Value Added Tax Chapter 12 PDF

Value Added Tax 129 CHAPTER 12 Value Added Tax 12.1 Introduction 129 12.2 General principles 129 12.3...

Value Added Tax 129 CHAPTER 12 Value Added Tax 12.1 Introduction 129 12.2 General principles 129 12.3 VAT and firms providing legal services 133 LEARNING OUTCOMES After reading this chapter you will be able to: explain in outline the general principles of VAT explain how, in relation to firms providing regulated services, VAT applies to professional charges and disbursements. 12.1 INTRODUCTION This chapter deals with VAT in so far as it affects firms providing legal services. We begin with a brief outline of the way in which VAT works. We then look at the particular issues that arise in relation to firms providing services. Value added tax is relevant both to the firm’s professional charges and to some disbursements paid by the firm on behalf of clients. 12.2 GENERAL PRINCIPLES Value added tax involves two distinct aspects: output tax (charged by a business to its customers) and input tax (charged to the business by its suppliers). A business registered for VAT charges its customers output tax for which it must then account to HMRC. In other words, it acts as an unpaid tax collector. It will normally be possible for such a business to deduct input tax charged to the business from the amount accounted for to HMRC. See 12.2.2. The standard rate of VAT has been 20% since 4 January 2011. There is also a zero rate and a reduced rate which apply to some goods and services. Some goods and services are exempt from VAT. See 12.2.1.3. 12.2.1 Output tax Value added tax is chargeable on the supply of goods or services where the supply is a taxable supply and is made by a taxable person in the course or furtherance of a business carried on by them (Value Added Tax Act (VATA) 1994, s 4(1)). Each element of this definition will be considered further below. The person making the supply is liable to account to the Government for the amount of tax which they charge. 12.2.1.1 Supply of goods This comprises all forms of supply whereby the whole property in goods is transferred, including a gift of goods. 130 Accounts for Solicitors 12.2.1.2 Supply of services This is anything which is not a supply of goods, but is done for a consideration. Note that a gratuitous supply of services is not a supply for VAT purposes, in contrast to a gift of goods. 12.2.1.3 Taxable supply This means any supply of goods or services other than an exempt supply. Exempt supplies are listed in Sch 9 to the VATA 1994 and include supplies of land (except for new commercial sales and leases of commercial property where the supplier has opted to be taxable), insurance, some postal services, finance, health services, and burial and cremation. Taxable supplies may be divided into two main categories: (a) those which are chargeable at the standard rate; and (b) those which are chargeable at a zero rate. Zero-rated supplies are listed in Sch 8 to the VATA 1994 and include supplies of food, water, books, international services and transport. A reduced rate of 5% applies, inter alia, to mobility aids, domestic fuel, installation of energy- saving materials, smoking cessation products such as nicotine patches and gum, renovation and alteration of certain dwellings and residential conversions, children’s car seats and carrycots with restraint straps. Zero-rated and exempt supplies are similar in that no VAT is actually charged in either case by the supplier to their customer. However, they must be carefully distinguished, since only a person who makes taxable supplies is able to recover input tax, ie, the VAT charged to them by their suppliers. A firm supplying legal services will be making a standard-rated supply. Legal services include professional charges and some payments made for clients (see below). A solicitor supplying insurance will be making an exempt supply. 12.2.1.4 Taxable person A person is a taxable person if they are or are required to be registered under the Act. A person must register if, broadly, the value of taxable supplies (not profit) in the preceding 12 months exceeded a figure specified in each year’s Budget (£85,000 for 2023/24 and £90,000 for 2024/25). A firm of solicitors will virtually always have to be registered. Notice that voluntary registration is permitted. A person may register voluntarily in order to recover input tax charged. 12.2.1.5 Business Value added tax is chargeable by a taxable person only on taxable supplies made in the course or furtherance of a business carried on by them. ‘Business’ includes any trade, profession or vocation, but the term is not limited to these activities since it also covers, for example, the provision by certain clubs and associations of facilities to members. Furthermore, although the services of an employee are not generally taxable, the Act provides that, where a person, in the course of carrying on a trade, profession or vocation, accepts any office, any services supplied by them as holder of the office shall be treated as supplied in the course of a business carried on by them and are therefore chargeable with VAT. A firm supplying legal services which is a taxable person must charge VAT not only on its supplies of legal services but also on any other supplies it makes in the course of its business, eg, the sale of redundant office equipment.  Value Added Tax 131 12.2.2 Input tax Where a taxable person is charged VAT on the supply of goods or services for the purposes of their business, they may deduct the tax charged to them from the amount of output tax which they account for to HMRC (s 25(2)). Since input tax charged to a taxable person is recoverable, it follows that VAT is not an expense of a person who makes only taxable supplies, whether at the standard or zero rate. A person who makes only exempt supplies is not a taxable person and so is unable to recover any input tax. Example A, an undertaker, and B, a bookseller, each buy stationery for £200 + £40 VAT. The bookseller supplies zero rated goods and so can recover the VAT; therefore, the expense to be charged to the Profit and Loss Account is only £200. The undertaker supplies exempt services and so cannot recover the VAT; therefore, the expense to be charged to the Profit and Loss Account is £240. Where a taxable person makes both taxable and exempt supplies, they are then partly exempt and may recover only a proportion of the input tax charged to them. A solicitor who supplies insurance may find themselves in this position. Where the exempt supplies made by a taxable person fall within certain de minimis limits, they can be ignored, with the result that all input tax is recoverable. 