Is Client Account Interest Costing Your Law Firm VAT?

Rising Interest Rates, Hidden VAT Costs

As interest rates remain elevated, many law firms are earning more from client account funds. But with higher interest comes a lesser-known risk: reduced VAT recovery.

If your firm receives exempt interest income while also charging VAT on legal services, this shift in income mix can quietly erode your ability to reclaim VAT on overheads.

VAT 101: Why Exempt Income Matters

When a business earns both taxable and exempt income, such as legal fees and interest, it can only fully recover VAT on costs directly tied to taxable work. The rest—known as residual VAT—must be apportioned based on the ratio of taxable to total income.

That means: more exempt income = less VAT you can reclaim.

The Quiet Problem for Legal Firms

Previously, when interest rates were low, the amount of exempt interest income was so small that it didn’t affect VAT recovery. Many firms remained within full VAT recovery thresholds thanks to rounding rules or the de minimis limit.

Now, with significantly higher interest inflows, this is no longer the case. Even modest amounts of exempt income can tip the balance, restricting the percentage of VAT your firm can claim back.

HMRC’s View: No More “Incidental” Label

HMRC generally doesn’t treat interest from client accounts as “incidental.” That means law firms must include it in their partial exemption calculations—regardless of whether it feels like passive income.

Failing to factor this in could lead to under-reported liabilities, future corrections, and costly HMRC penalties.

Practical Steps to Stay VAT-Compliant

1. Review All Interest Income: Include it in your annual VAT calculations.
2. Recalculate Residual VAT: Use the standard partial exemption method to assess how much VAT is at risk.
3. Check De Minimis Limits: If you’ve breached the threshold, VAT recovery will be restricted.
4. Document Everything: Maintain clear records of income streams and recovery rates.
5. Plan Ahead: Consider how to manage future overhead costs if VAT recovery drops.

Don’t Let “Passive” Income Trigger Active VAT Loss

Your firm’s VAT recovery could be quietly slipping due to growing interest on client account funds. With partial exemption rules tightening under the weight of rising rates, it’s critical to review your VAT approach now.

By staying proactive, your firm can stay compliant—and ensure you’re not leaving VAT on the table.