Exempt Supplies and the Effect on Input VAT Recovery

For many charities and not-for-profit organisations, understanding what Value Added Tax (VAT) they’re expected to pay can be confusing. A common misconception is that charities are automatically exempt from VAT. In reality, the VAT system applies to charities just as it does to commercial businesses, but with a unique set of rules, zero-ratings, and exemptions that can create confusion.

One of the key areas to understand is the concept of exempt supplies. Making exempt supplies means a charity does not have to charge VAT on that income, but this has a direct and often costly consequence: the charity generally loses its right to recover the input VAT incurred on the costs associated with making those supplies. This can lead to significant irrecoverable VAT costs, diverting funds away from the charity's core mission.

The VAT People outlines a charity's obligations to pay VAT on donations, services and other incomes and how the de minimis rule applies to a charity's income and activities

Understanding the VAT status of charity activities

Before considering exempt supplies, charities need to identify and categorise all activities and income for VAT purposes. An error at this stage can lead to incorrect VAT accounting, restricted input tax recovery, and potential HMRC penalties. Every activity will fall into one of three VAT categories.

Taxable supplies

These are goods and services on which VAT is chargeable. Taxable supplies are the only category that allows a VAT-registered charity to recover input VAT incurred on related costs. Taxable supplies include:

• Standard-rated (20%): most goods and services, such as consultancy services or the sale of new goods through a charity shop.
• Reduced-rated (5%): supplies that qualify for a lower rate, including certain fuel and power supplied for residential accommodation or charitable non-business use.
• Zero-rated (0%): VAT is charged at 0%, but these supplies remain taxable for VAT purposes. This distinction allows charities to recover input VAT on associated costs. Examples include the sale of donated goods, aids for disabled people, and qualifying advertising services.

Exempt supplies

These are business activities specified in VAT legislation as exempt from VAT. No VAT is charged on the income received. VAT incurred on costs linked to making exempt supplies cannot be reclaimed.

Outside the scope of VAT (non-business activities)

This category covers activities that do not fall within the VAT system because they are not classed as business activities, which we will outline in more detail. Income from these activities carries no VAT liability. As with exempt supplies, VAT incurred on related costs is not recoverable.

Correct classification underpins accurate VAT returns and defensible input tax recovery, particularly where charities carry out a mix of taxable, exempt, and non-business activities.

Defining "business" and "non-business" for VAT purposes

For charities, the starting point when assessing VAT treatment is separating business activities from non-business activities. This distinction matters because VAT applies only to activities that fall within the definition of a business for VAT purposes.

What are business activities?

HMRC defines a business activity as the supply of goods or services for consideration, meaning a payment is received. To qualify as a business activity, there must be a clear and direct link between the payment made and what the charity provides. This creates a legal relationship where one party supplies goods or services and the other pays for them. Both taxable supplies and exempt supplies fall within the scope of business activities.

Common examples of business activities carried out by charities include:

• Selling new goods through a charity shop.
• Charging admission to events or premises.
• Providing training courses in return for a fee.
• Supplying welfare services for a charge.
• Sponsorship arrangements where the sponsor receives identifiable benefits in return for payment.

What are non-business activities?

Non-business activities are those where the charity does not receive a direct payment in exchange for goods or services. Income from these activities sits outside the scope of VAT.

Typical examples of non-business income for charities include:

• Freely given donations: voluntary contributions where the donor receives nothing in return. This covers collection box donations, online donations through platforms such as JustGiving where no benefit is provided, and unsolicited payments.
• Grant funding with no direct benefit: grants provided to support a charity’s general objectives, where the funder does not receive a specific service or benefit in return. Where funding is conditional on the charity providing services to the funder or a third party, the payment is more likely to represent consideration for a taxable supply.

VAT incurred on costs linked to non-business activities cannot be recovered, which often results in irrecoverable VAT for charities with mixed activities. HMRC regularly reviews this area, making accurate identification of non-business activities a key part of managing VAT exposure.

Exempt supplies in the charity sector

Where a charity’s business income arises from an activity listed in VAT legislation as exempt, no VAT is charged on that income. Any input VAT that relates directly to making the exempt supply cannot be recovered, which can have a direct impact on overall VAT costs.

Common VAT-exempt activities undertaken by charities include:

• Welfare services: the provision of care, support, or spiritual welfare for elderly, young, sick, distressed, or disabled people. This can include services delivered by a local authority or a body with similar responsibilities.
• Education and training: the supply of education by an ‘eligible body’, a category that includes many charities, is exempt from VAT.
• Fundraising events: income from qualifying fundraising events may be exempt where specific conditions are met. For example, a charity can hold up to 15 events of the same type at the same location within a financial year before the exemption no longer applies.
• Cultural services: admission charges by a public body or an eligible cultural body, including certain charities, for access to museums, galleries, and theatres can fall within the exemption.
• Letting of land and buildings: rental income from property is usually exempt. Charities may choose to tax a property, which makes the rent standard-rated and allows input VAT on related property costs to be recovered.