12.2.3 Value of supply Where a supply is fully taxable, VAT at the standard rate (20%) is payable on the value of the supply. If the consideration is in money, the value of the supply is such amount as, with the addition of the total tax payable, is equal to the consideration (s 19(2)). If a price or fee is agreed, this will be deemed to include VAT unless expressly stated to be tax exclusive. It is important to remember to quote for a fee plus VAT. If VAT is not stated to be extra, the customer will only pay the fee quoted; the business will have to pay the VAT from the quoted fee and will end up with less money than it expected. For example, if a business registered for VAT, and making standard-rated supplies, quotes a fee of £100 and does not stipulate that VAT is extra, the £100 received is deemed to be made up of the fee and VAT at 20%. The total receipt is 120% of the fee so 100/120 will be fee and 20/120 will be VAT. Exercise 12A A firm agrees to provide a legal service for client X for £240. How much will be recorded on the profit costs account and how much as VAT? 12.2.4 Time of supply The importance of the time of supply (or tax point) is that it decides the quarter at the end of which a taxable person becomes liable to account for output tax on a particular supply. It also determines the quarter in which a taxable person can claim input tax on a taxable supply made to them. The basic tax points are as follows: (a) Goods When the goods are removed or made available to the purchaser (s 6(2)). (b) Services When the services are completed (s 6(3)). These basic tax points will be varied in the following cases: 132 Accounts for Solicitors (a) If, within 14 days after the basic tax point, the supplier issues a tax invoice, the date of the invoice will become the tax point unless a longer period has been agreed with HMRC (s 6(5) and (6)). In the case of solicitors, there is a general extension of the 14-day period to three months, so that, provided solicitors deliver their bills within three months of completion of their services, the date of each bill will be the tax point. (b) If, before a basic tax point arises, the supplier issues a tax invoice or receives payment, the supply will, to the extent covered by the invoice or payment, be treated as taking place at the date of the invoice or payment (s 6(4)). 12.2.5 Tax invoices Such invoices are of vital importance to a taxable person since they are evidence of their right to recover the input tax on a supply made to them, ie, without such an invoice, they will generally be unable to claim an input credit, irrespective of whether or not they have made payment to the supplier. A taxable person making a taxable supply to another taxable person must, within 30 days after the time of supply (or within such longer period as HMRC allows), provide them with a tax invoice, which must state the following particulars: (a) an identifying number; (b) the date of the supply, ie, the tax point; (c) the supplier’s name, address and VAT registration number; (d) the name and address of the person to whom the supply is made; (e) the type of supply, eg, sale, loan, hire; (f ) the description of the goods or services supplied; (g) the quantity of goods or the extent of the services and the amount (excluding VAT) payable for each description; (h) the total amount payable (excluding VAT); (i) the rate of cash discount; (j) the rate and amount of tax charged. 12.2.6 Collection and accounts Accounting for VAT will generally be by reference to quarterly accounting periods. Within one month after the end of each quarter, a taxable person must submit a completed return form to HMRC, together with a remittance for the tax due. The amount payable, ie total output tax charged less deductible input tax, is obtained from a statutory VAT account, which is required to be kept by every taxable person for each tax period. Apart from these details of the tax due, the return form must also contain a list of the tax exclusive value of all outputs, and also the total of all inputs exclusive of tax. Example (a) During an accounting period, a firm providing legal services sends bills charging total professional charges of £200,000 plus output tax of £40,000. In the same period, the firm buys office equipment for £40,000 plus input tax of £8,000. The firm accounts to HMRC as follows: £) Output tax charged 40,000) less input tax suffered (8,000) Payable to HMRC 32,000) The firm has to account for the £32,000 due irrespective of whether or not the customers have yet paid the firm the cash. This can sometimes cause a cashflow problem.  Value Added Tax 133 (b) During an accounting period, a retailer sells food for £50,000 plus output VAT at the zero rate. In the same period, the retailer buys equipment for £10,000 plus input tax of £2,000. The retailer accounts to HMRC as follows: £) Output tax charged 0) less input tax suffered (2,000) Recoverable from HMRC 2,000) Note: In both these examples, the supplier can recover the input tax paid because the supplier is making taxable supplies, even though, in the case of the retailer, they are at the zero rate. (c) A funeral director sends bills for burial and cremation totalling £150,000. No VAT is charged as these are exempt supplies. During the same period, the funeral director buys equipment for £15,000 plus input tax of £3,000. The funeral director is not a taxable person and so does not account to HMRC. Therefore, the funeral director cannot recover the input tax paid. The cost of the equipment to the business is £18,000. 