Legal update: Client account interest – a round-up of the key issues facing law firms

Client account interest has been a topic of debate for a number of years now.

Since the 2011 SRA Accounts Rules introduced the need for a formal interest policy and allowed firms to use judgement and discretion when paying interest to clients, there has been a lot of discussion about the best approach.

Up until about 12 months ago, most of this discussion was largely theoretical, as rates had been so low that most accrued interest on the client account was unlikely to pass the de minimis threshold set by firms in the vast majority of cases.

For many firms, the receipt of client account interest was so incidental to normal trading that it usually slipped by unnoticed.

Things changed during the Autumn of 2022, with the government’s controversial ‘mini Budget’ and rapidly rising inflation sending interest rates spiralling. Since then, firms that handle large volumes of client money have enjoyed some fairly significant sums of client interest being deposited into their office account, returning us to situations similar to almost 20 years ago, when interest was a substantial (and in some cases primary) component of profit.

This has brought many of the lingering debates back to the minds of client money handling firms, and has also created some new questions that we did not see coming.

In this issue we will consider the key points.

What is a ‘fair’ rate that firms should pay to their client?

Going back to basics, Rule 7 of the SRA Accounts Rules (as it currently stands at least) states that firms must account to clients for a ‘fair sum of interest’.

But what is a ‘fair sum’?

Those of us hoping for clarification from the SRA on this point can keep hoping as there is nothing in the way of guidance to help us decide on what is ‘fair’.

Some readers might recall that there was old (now deleted) guidance suggesting that firms should set the rate of interest payable on client money at the same level that a client could themselves achieve on an instant access business deposit account at the same bank.

Although current thinking has moved on since then, it is worth bearing in mind that it is not the responsibility of the law firm to go to great effort to find the best rate possible. Firms are not expected to shop around for a more favourable rate on behalf of their clients. That is not to say they cannot of course, and achieving a better rate for the client should have the knock-on effect of more profit for the firm.

A policy of paying interest at a rate based on the headline rates on the general client account at the bank at which client money is held is unlikely to draw any challenges from the SRA. Where firms operate more than one general client account with different banks, they may choose to adopt a ‘blended rate’, or apply the highest rate from those accounts. In any case, that rate is likely to be lower than the rates actually being received by firms because they will usually enjoy higher rates due to the volume of money held in aggregate. There is nothing stopping firms passing on those same rates to clients, but they are not obliged to do so.

Our advice has always been that firms should have a documented interest policy, which they show to their clients at the outset of a matter, explaining issues such as:

  • Their de minimis limit
  • When interest will be paid
  • The rate at which interest will be paid.

Some firms include their policy in their terms of business, so that they can easily demonstrate that the client has seen it.

What is a suitable de minimis?

Previous versions of the Accounts Rules used to recommend the use of a de minimis, below which interest would not need to be paid to clients. The current rules no longer mention a de minimis, but it remains an important element of any interest policy.

Under the old rules a £20 de minimis was commonplace, but most firms are now at £50, with some moving towards £100 for certain (generally larger or corporate) clients.

How often should firms pay interest to their client?

The other main measurement of fairness is centred around how often interest should be calculated and paid to the client, and the first thing to consider here is what the firm’s interest policy states.

A well-thought-out policy should state how often interest calculations take place. In some cases, this might be periodically; for example, annual calculations on long running trust administration matters, or it might be more often where particularly large volumes of client money are held. At the very least, it should be done at the end of the matter.

Good financial hygiene is important here – not just to ensure that the calculation takes place in all cases before a matter is archived, but also that the calculation takes place reasonably promptly in order to avoid creating a potential residual balance headache on old, unarchived matters.

Do not forget, even a relatively modest amount of client money held over a long period of time can attract a large amount of interest.

Make sure your client banking arrangements remain compliant

As rates of interest have been rising, we received a number of enquiries from firms asking about the ability (or not) to use more dispersed client banking arrangements in order to capture the best available deals – for example, fixed term treasury deposit accounts or placing a tranche of client money with another bank.

It is fairly common for firms to deposit a ‘top slice’ of client money in, for example, an overnight treasury account, as these have typically offered higher returns than a general client current account. We have seen firms locking client funds into longer-term deposit accounts that do not offer instant access, with terms ranging from weeks, to months and even whole years.

Do not forget that Rule 2.4 of the SRA Accounts Rules states that client money must be available on demand, unless you agree an alternative with your client and so, unless your client gives explicit instructions, you would be in breach of the rules if client money could not be accessed immediately.

