VAT compensation

Sign of the times

There's no doubt that over recent years people have become more forceful about their rights. If you sell them something that doesn't work properly, it may be down to their misuse, but they'll often look to you for financial recompense. Whether you decide to accept responsibility or just pay them off to avoid throwing good money after bad is up to you. Either way, there's a wrong and a right way to deal with it for VAT purposes.

No supply equals no VAT

If you make a compensation payment to a customer, it's outside the scope of VAT. That's because it doesn't relate to a supply of goods or services. In other words, it's completely neutral on your VAT bill. Or is it? Consider the case of one of our subscribers.

Damages

Bloggs Ltd sold and fitted a garage door for a customer for £2,000 plus VAT. Allegedly, the door was not fixed properly and it fell during use and damaged the customer's expensive driveway. Bloggs refitted the door at their own expense. The drive was not repaired but instead the customer demanded compensation for its ruined appearance, as well as something for the stress caused and her lost time in sorting the matter out. Bloggs Ltd agreed to pay her compensation of £1,500 to cover this.

VAT problem

Bloggs had paid over £300 of VAT to the Taxman on the original sale of the garage door (£1,500 x 20%). But there's no scope to reduce this VAT, despite agreeing to pay £1,500 back in the form of compensation. This is because the payment is not related to the sale of the door or its subsequent refitting but for financial damages claimed by the customer.

VAT solution

Instead of compensation Bloggs Ltd could have given the customer a credit note of £1,500 to reflect that the original product may have been defective. There would then be a refund of £1,500 against the original sale, saving the company £250 VAT (£1,500 x VAT fraction of 1/6). The customer still gets £1,500 in her pocket.

Tip 1. If you agree to financially compensate a customer, try to link this to a reduction in the original selling price of goods or services you supplied. This will mean that you can claim a reduction in the taxable value of the supply and will reduce your VAT bill accordingly.

Tip 2. Make it clear in all communications with the customer that you are giving them a price reduction (discount) on the original product or service.

Trap. You can only use the credit note arrangement to the maximum value of the original sale. If you refund more than this to your customer, the excess must be treated as compensation and it won't affect your VAT bill.

If you need any help or advice on VAT, dont hesitate to get in touch to organise a free initial meeting 0191 386 4786

VAT compensation

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