12.3 VAT AND FIRMS PROVIDING LEGAL SERVICES 12.3.1 Professional charges Firms providing legal services must charge VAT on their supply of services. Example Bill £ Professional charges 200.00 VAT @ 20% 40.00 Total 240.00 Entries: The firm will need a ledger account in the name of HMRC as well as a profit costs account and a ledger account in the name of the client. CR Profit costs account with professional charges CR HMRC with VAT DR Client ledger account (business section) with professional charges and VAT as two separate figures Client: Matter: Date Details Business account Client account DR CR BAL DR CR BAL Profit costs 200 200DR VAT 40 240DR Profit costs account Date Details Business account DR CR BAL Client 200 xxx 134 Accounts for Solicitors HMRC account Date Details Business account DR CR BAL Client 40 xxx 12.3.2 What are disbursements for VAT purposes? As a matter of convenience for the client, firms providing legal services frequently pay expenses (eg, court fees) on behalf of the client. Such expenses are often referred to as ‘disbursements’. HMRC does not regard ‘disbursements’ as part of the supply of legal services and so the firm does not have to charge VAT on them. However, to qualify as a disbursement for this purpose, an item must fulfil certain conditions. Not all items paid on behalf of a client are regarded by HMRC as disbursements. 12.3.2.1 HMRC’s view of disbursements HMRC’s view of what constitutes a disbursement is set out in para 25.1.1 of HMRC VAT Notice 700 (see also HMRC’s VAT Taxable Person Manual at VTAXPER39000). The crucial point is that if costs are incurred by suppliers in the course of making their own supply to their clients, then they must be included in the value of those supplies when VAT is calculated. If the payment to third parties is made purely as the agent of the client then it is a disbursement for VAT purposes, and is not included in the amount on which VAT is charged. To be a disbursement, the Notice says that all the following conditions must be met: you acted as the agent of your client when you paid the third party; your client actually received and used the goods or services provided by the third party (this condition usually prevents the agent’s own travelling and subsistence expenses, telephone bills, postage, and other costs being treated as disbursements for VAT purposes); your client was responsible for paying the third party (examples include estate duty and stamp duty payable by your client on a contract to be made by the client); your client authorised you to make the payment on their behalf; your client knew that the goods or services you paid for would be provided by a third party; your outlay will be separately itemised when you invoice your client; you recover only the exact amount which you paid to the third party; and the goods or services, which you paid for, are clearly additional to the supplies which you make to your client on your own account. HMRC’s view is that all the conditions set out above must be satisfied before a payment can be treated as a disbursement for VAT purposes. The House of Lords decision in Nell Gwynn House Maintenance Fund Trustees v C&E Commissioners STC 79 confirmed that VAT law draws a clear distinction in principle between: (i) expenses paid to a third party that have been incurred by you in the course of making your own supply of services to your client and which are part of the whole of the services rendered by you to your client; and (ii) expenses for specific services that have been supplied by the third party to your client and you have merely acted as your client’s known and authorised representative in paying the third party. Only in case (ii) can the amounts of the payments to the third party qualify for treatment as disbursements for VAT purposes. Examples of disbursements are items where the client is responsible for paying the third party, such as: inheritance tax; capital gains tax;  Value Added Tax 135 stamp duty and stamp duty land tax; estate agents’ fees. Counsel’s fees are disbursements as the service is supplied to the client (even though the solicitor is responsible for ensuring payment). The Law Society’s Practice Note, ‘VAT treatment of disbursements and expenses’, says that Land Registry fees for registration of title are disbursements (the position of searches and official copies is different – see 12.3.2.2 below). HMRC’s VAT Manual says at VTAXPER46000 that the following can be treated as disbursements: statutory charges such as court fees, estate duty, incorporation fees, land charge and land registry fees, probate fees, stamp duty; charges for the professional services of a third party. For example, the sale of a property is usually organised by a solicitor, who will present a bill to the vendor for both the solicitor’s own services and the commission payable to the estate agent. The supply of the estate agent’s services is to the vendor, not the solicitor, and so the solicitor may treat this as a disbursement for VAT purposes. The fees of notaries, surveyors, or witnesses, and charges for police and medical reports may also fall into this category. The paragraph says that telegraphic transfer fees or CHAPS which represent a charge by the bank to the solicitor for the service of transferring money out of the solicitor’s bank account cannot be treated as a disbursement and nor can general expenses borne by the solicitor including travel, accommodation and telephone charges. There is judicial authority for both of these propositions. In the tribunal case of Shuttleworth & Co v Commissioners of Customs and Excise (LON/94/986A), it was held that the transfer of funds by a solicitor was part of the overall conveyancing service provided by a solicitor to their client. Therefore, a CHAPS fee paid by a solicitor to the bank could not, for VAT purposes, be treated as a disbursement in the solicitor’s invoice to their client. In Rowe and Maw STC 340, the High Court ruled that travelling costs incurred by a solicitor in the course of their duties for their client and recovered from the client at cost could not be treated as a disbursement. The supply of travel was to the solicitor and therefore formed part of their onward supply of legal services to the client. 