Partial exemption for VAT: a 2026 guide for mixed-supply businesses

If your business makes both taxable and exempt sales, you need to understand partial exemption for VAT – and get it right. Miscalculate your input tax recovery and you could face an expensive HMRC correction, with interest and penalties to match. This guide explains how the partial exemption system works, what the current thresholds are, and how to make sure you’re neither over-claiming nor leaving money on the table.

What is a mixed-supply business?

Most businesses sit neatly in one camp: they make taxable sales and reclaim all the VAT they incur on costs. But some businesses generate income from both taxable supplies (standard-rated or zero-rated) and exempt supplies. Exempt supplies carry no VAT charge and, by default, no entitlement to reclaim associated input tax.

Common examples include:

• Private schools and education providers. Following the removal of the VAT exemption on school fees, many independent schools – previously entirely outside the VAT net — now have to contend with partial exemption for the first time, balancing taxable fee income with exempt welfare services such as school meals, boarding and pastoral care.
• Healthcare and aesthetics clinics. These often charge for VAT-exempt medical treatments alongside standard-rated cosmetic procedures or retail product sales
• Financial services. Brokers earning exempt commission income while charging taxable fees for advisory or consultancy services
• Property and landlords. Partial exemption would apply to landlords with mixed portfolios that combine residential lets (exempt) with commercially let units (standard-rated)

A common trap is confusing exempt supplies with zero-rated ones. Both sound like “no VAT”, but they work very differently. Zero-rated sales (such as most food or children’s clothing) are technically taxable: the rate just happens to be 0%, which means you can still reclaim VAT on your costs in full. Exempt supplies are different: VAT is not just charged at zero, it is outside the VAT system altogether. This is what triggers the partial exemption rules.

The three pots of VAT recovery

When you are partially exempt, HMRC requires you to divide your input tax into three categories.

Pot One: Directly attributable to taxable supplies. VAT on costs used exclusively to make taxable sales – for example, materials used only in your taxable product line. You can reclaim 100% of this.

Pot Two: Directly attributable to exempt supplies. VAT on costs used exclusively to make exempt sales. In principle, you cannot reclaim any of this.

Pot Three: The residual pot. VAT on overhead costs that support the business as a whole – such as rent, IT infrastructure, accountancy fees and utilities. These cannot be directly attributed to either taxable or exempt activity, so a calculation is needed to split them. Under the standard method, the split is based on the proportion of your turnover that is taxable for VAT purposes (meaning standard-rated, reduced-rated, or zero-rated). So if 70% of your income falls into those categories, you reclaim 70% of the residual VAT.

The real financial exposure for most businesses lies in Pots Two and Three. Get the attribution wrong – or fail to keep records that support it – and you risk losing reclaims you were entitled to, or facing HMRC corrections with interest and penalties.

The “de minimis” rules: the safety net

Not every partially exempt business loses the right to reclaim its exempt input tax. HMRC provides a de minimis threshold – literally “too small to matter” – which works as a safety net. In a nutshell, if your exempt input tax falls below a certain level, you can treat it as recoverable in full.

To qualify as de minimis in 2026, your total exempt input tax must satisfy both of the following conditions:

• It must be no more than £625 per month on average (£1,875 per quarter, £7,500 per year)
• It must be no more than 50% of your total input tax for the period.

Both tests must be passed. Fail either one and the full exempt input tax becomes unrecoverable.

An example: the de minimis test in action

Imagine there is a company called Excelsis Cosmetix Ltd, a clinic offering VAT-exempt medical procedures alongside standard-rated cosmetic treatments and retail skincare products. In Q1 2026, Excelsis Cosmetix incurs the following VAT on its costs:

Excelsis Cosmetix’s taxable income in Q1 represents 50% of its total turnover, so under the standard method the residual pot is split 50/50. That gives £500 attributable to exempt activities.

Total exempt input tax = £1,200 (Pot 2) + £500 (Pot 3) = £1,700

The de minimis test:

•       £1,700 against a quarterly limit of £1,875 ?
•       £1,700 against 50% of total input tax (£3,600) ?

Excelsis Cosmetix passes both tests and can reclaim the full £7,200. But if its exempt input tax had been £200 higher – perhaps because a quieter month shifted the income ratio – it would have failed the first test and lost £1,700 of reclaims in a single quarter.

Note: this example uses a straight 50/50 income split for clarity. In practice, the standard method of apportionment uses actual taxable turnover as a proportion of total turnover, calculated each quarter. Many businesses in property, financial services and healthcare operate under a special partial exemption method agreed with HMRC, which may produce a more favourable or more accurate result than the standard method – see below.

Special partial exemption methods

The standard method works well for many businesses, but it is not always the most accurate or equitable basis for apportionment. Where it produces a result that does not fairly reflect the use of costs, businesses can apply to HMRC to use a special method.

Special methods are common in sectors where turnover is not a reliable proxy for use – financial services businesses, for example, often use transaction counts or staff time as the basis for their calculations. Property businesses with complex mixed portfolios may use floor area or rental income splits.

A special method must be agreed with HMRC in writing before it is used. Once in place, it must be applied consistently, but it can be renegotiated if the business changes significantly. If your business is partially exempt and the standard method feels like a poor fit, this is worth raising with a VAT specialist like us.

The annual adjustment: the year-end wash-up

Quarterly partial exemption calculations are provisional. HMRC requires every partially exempt business to carry out an annual adjustment at the end of its partial exemption year (which usually aligns with the VAT year ending 31st March, 30th April, or 31st May, depending on which VAT return period you are on).

The annual adjustment recalculates your input tax recovery using your full year’s figures rather than each quarter’s snapshot. This matters because income patterns shift across the year – a business that looks 60% taxable in Q1 might be only 45% taxable across the full year. This will change both the residual pot apportionment and the outcome of the de minimis test.

The result of the annual adjustment is declared on the VAT return for the period in which the partial exemption year ends, either as additional tax due or as a credit. Businesses that skip the annual adjustment – or apply it incorrectly – can easily find themselves on the wrong side of HMRC compliance checks.

What HMRC looks for

HMRC pays close attention to partial exemption claims in industries known to generate mixed income. Compliance activity in this area tends to focus on:

• Businesses applying a fixed recovery rate year after year without reviewing whether it still reflects the actual use of costs
• Incorrect attribution of costs between the three pots – particularly shared overheads being claimed as fully taxable
• Failure to carry out, or incorrectly performing, the annual adjustment
• Businesses that have crossed the de minimis threshold but are still reclaiming exempt input tax in full

Good record-keeping is essential. You should be able to demonstrate the basis on which you have attributed each material cost to taxable, exempt, or residual use.

Is your partial exemption position under control?

If your business makes any exempt income – however modest – it is worth reviewing your VAT recovery position carefully. The de minimis rules provide a useful buffer, but they have strict limits, and straying over the threshold even briefly can result in a significant retrospective correction.

At THP, our specialist VAT team works with businesses across a wide range of sectors to review their partial exemption calculations, assess whether the standard or a special method is appropriate, and ensure annual adjustments are carried out correctly.

If you would like a health check on your partial exemption for VAT position, please get in touch today or visit our VAT Services page to find out more.

This article is for general guidance only and does not constitute VAT advice. Partial exemption calculations depend on the specific facts of your business. Please speak to a qualified VAT adviser before making changes to your VAT recovery methodology.