Client account interest and VAT: an emerging risk for law firms

Recent changes in the economic and regulatory environment have brought renewed attention to the VAT treatment of interest earned on client monies. What was once commonly viewed as a low-impact technical point is now emerging as a substantive risk area for many law firms.
With interest rates remaining elevated, the level of income earned on client funds has increased significantly. At the same time, HMRC has sharpened its focus on how that interest is treated for VAT purposes, particularly in the context of partial exemption. Together, these developments mean that an issue which was historically often disregarded now warrants careful review.

What has changed?

For some firms, the quantum of interest earned on client monies held in designated client accounts is significant, running into hundreds of thousands or even millions of pounds per annum.
Historically, when interest rates were low, this income was frequently treated as immaterial for VAT purposes and, in practice, often excluded from partial exemption calculations. That position has now changed materially with the sustained period of higher interest rates.
HMRC is actively targeting law firms and other regulated professional practices that hold significant client funds. Its approach is to assert that interest earned on client accounts constitutes exempt income of the firm for VAT purposes. In some cases, HMRC has gone further, arguing that the full amount of interest should be included in the partial exemption calculation even where that interest is ultimately paid over to clients.

HMRC’s current approach to client accounts

The VAT position in this area is complex and highly fact specific. It depends on the firm’s activities, the operation and structure of client accounts, and the application of historic case law.
HMRC is drawing on relevant case law and its experience from current live investigations in this area, while firms may also have counteracting factors that require careful evaluation. There is no single or prescribed answer, and outcomes can differ materially depending on the facts.
Importantly, we are increasingly seeing this issue raised as part of wider VAT compliance reviews rather than as a standalone enquiry, which can limit the opportunity to shape the narrative once HMRC engagement has started.

Wider regulatory developments on client accounts

Alongside HMRC activity, the Ministry of Justice has launched a consultation proposing that a significant proportion of interest earned on lawyers’ client accounts in England and Wales be diverted to the justice system.
While this is not a VAT measure, it reinforces the heightened scrutiny of client account interest and raises broader questions around ownership, attribution and treatment. Law firms also have the opportunity to engage with the consultation process and make their views known.

Contributions can be made to this consultation up to 9th February 2026.

Why this matters now

Given the quantum involved, the current HMRC focus, and the direction of travel from both HMRC and the Ministry of Justice, this issue now represents a clear financial, compliance and governance risk for many law firms.
Addressing the position proactively allows firms to understand their exposure, assess the strength of their current approach, and put a defensible position in place before the issue is raised by HMRC.

How Gravita can help

We are advising a growing number of law firms on this issue as HMRC’s activity accelerates. Our support typically includes:

• Reviewing the VAT treatment of interest earned on client monies, including issues of ownership and attribution
• Analysing relevant legislation, HMRC guidance, case law and current HMRC enquiry positions
• Assessing the impact on partial exemption calculations and identifying where the standard method may produce a distorted result
• Identifying areas of technical uncertainty, exposure and challenge, including retrospective risk
• Advising on practical options to protect VAT recovery, which may include changes to approach, restructuring, or consideration of a special partial exemption method

Depending on the facts, there may be multiple angles available either to support the position that interest should not be treated as exempt income of the law firm, or to optimise and protect VAT recovery even where it is.

Next steps

If you would like to understand how these developments may affect your firm, or to sense-check your current position, please get in touch with our expert VAT partners David Gage or Sandy Cochrane.