Living the Eye Life! – January 2026
Here is our latest selection of queries received whilst we are on the front line working with law firms.
Q I have about a query that has arisen on interest on our client account and the tax treatment thereof.
The background is: –
- We have held client money in our main client account (not a designated deposit account) and I have calculated that we have received interest of just under £5k on this matter
- I have said to the client that I will make a payment in lieu of interest of the full amount of just under £5k
- I have said that because this sum is not the firm paying interest to the client (as we are not a bank), rather it is a payment “in lieu of interest”. As such the payment to the client is not taxable
- I have further said that we pay tax on the interest we receive so they do not have to
My client is telling me that I am wrong, and that they will be liable for any tax due on the interest I have proposed paying to them.
I wonder if there is a distinction here between us accounting for the interest the firm earns on its main client account as in this situation, and interest that is paid on a designated deposit account where interest due to the client will attract tax.
A The immediate answer, which is very topical, is that firms should not be giving tax advice. From 1 April 2026, registration with HMRC will be required for those who deliver advice to their clients in respect of tax. There are sanctions for failure to do so, and sanctioned tax advisers can be required to inform all their clients that they have been sanctioned.
This will be of interest both to tax advisers and to their clients. Tax advisers can include accountants, solicitors and any other consultant (specialist or otherwise) whose support services touch upon tax.
In this particular example the client is correct, and the firm gave wrong advice. Hence the need for the above requirement.
Firms pay their clients a gross amount in lieu of interest and the clients are responsible to account for such interest income in their own tax returns. Any tax that is due on this interest will depend on their own individual tax position.
When it comes to calculating the interest due to your client, you should of course refer to your firm’s Interest Policy. This is the Interest Policy that your terms of business should refer to so that it can be provided to your clients on request. We recommend that your interest Policy forms part of you Accounting Policy Document so that it can be amended as and when required.
Remember, all interest calculations must be carried out in accordance with your Interest Policy, so it is very important that you are satisfied with all the obligations it places on the firm and that it complies with the Rule 7 of the SRA Accounts Rules.
Q We have recently undertaken a considerable amount of work in tackling our residual balances and have now reached the point where the number of old balances is quite low. Are we safe to assume that the regulator will share this view provided we stay on top of them?
A That would be a very dangerous assumption to make! Let’s start with the Accounts Rules and specifically Rule 2.5 “You ensure that client money is returned promptly to the client, or the third party for whom the money is held, as soon as there is no longer any proper reason to hold those funds”.
So put simply, if there is no longer an ongoing legal transaction, you must return the money. Failure to do so is a clear breach of Rule 2.5. This breach often leads on to a breach of Rule 3.3 – you must not use a client account to provide banking facilities to clients or third parties.
The SRA regularly issues updated case studies in this area, and we are already seeing increased activity by the regulator to enforce Rules 2.5 and 3.3 at the end of 2025 and into 2026.
Q We have been speaking with our reporting accountants about the interest we have earnt on our client account which we have always treated as income. We have always reimbursed our clients with the interest they are entitled to in accordance with our interest policy, so we are talking about the income that is due to us. Because of higher interest rates over the past couple of years this is not an insignificant amount. Our accountants seem to be of the opinion that it may impact on our ability to reclaim all of the VAT on our expenditure. What is the position of HMRC?
A It’s far from clear! The question of restricted VAT reclaims as a result of income derived from client account interest has been raised by a number of leading accounting firms in the legal sector. Opinion on whether a partial exemption does or does not apply is divided. Although the amounts involved are in some cases quite material, some accountants argue that the earning of interest is still, by its nature, incidental to the service provided to clients and so does not give rise to partial exemption. Further they contend that HMRC’s own guidance makes this very point. Other firms are less robust. Currently solicitors are guided by the opinion of their own Accountants. This is a topic that you should keep an eye on in 2026. Given the recent round of interest rate cuts, and various consultations about the future of interest on client accounts, this is an issue that may be overtaken by events anyway
David Thorpe
Director – Financial Eye