Charities should distinguish exempt supplies from zero-rated supplies. In both cases, no VAT is charged to the customer, but zero-rated supplies remain taxable for VAT purposes and allow input VAT recovery, whereas exemption prevents recovery of VAT on associated costs.

The rules of input VAT recovery for charities

For VAT-registered charities, the ability to recover input VAT depends on how the related costs are used. The treatment of input tax can be considered in three stages.

• Input VAT on costs linked to taxable supplies: a VAT-registered charity can reclaim input VAT incurred on purchases that are used directly to make taxable supplies, including standard-rated, reduced-rated, and zero-rated supplies. For example, VAT charged on the purchase of new goods intended for resale through a charity shop is fully recoverable.
• Input VAT on costs linked to exempt and non-business activities: input VAT cannot be reclaimed where costs relate directly to exempt activities or non-business activities. This includes VAT incurred on expenses associated with exempt fundraising events. Similarly, VAT on costs linked to general fundraising that generates voluntary donations is not recoverable.
• Input VAT on overheads and mixed-use costs: many expenses, such as accountancy fees, utilities, and general office costs, support more than one type of activity. Where costs relate to taxable, exempt, and non-business activities, the input VAT must be apportioned. Only the proportion that relates to taxable supplies can be reclaimed. This is where the partial exemption rules apply and calculations are required to determine the recoverable element.

Understanding these distinctions can be complicated, but it is vital, as tax non-compliance is associated with a range of penalties. The team at The VAT People can support charities to meet their obligations efficiently and remain compliant with all of the relevant tax legislation.

Partial exemption and the de minimis rule

A charity that makes both taxable and exempt supplies is treated as partially exempt for VAT purposes. This requires a calculation to establish how much residual input VAT, arising from mixed-use costs and overheads, can be reclaimed.

Under the standard method, input VAT is apportioned by reference to the value of taxable supplies as a proportion of the charity’s total supplies. In practice, this approach can be complex and may not always reflect how costs are used.

There is a simplification known as the de minimis rule. This allows a charity to recover input VAT that would otherwise be blocked by exemption, provided the amount remains within set limits. A charity meets the de minimis test if its exempt input VAT is:

• no more than £625 per month on average; and
• no more than 50% of its total input VAT for the relevant period.

If these limits are exceeded, the exempt input VAT cannot be reclaimed. Regular monitoring of partial exemption calculations can help charities assess their position and manage the impact on cash flow.

VAT on donations, grants, and sponsorship

Charities often receive income that does not resemble a typical commercial transaction, which can make VAT treatment less straightforward. Donations, grants, and sponsorship each require careful analysis to establish whether the income they generate falls within the scope of VAT.

Understanding the differences between voluntary donations and donations where benefits are involved affects VAT liabilities. These differences are set out below:

Donations

• Voluntary donations: where a payment is freely given and the donor receives no benefit in return, it is outside the scope of VAT. No output VAT is due, and the income does not count towards the VAT registration threshold.
• Donations with benefits: if a donor receives a benefit in return for their payment, the amount may be treated as consideration for a taxable supply. This commonly arises in supporter or membership schemes where the value of benefits, such as free entry or publications, exceeds HMRC’s permitted limits. Similarly, a required minimum payment to receive an item is generally treated as payment for a supply.

Grant funding

The VAT treatment of grants depends on the conditions attached to the funding.

• Outside the scope of VAT: where a grant is provided to support a charity’s activities without any obligation to provide goods or services to the funder, it is non-business income and outside the scope of VAT.
• Taxable or exempt supply: if grant funding requires the charity to carry out specific activities for the funder or for a third party, the payment is likely to represent consideration for a supply. The charity must then determine whether that supply is taxable or exempt under VAT legislation.

Sponsorship

Sponsorship income is commonly treated as a taxable supply. Where a sponsor receives benefits such as advertising, publicity, or the right to have their name associated with an event, the charity is supplying services. This income is normally standard-rated, and output VAT must be accounted for. VAT incurred on costs linked to providing those sponsorship benefits is generally recoverable.

Using trading subsidiaries

Many charities use trading subsidiaries as part of their VAT and wider tax planning. A trading subsidiary is a separate commercial entity owned by the parent charity. It can carry out taxable business activities, such as running a café or operating a shop that sells new goods, without affecting the charity’s VAT position on its primary activities.

The use of a trading subsidiary can offer several advantages:

• Protecting the primary purpose assets of the parent charity by separating commercial risk from charitable activities.
• Allowing more efficient VAT management, as the subsidiary can register for VAT and recover input VAT on costs that relate wholly to its taxable supplies.
• Enabling profits generated by the subsidiary to be donated to the parent charity, with those donations treated as outside the scope of VAT.

When structured and operated correctly, trading subsidiaries can provide a clear framework for managing taxable income while supporting the charity’s objectives.