12.3.2.2 So what items are not disbursements? Items which do not qualify as disbursements are those which are a necessary part of the service supplied to the client, for example, telephone charges, postage and photocopying charges; these are overheads of the business, and HMRC requires the firm to charge VAT on them. The SRA considers that it is not normally appropriate to make a separate charge for such items, although there may be exceptional cases where it is permissible, eg when unusual amounts of photocopying are involved. Firms normally increase their professional charges to cover these items. Travelling expenses incurred by a solicitor are not disbursements and must be included as part of the overall charge. This view was upheld in the case of Rowe & Maw (A Firm) v Customs and Excise Commissioners 1 WLR 1291. The court held that the cost of fares incurred by a solicitor was incurred for the solicitor, not for the client. Any expenses incurred by a firm in order for it to complete its supply of professional services will not be a disbursement. Until 1 December 2020 there was some uncertainty as to whether or not search fees could be treated as disbursements. This was because of a concession agreed informally between HMRC and the legal profession in 1991 which allowed solicitors and conveyancers to treat fees for property searches conducted by post as disbursements, even though not meeting all the disbursement conditions set out in section 25.1.1 of HMRC’s VAT Notice 700. Increasingly such searches came to be carried out electronically by specialist online search agencies 136 Accounts for Solicitors engaged by solicitors. In Brabners LLP v HMRC UKFTT 0666 (TC) it was held that an electronic search fee could not be treated as a disbursement as it did not fulfil the criteria. The result produced inconsistency so HMRC withdrew the concession for postal searches as from 1 December 2020. See Revenue and Customs Brief 6 (2020): ‘VAT treatment of property search fees charged by solicitors and conveyancers’. HMRC’s view, as set out in full in its internal manual ‘VAT Taxable Person Manual’ (VTAXPER47000), is that whether a fee for a search is to be treated as a disbursement will depend on how the information obtained in the search is used. If it is passed on to the client without comment or analysis, the fee may be treated as a disbursement – it would be relatively unusual for this to be the case. More commonly, the firm will use the information to provide advice or a report, and here the fee for the search will form part of the charges for its services and will be subject to VAT. HMRC said in Revenue and Customs Brief 6 (2020) that revised guidance on VAT disbursements would be published ‘to ensure consistency and provide clarity’. Further guidance is required as there is a lack of clarity in the case law as to what can and cannot be regarded as a disbursement. The decision in Barratt, Goff and Tomlinson (a firm) v HMRC (Law Society Intervening) UKFTT 71 (TC) differs from the Brabners decision. In Barratt the tribunal allowed fees paid by solicitors for medical records and reports obtained in connection with personal injury claims to be treated as disbursements. The justification for the difference between the two decisions appears to be that solicitors can only obtain access to patient records with the client’s consent. The records are otherwise confidential and are not matters of public record. The client is the subject matter of the records and (at least for certain purposes) could be regarded as the ‘owner’ of the records and reports. In these circumstances, the solicitor is, arguably, merely an intermediary used to facilitate the obtaining of the service. There is, therefore, an arguable difference from the position in relation to property searches where anyone can commission searches. The Court of Appeal recently indicated that it thought there was a strong case for a position that disbursement treatment should not be available where a solicitor acts as ‘more than a postbox’. That was in the context of a case about medical reports and records obtained by a solicitor for use in a client’s personal injury claim (British Airways plc v Prosser EWCA Civ 547). Newey LJ said at that in a typical case in which a solicitor commissions a reporting agency to obtain a medical report or records, the report/records will be ‘supplied to the solicitor... to enable him effectively to perform the service supplied to his client’ (in the words of Bridge J in the Rowe & Maw case). In the Barratt case, there was no commissioning from a reporting agency. Barratt obtained medical reports and records itself. Newey J said at : That distinction could potentially affect the contractual analysis: it is easier to conceive of a solicitor who obtains reports and records direct acting merely as his client’s agent, although there is plainly scope for argument to the contrary. I can see a strong case for saying that, whatever the true contractual position, as a matter of economic and commercial reality a solicitor who is more than a postbox does not incur the cost of the reports/records ‘in the name of and on behalf of ’ his client. The point was not, however, squarely before us and I prefer not to express a final view on it. The same item may amount to a disbursement in one situation and not in another. For example, a solicitor dealing with the administration of an estate might pay a valuer’s fee on a particular asset. This would be a disbursement if the personal representative, who was also a beneficiary and entitled to the asset to be valued, had requested the valuation to assist in the decision as to whether or not to sell the asset but would not be if the solicitor had requested it in order to calculate the inheritance tax payable on the estate.  Value Added Tax 137 The Law Society Practice Note, ‘VAT treatment of disbursements and expenses’, says that fees for Official Copy entries obtained on the sale of a property are unlikely to fulfil the criteria for a disbursement. The official copies are likely to have been used to provide advice, meaning that the supply of information is a supply to the firm and therefore that the cost must be treated as part of the firm’s overall legal services. 