Rising client interest income prompts potential tribunal challenge to HMRC
A group of law firms is considering a tribunal challenge against HMRC as tensions escalate over a complex dispute involving input VAT recovery linked to rising client interest income. The issue has emerged as interest rates have increased since 2022, resulting in firms receiving significant sums of interest on client funds held in their accounts.
Law firms normally recover the full amount of input VAT, which is the tax paid on goods and services used for business purposes. However, income from client interest is not subject to VAT. Depending on the total interest received, this can restrict a firm’s ability to recover input tax, creating substantial financial implications for some practices.
Before 2008, when law firms last recorded large amounts of client interest, HMRC frequently granted partial exemptions. These exemptions allowed firms to mitigate the impact of restricted VAT recovery by recognising the non business element represented by interest income. This time, however, HMRC has rejected all applications for partial exemptions submitted by law firms, creating frustration across the sector.
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Andrew Allen, partner and head of the legal sector at the accountancy firm PKF Francis Clark, said in an article published today that the potential cost to firms is significant. He noted that, at the 2025 financial year end, the latent liability associated with restricted input VAT commonly ranged between £50,000 and £750,000. For many practices, he said, the sums at risk are material and could affect their financial position.
Allen confirmed that his firm is in contact with a number of law firms that have reached an impasse with HMRC. He said that if discussions with the tax authority continue to stall, the next step may be a tribunal hearing to resolve the issue. He added that efforts are underway to coordinate a collective response on behalf of the legal sector, depending on the level of interest from affected firms.
The dispute comes at a time when law firms are already facing increased scrutiny over their handling of client money. Rising interest rates have produced unexpected income streams for many firms, but the tax consequences of these changes have become a source of concern. Current HMRC policy means that firms receiving substantial volumes of client interest may find themselves unable to recover input VAT fully, despite the majority of their work relating to taxable business activities.
With no partial exemptions available, firms must evaluate the potential financial impact and consider whether a coordinated tribunal challenge offers the best route to clarity. For now, discussions remain ongoing, but the issue appears poised to develop further as more firms recognise the scale of the possible liability.