As from 1st April 2015, HMRC changed the way that VAT on settlement discounts (also called prompt payment discounts) needs to be dealt with. So what does this mean for you?

Settlement discounts are offered as an incentive for a customer to pay an invoice more quickly – in return for a quick payment they receive a discount on the price.

Previously, VAT was calculated as if the discount would always be taken up and was only calculated on the discounted charge. Even if the customer paid outside the discount terms, the reduced amount of VAT was applied.

From 1st April this has changed and VAT must be charged on the amount actually paid. If the customer doesn’t meet the prompt payment terms, then VAT must be charged on the full amount.

The difficulty lies in the fact that when the invoice is issued, there is no way of knowing whether the customer is going to make a prompt payment or not, so there is no way of knowing how much VAT needs to be charged. HMRC have offered two alternatives for how this can be dealt with.

The first alternative is to use credit notes. In this scenario, the invoice is issued at the full price with the full amount of VAT calculated and shown. The invoice also lays out the terms and discount available.

Once the customer makes payment, if the terms have been met, the supplier issues a credit note for the discount amount and the reduction in VAT. Both parties reflect the original invoice and the credit note in their accounting records.

The second alternative is for the supplier to issue an invoice which shows the settlement terms and also includes a statement that the customer is only allowed to reclaim the VAT that has actually been paid. HMRC have suggested some wording that could be used:

“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. Following payment you must ensure you have only recovered the VAT actually paid.”

If the payment is then received within the discount period, the supplier must amend their accounting records to reflect the revised VAT charge, although no further communication is needed with the customer. If the payment is received outside of the discount period, no further action is needed. The customer must also ensure that their accounting records reflect the correct amount of VAT according to when the payment was made.

In all scenarios, both the supplier and the customer must keep records to show how the VAT amount has been arrived at – invoices, credit notes, and payment records such as bank statements.

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About the Author

Julie Stevens is Managing Director at Evenstone Ltd. Evenstone are accountants who specialise in helping people get the most out of their Brightpearl accounting through monthly support packages, ad-hoc services or training.