12.3.3 The treatment of ‘non-disbursements’ in the firm’s accounts ‘Non-disbursements’ are payments made to third parties by the firm which do not come within the narrow definition of disbursements. HMRC sometimes refers to them in its guidance as ‘recharges’. Firms have to treat these items as part of their taxable supply. It is important that firms do not mis-classify these items as disbursements. If they fail to charge VAT on these items, they are understating their VAT outputs. They will become liable for the underpayment of VAT with interest and penalties. Firms do not usually make a separate charge for items such as postage, fares and telephone calls which are really just overheads of the business. They simply make sure that the amount they charge for professional fees is sufficient to cover the overheads. Search fees could be dealt with similarly by recording the payment using a searches account: Entries: CR Cash – Business section with the amount paid If the search fee bears VAT (as most do), the VAT exclusive amount and the VAT will be entered as separate items. DR Searches account Plus, if the search is taxable: DR HMRC account with the VAT charged to the firm However, firms will normally want a record of searches incurred for each client so that they are shown separately from professional charges on the bill. It will therefore be necessary to enter them on the client ledger account so that they will not be overlooked when a bill is sent. The easiest course is to debit them to the client ledger when they are paid and include a note in the details column that they are part of the firm’s taxable supply. Entries: CR Cash – Business section If the search fee bears VAT (as most do), the VAT exclusive amount and the VAT will be entered as separate items. DR Client ledger – Business section with the VAT exclusive amount and make a note in the details column that the payment is part of the firm’s taxable supply Plus, if the search is taxable: DR HMRC account with the VAT input tax charged to the firm When the bill is issued, VAT output tax will be charged on the professional charges and the search. 138 Accounts for Solicitors Example You act for Bartok who is buying a house. May 1 You pay a mining search fee of £10 + VAT of £2. This is not a disbursement for VAT purposes, although you will want to show it separately on your bill. 2 You pay a local land charge search fee of £10 which again is not a disbursement for VAT but will be shown separately on the bill. 30 You issue a bill. Your professional charges are £300 + VAT of £60 but you will increase your VAT by £4. Your bill will show the two search fees separately from your professional charges. Client: Bartok Matter: Purchase Date Details Business account Client account May DR CR BAL DR CR BAL 1 Mining search (VAT £2 paid) 10 10DR 2 Local land charge search (VAT £2 paid) 10 20DR 30 Profit costs 300 320DR VAT on £320 64 384DR HMRC Date Details Business account DR CR BAL May 1 Cash. Bartok. Mining search 2 2 Cash. Bartok. Local land charge 2 search 30 Profit costs 64 The Bill will appear as follows Professional charges £300 Taxable search fees: Mining search £10 Local land charges search £10 £320 VAT @ 20% £64 Where items paid for by solicitors do not fulfil the criteria for disbursements and are included in the supply of legal services, the result is that the client pays VAT on the combined figure. This only has a financial impact on the client if the supplier of the search did not charge VAT. Including the cost in the solicitor’s supply of services means that the client pays additional VAT. Of course, if the client is registered for VAT, the VAT paid is input tax and will reduce the amount of output tax they pay. Where the original supplier charged VAT, the solicitor will treat that VAT as input tax. The VAT exclusive amount will be added to the supply and the solicitor will charge output tax. There is no effect on the amount paid by the client. However, where the client is not registered for VAT, they cannot recover the tax paid. 12.3.4 The treatment of disbursements in the firm’s accounts The firm simply passes on the cost to the client. The payment may be for an item which is non-taxable or which includes its own VAT element.  Value Added Tax 139 12.3.4.1 Non-taxable disbursements These are payments for something not subject to VAT, such as exempt supplies and supplies not in the course of business, for example court fees, stamp duty land tax, Land Registry fees, etc. The firm can pay these out of the client bank account if there is sufficient money in the client bank account. Otherwise, they are paid out of the business bank account. In neither case does the firm pay VAT to the supplier or charge the client VAT when obtaining reimbursement. 12.3.4.2 Disbursements including a VAT element These are payments made by the firm to a taxable person in respect of taxable supplies (eg, counsel, surveyor, accountant, estate agent, etc). The payment made by the firm will include a VAT element. That VAT element is passed on to the client. The firm does not charge the client any additional VAT. The difficulty with passing on VAT is that clients who are registered for VAT will want to recover it from HMRC and can do so only if they have a VAT invoice addressed to them. When a firm pays a disbursement that includes VAT on behalf of a client, the supplier may have addressed the invoice to the client or to the firm making the payment. If the invoice is addressed to the client, life is simple. The ‘agency’ method is used and the VAT inclusive amount is simply passed on to the client. It is rather more complicated if the invoice is addressed to the firm. The ‘principal’ method must be used which requires the solicitor to resupply the service to the client and provide a new VAT invoice. (1) Agency method If the invoice is addressed to the client, the supply is treated as made to the client. The