In some cases, access terms can be broken at the expense of interest, and this should not give firms a compliance problem, but care must be taken if this is not the case.

In general, however, as we have seen rates on instant access accounts improving, the appetite for fixed-term deposit accounts has fallen.

Do not overlook your designated deposit accounts

It has become much less common for firms to use client designated deposit accounts (DDAs) over the years, as the administrative burden of operating separate accounts, coupled with the difficulty of opening new accounts, has made them less attractive.

In most cases, interest earned on a DDA is paid directly into the account and that is where it normally stays, but firms are reminded that the Accounts Rules do not differentiate between this and interest earned on the general client account.

There is therefore no special treatment required for interest on any DDAs that firms still hold, and it can be included in the normal client interest calculations and allocated accordingly.

A reminder of the tax position on interest

A topic that we have mentioned in previous issues, but which is worth repeating, is the way in which the payment of tax on all interest received (including both client and non-client related interest) is treated in light of the forthcoming change to the tax basis period rules for partnerships, LLPs and sole practitioners.

Just to recap, for the tax year ending 5 April 2024, there will be a ‘tax catch-up charge’, for all self-employed individuals where their businesses have accounting dates which are not either 31 March or 5 April each year (i.e., they are noncoterminous with the end of the tax year), and the impact of this payment will land on 31 January 2025. For a firm with a 30 April year end, the profits assessed for the 5 April 2024 tax year will be the 12 months ended 30 April 2023 plus the 11-month period to 31 March 2023, less overlap relief.

Taxpayers can elect whether to pay the whole catch up tax charge on 31 January or to spread it, interest free, over a five-year period, which of course most firms will do to ease the cash flow pressure.

The main exception to the ability to spread the tax burden for law firms is that any element of this catch-up profit that relates to interest cannot be spread. Given the amounts of client interest may be significant for firms, this can have a big impact for firms that are not prepared.

Another important issue is that, for partnerships and LLPs, interest is taxed on a cash basis (i.e., when it is received and paid) rather than on an accruals basis. Therefore, firms need to ensure that they have credited their client ledgers with any interest due in advance of 31 March 2024 to ensure that they receive a tax deduction for it, rather than simply including an accrual for interest payable within their accounts.

VAT and partial exemption

There has been much talk recently of the unintended, and potentially unwelcome, consequence of the surge in client interest income which arises where the earning of interest may no longer be classed as ‘incidental’ to the normal trading activities of the firm for VAT purposes.

Because interest is exempt from VAT, but the normal business of a law firm is not, there is the potential for VAT partial exemption rules to arise. This may affect a firm’s ability to reclaim input VAT in full on their trading expenses.

In simple terms, where a proportion of a firm’s total income is made up of a VAT exempt amount and the partial exemption rules apply, a corresponding proportion of its reclaimable input VAT becomes irrecoverable.

We are aware that some firms have looked to mitigate their exposure to this potential problem by, for example, applying to HMRC to adopt a ‘special method’ of VAT attribution, which looks to limit the apportionment of irrecoverable VAT to the proportion of time spent actively managing the interest earning function. This can be a lengthy and potentially time intensive process, and is only recommended where a firm is confident that they are captured by the rules. A further downside of the special method is that once you are in it, you cannot get out again, without renegotiating with HMRC.

It should be noted that it is highly unusual for law firms to have extensive resources allocated to anything other than VATable supplies. It is not usual, for example, to see firms expending a significant proportion of staff time on the act of actually earning interest; this is usually an incidental consequence of handling a client matter. Even where members of staff were to spend long periods of time pursuing best rates, employee costs will primarily fall outside of the scope of VAT, and so it is our view that the majority of firms should not actually have a great deal to worry about, irrespective of the overall amount of client interest earned.

An exception to this might arise where, for example, a firm engages a consultant to source the best available rates on client money and the consultant charges for their services by way of a VAT invoice. This can be dealt with quite simply by specifically blocking the reclaim of input VAT on those costs.

In any case, under the de minimis rules, HMRC allows the recovery of up to £7,500 of VAT per year that would otherwise be captured.

Due to the potential complexities with this, we recommend that firms consider their own position carefully and take advice where necessary, rather than assuming they are automatically captured by partial exemption requirements and making unnecessary adjustments to their reclaimable input VAT. We are of course very happy to help.

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