Here are some practical tips for accounting for VAT partial exemption on Xero.
What is partial exemption?
A basic principle of VAT is that you can only reclaim VAT that relates to “taxable supplies”. A “taxable supply” is a sale or other income line where you charge VAT. If you only sell products where you charge VAT, then you can reclaim all of your VAT as a business. However, if you have sources of income that do not attract VAT – for example residential rent or grants – then you cannot reclaim all of your VAT.
There are essentially three parts of the process. Firstly, recording the VAT correctly, secondly carrying out a partial exemption calculation and finally adjusting the VAT return. This process applies whichever system you use, however this post sets out how it applies to Xero.
1. Recording VAT transactions
On Xero, VAT is captured by use of a Tax Code.
Your version of Xero may come with some default codes set up (or you may have inherited some from whoever implemented the system). For example, in the UK at the moment (March 2022) there are four rates in use – 0%, 5%, 12.5% and 20%.
In order to capture VAT partial exemption on Xero, you will need to set up three (perhaps four*) codes for each of the tax rates you might use. These are:
- Recoverable inputs – this is for expenses that relate to taxable suppliers
- Irrecoverable inputs – this is for expenses that relate to exempt suppliers
- Inattributable inputs – this is for expenses that you cannot allocate to either of those two boxes
- *If you are doing the accounting for a charity you might also want to set a “non-business” inputs code as non-business inputs cannot be recovered.
Once you have set these up, you can record income, expenses and bills with the correct tax code.
The reason I particularly love Xero is because of the “Find and Recode” functionality. This applies to tax codes as well as account codes, tracking codes etc. This is super useful if you have a less experienced person doing the transactional work on Xero, as you can always amend the coding at month or quarter end.
2. Calculating VAT partial exemption
Unfortunately there isn’t a way to do the actual partial exemption calculation on Xero. However, because you have been recording things correctly at source, you can quickly see the totals that are in your various recoverable, irrecoverable and inattributable inputs and pop them into a spreadsheet. You can do this by going into “transactions by tax rate” within the VAT return module. (See picture below). The Export report will also provide this breakdown.
3. Adjusting the VAT return
Once you have calculated the amount of input tax you cannot recover, you need to adjust the VAT return.
This is done via the “Adjust” hyperlink. Be careful about whether your adjustments are positive or negative! (Forget double entry, the sign should reflect what you want to happen to the box 4 balance, so if you want to reduce it you need a minus). You also cannot delete an adjustment. So if you make a mistake you need to add an adjustment to cancel it out.
The “Adjust” dialogue allows you to give a reason and also to determine whether the adjustment creates an accounting entry or not. The box is ticked by default as you usually do need to make an adjustment! One side of the entry will go to the VAT control account (820), the other side will go to the combination you set. (Bizarrely, it gives you the choice of what tax code the adjustment is but this doesn’t seem to matter as the entire amount is then coded as a tax amount.)
As noted in a post a few months back, Xero is a pretty good choice of accounting system for charities. The VAT return mechanism is comparable to other systems, and Find and Recode functionality makes it easier to apply. I have not yet come across any accounting system that does stage 2 – I would love to hear about it if you have.