firm simply acts as the agent, handing over the money on behalf of the client. If there is sufficient client money standing to the credit of the client, the payment can be made from the client bank account; otherwise, it must be made from the business bank account. The firm does not separate the supplier’s fee and VAT in the firm’s accounting records; it simply records the total paid. The firm must, if asked, send the supplier’s tax invoice to the client. If the client is registered for VAT and the supply is in the course or furtherance of a business, the client will use the invoice to recover the input tax. Example You pay a surveyor’s bill on behalf of a client, ABC Co Ltd. The bill is for £1,000 plus £200 VAT. The invoice is addressed to the client and is paid using the agency method. You simply pay the total sum of £1,200 and do not distinguish between the fee and the VAT. Whether the payment is made out of business money or client money, you will charge the client £1,200, again without distinguishing between fee and VAT. Assume that you are holding £2,000 on account of costs and so are able to make the payment from the client bank account. The entries will be as follows: 140 Accounts for Solicitors Client: ABC Co Ltd Matter: Contract Dispute Date Details Business account Client account DR CR BAL DR CR BAL 2,000 CR Cash – surveyor 1,200 800 CR Cash account Date Details Business account Client account DR CR BAL DR CR BAL xxx ABC Co Ltd – surveyor 1,200 xxx No entries are made on the firm’s HMRC ledger account in relation to the payment. If the client is registered for VAT, and therefore wants the invoice, you must send the client the surveyor’s original invoice. The invoice is addressed to the client, and so the client can claim an input. (2) Principal method If the invoice is addressed to the firm, the supply is treated as made to the firm in the first instance. The firm can claim the supply as an input. The firm, therefore, must use business money to pay the supplier’s fees, together with the input tax. The firm then resupplies the item to the client at the same price. The firm will charge the client output tax on both the firm’s professional charges and the disbursement. If the client is entitled to a tax invoice, the firm will provide one invoice to cover both the disbursement and the firm’s own professional charges. Example You receive a surveyor’s invoice for £200 plus £40 VAT. You pay: £ Surveyor’s fee 200 plus input tax 40 240 You record the fee and the VAT as separate items on the cash account. The VAT is recorded on the HMRC account. The tax exclusive amount is recorded on the client ledger account. When you later charge the client your own professional charges of £400, the bill will include: £ Surveyor’s fee 200 Professional charges 400 plus output tax (£40 + £80) 120 The surveyor’s fee and the VAT are separate items on the bill. Note: A disbursement paid on the principal method must be paid out of the business bank account, even if there is client money available. This is because the supply is treated as made to the firm and not to the client.  Value Added Tax 141 So, if we take the same example that we used at (1) above for the agency method, the firm will have to pay the disbursement from the business bank account even though client money is held for the client. The entries will be as follows: Client: ABC Co Ltd Matter: Contract Dispute Date Details Business account Client account DR CR BAL DR CR BAL 2,000 CR Cash – surveyor (VAT £200 paid) 1,000 1,000 DR HMRC account Date Details Business account DR CR BAL Cash – surveyor 200 xxx Cash account Date Details Business account Client account DR CR BAL DR CR BAL ABC Co Ltd – surveyor 1,000 xxx xxx – VAT 200 xxx xxx When you charge the client for the work done, the VAT on the profit costs is increased by the VAT on the disbursement. Assume you charge profit costs of £600. Client: ABC Co Ltd Matter: Contract Dispute Date Details Business account Client account DR CR BAL DR CR BAL 2,000 CR Cash – surveyor (VAT £200 paid) 1,000 1,000 DR Profit costs 600 1,600 DR VAT (£200 + £120) 320 1,920 DR HMRC account Date Details Business account DR CR BAL Cash – surveyor 200 xxx Client 320 xxx Profit costs Date Details Business account DR CR BAL Client 600 XXX 142 Accounts for Solicitors HELP ON PRINCIPAL METHOD Students generally find principal method disbursements difficult to deal with. The following summary may be helpful: (1) Identify that the disbursement is to be treated on the principal basis – if the invoice is addressed to the firm, it will be treated on the principal basis. (2) CR the disbursement and the VAT on it to cash account business section – it is common, but not essential, to show the two elements separately. (3) DR VAT to HMRC ledger. DR VAT exclusive amount to client ledger business section. Make a memorandum note in the ‘Details’ column of the client ledger of the amount of VAT which must be added to the VAT charged to the client when an invoice is issued. (4) When a bill is issued, add the VAT on the principal method disbursement to the VAT on the professional charges and make the normal entries for delivery of a bill. DR client ledger business section, with VAT and costs as two separate amounts. CR the profit costs account with costs. CR HMRC account with total VAT charged. 12.3.4.3 Counsel’s fees – concessionary treatment Normally, counsel’s fee notes are addressed to the firm and therefore would have to be treated on the principal basis. However, a concessionary treatment for counsel’s fees was agreed between HMRC, The Law Society and the Bar when VAT was first introduced, and was published in the Law Society Gazette, 4 April 1973. The concession is not set out in any HMRC manual or VAT notice. The firm is allowed to alter the fee note so that it is addressed to the client. It is then treated on the agency basis. The firm must give the fee note to the client so that the client can reclaim the input tax. The firm should keep a photocopy of the amended receipted fee note in case the fee note needs to be dealt with in an assessment of costs. On 31 August 2021, the Law Society announced that HMRC had recently confirmed that the concession still stands but that it is reviewing the concession to consider whether it should be withdrawn. See ‘Confirmation and review of VAT concessionary treatment for counsel’s fees – share your experiences’. Exercise 12B You act for Barton in connection with a tax dispute. The following events occur: July 8 You receive £1,000 from Barton on account of costs to be incurred. 