Legal firms are currently facing both increased HMRC scrutiny and evolving opportunities in relation to their VAT affairs. Recent HMRC developments relating to client account interest, defined benefit (DB) pension schemes and increased HMRC scrutiny mean that there is no better time to review existing treatments, governance and controls with regards to VAT accounting.

Client account interest: VAT recovery risk

Law firms often treat interest earned on cash deposits as ‘incidental’, meaning that it does not restrict VAT recovery on associated costs. However, this position is more complex for law firms where interest is generated from client funds.

With interest rates remaining elevated, the potential impact on VAT recovery has become more significant. HMRC is increasingly challenging VAT recovery arrangements adopted by firms and we understand that litigation is now in progress in this area.

Key VAT risks for law firms

• HMRC activity is expected to increase in relation to the VAT impact of interest on client money accounts.
• Existing VAT recovery methodologies may no longer be appropriate.
• There is a heightened risk of historical over-recovery of input VAT.

A proactive review can help firms assess whether VAT recovery adjustments are needed and whether their current partial exemption methodology remains appropriate.

Defined Benefit pension schemes: VAT recovery opportunity

Following a change in HMRC policy, employers may now be able to recover input VAT on investment advisory costs relating to DB pension schemes that were previously treated as irrecoverable. HMRC has released guidance on the go-forward position for VAT recovery on DB pension schemes. The new Public Notice confirms that if the employer is to recover the VAT on administration or investment advisory costs it must have an invoice in its name. This Public Notice also confirms that recharges between the employer and the pension scheme for administration and investment advisory costs can be treated as outside the scope of VAT.

HMRC has invited historical claims for under-recovered VAT and we have already successfully helped businesses to agree claims with HMRC. Claims are subject to the four-year time limit, so timely action is essential to ensure amounts do not fall outside the statutory window.

Preparing for increased HMRC scrutiny and VAT inspections

We are seeing increasing evidence that HMRC appears to be taking a more active approach to VAT compliance in the legal sector.

Recent activity includes:

• ‘Nudge’ letters highlighting risks in areas such as place of supply and overseas establishments.
• Indications that VAT inspections should be expected in the short to medium term if a firm has not been inspected recently.
• A broader compliance drive supported by increased resourcing.
• Upcoming changes such as e-invoicing.

Against this backdrop, firms should take the opportunity to:

• Review VAT recovery methodologies, particularly where interest income is received.
• Check whether a claim may be possible on DB pension scheme costs and whether the go-forward VAT position is in line with HMRC’s latest guidance.
• Assess the robustness of VAT processes and controls.
• Ensure systems and procedures are fit for increased HMRC scrutiny.

Taking early action can help mitigate risk, identify potential recovery opportunities and support continued compliance in a changing regulatory environment.

How we help law firms manage VAT risk and compliance

Our VAT specialists help law firms manage HMRC risk, strengthen VAT controls and identify VAT recovery opportunities. We combine technical expertise with practical insight to support law firms with:

• VAT recovery reviews and remediation.
• Preparation and submission of claims.
• HMRC enquiry support.
• Implementation of robust, scalable VAT processes and controls.

If you would like to discuss any of the issues raised, please contact Simon Atkins or your usual RSM adviser.

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