £20,000 of overhead VAT was incurred, the charity recovered £12,000 during the year (60%) but should have recovered £10,000 (50%).
Annual adjustment required: repay £2,000 to HMRC.
Example 2: business vs non‑business apportionment
A charity uses its premises for both charitable (non‑business) activities and room hire (business activity). During the year, it estimates that 40% of building‑related costs relate to business use. Based on this, it reclaims 40% of the VAT on those shared costs.
At the year end, a usage review shows business activity actually accounted for only 30% of total building use.
If the charity incurred £10,000 of VAT on building costs, it reclaimed £4,000 during the year (40%) but should have reclaimed £3,000 (30%).
Annual adjustment required: repay £1,000 to HMRC.
These annual adjustment calculations can be complex, but are essential, and failure to carry them out would cause issues in the event of any VAT enquiry or review.
CT has a team of VAT specialists with extensive experience of advising charities in this particular area of taxation and if you require further guidance or assistance please do not hesitate to get in touch with Kerry Annand (Head of VAT) via vat@ct.me.