10 You pay a court fee of £100 out of client money. 22 You pay an accountant’s fee of £400 plus £80 VAT. The invoice was addressed to you. The payment is a disbursement 29 You pay counsel’s fee of £600 plus £120 VAT. The invoice was addressed to you but you add Barton’s name. August 7 You send Barton a bill and VAT invoice. Your profit costs are £800 plus appropriate VAT. 9 You transfer the £180 remaining in the client bank account to the business bank account in part payment of your costs. 11 You receive from Barton a cheque for the balance of the costs outstanding. Prepare the cash account and client ledger account for Barton, together with the relevant entries on the ledger account for HMRC.  Value Added Tax 143 Exercise 12C You act for Avis in a boundary dispute. The following events occur: November 5 You pay a court fee of £100 on Avis’s behalf. 7 You receive a cheque from Avis for £1,200 in payment of the £100 court fee and an additional £1,100 generally on account of costs. You do not split the cheque. 9 You pay counsel’s fee of £400 plus VAT on behalf of Avis. The invoice was addressed to you, but you add the name and address of Avis. 11 You pay a surveyor’s fee of £200 plus VAT. The invoice was addressed to you. The payment is a disbursement. 13 You send Avis a bill. Your profit costs are £600 plus VAT. 15 You transfer the £620 remaining in the client bank account in part payment of your bill. You receive a cheque from Avis for the balance of £340. Comment on the application of the SRA Accounts Rules 2019, and explain what steps you will take to deal with the VAT elements involved in this transaction. Prepare the cash account and client ledger account for Avis, together with the relevant entries on the ledger account for HMRC. SUMMARY (1) Persons who are registered for VAT must charge their customers/clients VAT at zero, standard or reduced rate on all taxable supplies of goods and services made in the course or furtherance of the business, and can recover any VAT charged to the business. A solicitor’s taxable supply will be increased by payments made to third parties which do not qualify as disbursements. (2) Persons who make only exempt supplies do not charge VAT to their customers/ clients, but neither can they recover VAT charged to the business. (3) Firms must charge VAT on their supply of legal services but do not charge VAT on disbursements paid on behalf of their clients as these are not part of the supply of legal services. However, to qualify as a disbursement, the supply must be for the client’s use and not for the solicitor. If the payment is for an item required by the solicitor to provide legal services, the item is not a disbursement. It is part of the solicitor’s fee for providing the service. The solicitor must charge VAT on the item. (4) The cost of a disbursement is simply passed on to the client. (5) If the disbursement includes an element of VAT charged by the original supplier, the firm will treat the disbursement either on the agency basis or on the principal basis. The choice of basis is governed by to whom the invoice is addressed. (6) If the invoice is addressed to the client, the firm treats the disbursement on the agency basis: (a) the whole payment is recorded on the cash account and client ledger without distinguishing the VAT; (b) the firm can use client money to make the payment if there is sufficient available: if not, the firm uses its own money; (c) the firm must give the client the original supplier’s invoice if the client is registered for VAT. (7) If the invoice is addressed to the firm, the firm treats the disbursement on the principal basis: 144 Accounts for Solicitors (a) the whole payment is recorded on the cash account, the VAT is recorded on the HMRC account and the VAT exclusive amount is recorded on the client’s ledger account; (b) the VAT will be charged to the client when the firm bills the client; (c) the firm must use its own money to pay the disbursement even if client money is available; (d) the firm must give the client a VAT invoice covering both the professional charges of the firm and the VAT on the disbursement; (e) in the case of counsel’s fee note, the firm is allowed to cross out the firm’s name and add the client’s; the invoice can then be dealt with on the agency basis.  Value Added Tax 145 SOLUTIONS Exercise 12A The fee is inclusive of VAT. If the professional charges are regarded as 100%, the solicitor may be said to have received 100% plus 20% (profit costs plus VAT). To calculate the amount to be treated as professional charges, it is therefore necessary to divide by 120 to give 1% of the receipt and to multiply by 100 to give 100% of the receipt. 100 Receipt × --------- 120 100 £240 × --------- = £200 120 VAT = £40 Exercise 12B Notes July 8 The money is client money. It should paid into the client bank account promptly pursuant to Rule 2.3. 10 Rule 5.1 permits the payment out of the client bank account. The court fees are exempt from VAT. 22 The invoice was addressed to you, so the disbursement must be paid using the principal method out of the firm’s own money. Remember that you are responsible for paying the input tax. At this stage, you only debit the fee, not the VAT, to the client. The cash account records the fee and the total paid, ie the VAT. You debit the VAT to the HMRC ledger account. [Note: You will see a note in the details column of Barton’s ledger account that the solicitor has paid input tax. This is a reminder to charge the client output tax later.] 