How to compensate customers and not lose out on VAT

It’s a sign of the times that customers are looking for value and have become far more clued up when it comes to claiming compensation when things go wrong (PPI mis-selling anyone?).

If you sell something to a customer and it doesn’t work properly it may be down to their abuse, but chances are they’ll still come to you looking for financial compensation.

It’s up to you whether you pay up and cut your losses, however if you don’t do things properly you could end up with a nasty VAT headache.

Normally if you make a compensation payment to an unhappy customer, it’s outside the scope of VAT. In other words because it doesn’t relate to a supply of goods or services it shouldn’t affect your VAT bill.

So why is there a VAT problem?

Well let’s give you an example.

Trotters Ltd sells and fits electric gates for a customer for £12,500 plus VAT.

Apparently the gates aren’t fitted properly and fall off during use and damage the customer’s expensive Mercedes (ouch!). Trotters Ltd refits the electric gates at their own expense. The car is not repaired.  Instead the customer demands compensation for the repair bill and the inconvenience caused. Trotters Ltd agrees to pay him compensation of £12,500 to cover this.

Where does VAT come into this you’re probably asking..

Well, Trotters Ltd originally paid up a whopping £2,500 VAT to the taxman when they sold the electric gates (£12,500 x 20%).

However there’s no chance of getting the VAT back despite the fact they have shelled out £12,500 as compensation. That’s because the payment has nothing to do with the sale of the gates or refitting them – it’s financial compensation demanded by the customer.

So what’s the solution?

Instead of first giving compensation of £12,500, Trotters Ltd could have given the customer a credit note for £12,500 to reflect the fact that the gates may have been defective. There would then have been a refund of £12,500 against the original sale, which would save the company £2,083.33 VAT (£12,500 x VAT fraction of 20/120) and the customer would have got £12,500 in his pocket.

So be warned, if you do agree financial compensation with a customer make sure you link this to a reduction in the original selling price of your goods and services.

However, you must make it clear in any correspondence that you are giving your customer a price reduction on your original goods/services.  And of course you can only use the credit note arrangement for the maximum value of your original sale.  If you refund over and above this amount the excess will be treated as compensation and won’t reduce your VAT bill.

And remember, these tips are not a replacement for professional advice tailored to your precise needs and circumstances.


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