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How is VAT affected by discounts?

If you offer your customers a discount on the amount they pay for goods or services supplied, you must make sure that you account for the VAT correctly.

What are discounts?

There are two types of discount a business may offer to its customers:

A trade discount may be offered to a customer for a number of reasons, including:

  • buying in bulk
  • the total price of an order exceeding a certain amount
  • loyalty
  • to promote a certain product.

An example of a trade discount is, a customer receiving 10% off the trade price for placing an order of more than £500. 

A prompt payment (or early settlement) discount may be offered to a customer to encourage them to pay more quickly.

An example of a prompt payment discount is a customer being offered a reduction in the amount payable of 3% if the payment is made within seven days.

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How do I calculate VAT for trade discounts?

To calculate the VAT on a trade discount, deduct the discount from the net price before the VAT is calculated.

VAT calculator

Work out how much VAT you'll need to pay by typing in the figure below and clicking whether this is before (Gross) or after VAT (Net)?

£

This calculator works out how much VAT you’ll pay using the standard rate of 20%. Some goods and services fall under the reduced rate of 5%. Find out more about how VAT works

This calculator works out how much VAT you’ll pay using the standard rate of 20%. Some goods and services fall under the reduced rate of 5%. Find out more about how VAT works

How do I calculate VAT for prompt payment (early settlement) discounts?

Calculating the VAT on a prompt payment discount is more complicated than the calculation for a trade discount.

With a prompt payment discount the VAT is based on the actual amount received, but you (the supplier) will need to account for the VAT and prepare the invoice before the amount is received.

To calculate VAT on a prompt payment discount:

  • decide which of the options below your business wishes to follow
  • calculate the VAT in the normal way, i.e. net x VAT rate.

Choose one of the following two options:

Option 1. Issue a credit note – If the customer pays the lower amount (ie. takes advantage of the prompt payment discount offered), issue a credit note for the amount of the discount (plus VAT).

Option 2. Include further information on the original invoice – If you do not want to issue a credit note each time a customer takes advantage of a prompt payment discount, then further information must be included on the original invoice:

  • a statement that the customer can only recover the VAT actually paid, and
  • the terms of the prompt payment discount. HMRC recommends that we include the discounted price, the VAT on the discounted price and the total amount due if the prompt payment discount is taken up.

HMRC recommend the following standard 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”.

Downloadable examples: Calculating VAT on discounts

Click on the download button below to view and download reusable templates for an invoice and credit note. 

Calculating VAT on discounts can be done in one of the two ways. Extracts in the attached invoices contain discounts shown as follows:

Option 1: Issue an 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 – £45.00 = £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 the reduced amount, 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 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.’ 

 

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Do I need to charge VAT on free gifts?

VAT is usually charged on the cost of goods, except in the following circumstances:

  • business gifts costing less than £50 in total (per person per annum)
  • a free meal to an employee.

Interactive tutorial: VAT invoices and discounts

Find out more about VAT invoices and discounts. This tutorial shows:

  • what an VAT invoice must show
  • simplified VAT invoices
  • the calculation of discounts and VAT.

Click on the Start button below to view. 

Quiz: Do you understand VAT on discounts?

Try this quiz to see if you can calculate VAT on discounts. To answer, check a tick box against one of the options below and click submit to reveal the answer. 

A supplier offers a customer a trade discount of 10% for orders over £500, and a prompt payment discount of 2.5% if the invoice is paid within seven days. The customer places an order for £600 (net) and pays within seven days. The amount the customer pays is:

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