29 Adding the client’s name to the invoice, as permitted under the concession, means you can treat the payment on the agency basis. There is sufficient money in the client bank account, and it is sensible to make the payment out of client’s money as permitted by Rule 5.1. August 7 You debit Barton’s ledger account, business section, with your professional charges and VAT. You must consider carefully how much output tax to charge. You must charge output tax at the standard rate on the value of the legal services, ie: (1) the value of the professional charges of £800; plus (2) the value of any general disbursements – there are none in this case; plus (3) the value of any taxable disbursements paid on the principal method – in this case the accountant’s fee of £400. Therefore, you must charge VAT on £800 professional charges plus £400 accountant’s fee, which makes a total of £1,200. VAT @ 20% is £240. The double entries for professional charges and VAT will be in the profit costs ledger account (not shown) and HMRC ledger account respectively. [Note: There is no entry in the cash account at this point as no movement of money is involved.] 146 Accounts for Solicitors August 9 Rule 4.3 permits the withdrawal from the client bank account for payment of costs because a bill or other written notification of costs has been issued. 11 This money is received from Barton specifically in payment of the outstanding professional charges and expenses. The money should be paid straight into the firm’s business bank account. The accounts will look like this: Client: Barton Matter: Tax dispute Date Details Business account Client account DR CR BAL DR CR BAL Jul 8 Cash. On account 1,000 1,000CR 10 Cash. Court fee 100 1,900CR 22 Cash. Accountant’s fee [VAT £80 paid] 400 1,400DR 29 Cash. Counsel’s fee 720 1,180CR Aug 7 Profit costs 800 1,200DR VAT (£80 + £160) 240 1,440DR 9 Cash. Transfer from client to business 1,180 1,260DR 180 – 11 Cash. From Barton. Balance due 1,260 – Cash account Date Details Business account Client account DR CR BAL DR CR BAL Jul Balance xxx xxx 8 Barton 1,000 10 Barton 100 22 Barton 400 VAT 80 29 Barton 720 Aug 9 Barton 1,180 180 11 Barton 1,260 HMRC account Date Details Business account DR CR BAL Jul 22 Cash. Re Barton 80 80DR Aug 7 Barton 240 160CR The CR balance shown on HMRC ledger account represents the amount of VAT owed to HMRC. Exercise 12C (1) 5 November You are not holding any money for Avis. Therefore, Rule 5.3 applies and the money cannot be paid out of the client account. The payment is made out of the business account. Entries: DR Avis ledger account CR Cash account } Business section  Value Added Tax 147 7 November The receipt is a mixture of business and client money. Rule 4.2 requires you to allocate promptly any funds from mixed payments to the correct bank account. If the funds are paid into the client bank account initially, then £100 must be transferred to the business bank account promptly. Entries: CR Avis ledger account £1,200 DR Cash account £1,200 } Client section DR Avis ledger account £100 CR Cash account £100 } Client section CR Avis ledger account £100 DR Cash £100 } Business section 9 November The payment is now treated as addressed to Avis. You pay an inclusive sum of £480 with no separate record of VAT. There is sufficient money in the client bank account, so make the payment out of the client bank account – Rule 5.1. Entries: DR Avis ledger account CR Cash account } Client section 11 November This invoice was addressed to you, so you must pay it using the principal method. You record the fee and VAT separately. You DR the fee to Avis and the VAT to HMRC. Even though there is enough money in the client bank account, you must make a payment on the principal method out of the business bank account. Entries: Fee DR Avis ledger account CR Cash account } Business section VAT DR HMRC ledger account CR Cash account } Business section 13 November You make entries for professional charges and VAT separately. The DR entry in the client’s ledger account is in the business section. You calculate VAT on the total of profit costs, general disbursements (none in this case) and taxable disbursements paid on the principal method. The surveyor’s fee was paid on the principal method. VAT is therefore charged on £600 profit costs plus £200 surveyor’s fee, making a total of £800. VAT will be £160. 148 Accounts for Solicitors Entries: Professional charges DR Avis ledger account CR Profit costs } Business section account VAT DR Avis ledger account CR HMRC account } Business section 15 November You have £620 remaining in the client bank account. Avis owes you £960. You will transfer the £620 and receive a cheque for £340 from Avis. Rule 4.3 allows you to withdraw money from the client bank account to pay your professional charges provided you have given the client a bill or other written notification of costs. You cannot withdraw more than you are holding for the client (Rule 5.3) so are limited to a transfer of £620. When the client sends the balance of £340, this is a receipt of business money. You must keep client and business money separate (Rule 4.1), so you should pay the money into your business account. Entries: For transfer Withdrawal from client account DR Avis ledger account CR Cash account } Client section Receipt into business account CR Avis ledger account DR Cash account } Business section For receipt of money from Avis into business account CR Avis ledger account DR Cash account } Business section Client: Avis Matter: Boundary dispute Date Details Business account Client account DR CR BAL DR CR BAL Nov 5 Cash. Court fee 100 1,100DR 7 Cash. From Avis. On account of costs 1,200 1,200CR 7 Cash. Repayment court fee 100 – 100 1,100CR 9 Cash. Counsel’s fee 480 1,620CR 11 Cash. Surveyor’s fee [VAT £40 paid] 200 200DR 13 Profit costs 600 800DR VAT (£120 + £40) 160 960DR 15 Cash. Transfer from client to business account 620 340DR 620 – Cash. From Avis. Balance due 340 –  Value Added Tax 149 Cash account Date Details Business account Client account DR CR BAL DR CR BAL Nov Balance xxx xxx 5 Avis 100 7 Avis 1,200 7 Avis 100 100 9 Avis 480 11 Avis 200 C&E 40 15 Avis 620 620 Avis 340 HMRC account Date Details Business account DR CR BAL Nov 11 Cash. Re Avis 40 40DR 13 Avis. VAT 160 120CR 150 Accounts for Solicitors