How is VAT affected by discounts?

What are discounts?

Businesses may offer different types of discounts to encourage sales, reward customer loyalty or improve cash flow. 

Trade and bulk discounts

These discounts reduce the selling price offered at the point of sale, maybe due to:

• buying large volumes
• spending above a specified order value
• customer loyalty programmes
• promoting selected products or services.

Offering a customer 10% off an order worth more than £500 is an example of a bulk discount.

Prompt payment discounts

A prompt payment discount (sometimes called an early payment discount) is offered to encourage customers to pay invoices sooner than the agreed credit terms.

For example, a supplier may offer a customer a 3% discount if payment is received within seven days of the invoice date.

VAT treatment of discounts

The VAT treatment can vary depending on the type of discount offered, so it is important to understand the distinction.

To calculate the VAT on a sale that includes a bulk or trade discount, you need to deduct the discount amount from the net price before you calculate the VAT.

Calculating the VAT on a sales that includes a prompt payment discount is more complicated than the calculation for trade or bulk discounts.

With a prompt payment discount VAT is based on the actual amount received from the customer. However, as the supplier, you must account for the VAT and will have to prepare the invoice without knowing whether the customer will take advantage of the prompt payment discount or not; because of this, HMRC allows businesses to deal with prompt payment discounts in one of two ways:

Option 1: Issue a credit note

If the customer pays the discounted amount, issue a credit note for the value of the discount and the associated VAT. This reduces the VAT originally charged on the full invoice value.

Option 2: Include prompt payment discount wording on the invoice

Instead of issuing a credit note each time, you can include appropriate wording on the original VAT invoice explaining the discount terms and confirming that the customer may only recover the VAT actually paid.

HMRC recommends showing:

• the prompt payment discount terms
• the discounted price
• the VAT due on the discounted price
• the amount payable if the discount is taken.

Example wording:

“A discount of X% of the full price applies if payment is made within Y days of the invoice date. No credit note will be issued. On payment you may only recover the VAT actually paid.”

Using option 2 can reduce administration for businesses that regularly offer prompt payment discounts.

Click on the download button, then open the example invoice and credit note. 

The examples in the downloaded document show the two HMRC-approved methods for accounting for prompt payment discounts. In both cases, VAT is ultimately calculated on the amount the customer actually pays if they take advantage of the discount.

Option 1 – Issue a sales invoice

• An invoice is prepared for the full amount. In this example the amount is £300. 
• The rate of VAT is clearly shown (at 20%)
• The trade discount is calculated at 15% and deducted from the usual price (£300 – £45 = £255)
• The VAT is calculated on the net: £255 x 20% = £51
• The amount payable if the prompt payment discount is not taken is shown (£306), along with the terms of the prompt payment discount: ‘A 3% discount applies if payment is made within seven days of the invoice date.’ 

Option 1 – Issue a credit note

The customer pays pays within seven days and £296.82 is received, therefore a credit note is issued. 

• The rate of VAT is clearly shown (at 20%)
• This is 3% of the net figure on the invoice: £255 x 3% = £7.65
• The VAT is calculated on the net: £7.65 x 20% = £1.53
• This is the amount by which the original invoice has been reduced. The customer paid £296.82 (£306.00 – £9.18).

Option 2: Include further information on the original sales invoice

The invoice is prepared for the full amount of £300 with additional information: 

• The rate of VAT is clearly shown (at 20%)
• The trade discount is calculated at 15% and deducted from the usual price (£300 – £45 =£255)
• The VAT is calculated on the net. £255 x 20% = £51
• The amount payable if the prompt payment discount is not taken is shown (£306), along with the terms of the prompt payment discount: ‘A 3% discount applies if payment is made within seven days of the invoice date. No credit note will be issued. On payment you may only recover the VAT actually paid.’ 

For more assistance with calculating VAT, use our online UK VAT Calculator.

Giving goods away free of charge can create a VAT liability, particularly if your business reclaimed VAT when purchasing those goods.

However, HMRC provides an exemption for certain business gifts. You do not normally have to account for VAT on gifts given to a customer or other recipient if:

• the total cost of gifts to that person does not exceed £50 in any rolling 12-month period; and
• the gift is not a voucher that can be exchanged for goods.

If the £50 limit is exceeded, VAT may become due on the gifts provided to that recipient.

Special rules also apply to goods given to employees. For example, a free meal provided to an employee is generally not treated as a taxable gift for VAT purposes.

As with other VAT reliefs, you should keep records of gifts provided and their value.