When a bank or other firm puts you back in the position you would have been in, for example after a complaint that payment protection insurance (PPI) was missold, the refund of what you paid is not taxable because it is your own money coming back. The extra simple interest, typically 8% a year, added to compensate you for being without that money is interest and is taxable as savings income. Since Finance Act 2013 the payer must deduct tax from it at the savings basic rate, which many people can reclaim.

Why is the refund itself not taxable?

HMRC’s Savings and Investment Manual at SAIM2105 explains that when a PPI complaint is upheld the customer is usually restored to the position they would have been in without the policy. This general redress may include three elements:

  • a refund of the PPI premiums;
  • historic interest, meaning the interest the customer paid on premiums added to a loan or card balance; and
  • simple interest at 8% a year for being deprived of the money paid.

The worked examples at SAIM2115 and SAIM2120 confirm that refunded premiums and historic interest are not taxable “because they are refunds of amounts paid”. You are not receiving income; you are getting back money you should never have paid.

Why is the added interest taxable?

Section 369 of the Income Tax (Trading and Other Income) Act 2005 charges income tax on interest, and SAIM2105 states that the 8% interest is taxable on the customer and must be declared to HMRC or included in a Self Assessment return.

The underlying principle comes from Westminster Bank Ltd v Riches, discussed at SAIM2070: interest on damages, running from when the cause of action arose, is “interest of money” because it compensates for delay in payment. The label does not decide the matter. A sum calculated using an interest rate can still be capital, and an amount described as compensation can be interest.

SAIM2075 says an “enhancement element” in redress for a missold financial product is highly likely to be interest if all three of these are true:

  1. it is paid under a legal obligation, which redress in settlement of a complaint normally is;
  2. it can be distinguished from the rest of the redress and is calculated by reference to a principal sum, such as the amounts invested; and
  3. it is calculated by time and represents a commercial return for the period you were deprived of the money.

HMRC’s own contrast is useful. Where a missold investment was valued by assuming growth at 1% above Bank of England base rate, that calculation of the loss was not interest, even though it used a rate. The additional amount for the delay between cashing in the investment and receiving compensation was interest.

Why has tax already been taken off?

Section 874(5A) of the Income Tax Act 2007 treats interest payable to an individual in respect of compensation as yearly interest, whatever period it covers. The payer must then deduct income tax at the savings basic rate under section 874(2). Banks and building societies are normally exempt from deducting tax from interest, but SAIM9116 confirms that the exemption does not cover compensation interest paid on or after 1 October 2013 by banks or 1 September 2013 by building societies.

The savings basic rate is 20% for 2026 to 2027. From 6 April 2027 it rises to 22%, along with savings higher and additional rates of 42% and 47%.

Not every interest payment from a financial firm is compensation interest. SAIM9116 gives the example of an insurer paying a few pounds of interest on a late annuity instalment: that is ordinary short interest on a late payment, with no tax deducted.

Can you reclaim the tax deducted?

Often, yes. Compensation interest is savings income, so it can be covered by the same allowances as bank interest; see the Personal Savings Allowance.

  • If your income is less than £17,570, GOV.UK says you can use form R40 to reclaim tax deducted from savings or PPI interest.
  • If your income is higher, you can still reclaim tax on interest that falls within an unused Personal Savings Allowance of £1,000 (basic rate) or £500 (higher rate).
  • Refunds of tax on interest can be claimed for up to 4 years.

Higher and additional rate taxpayers are in the opposite position: the deduction does not cover their full liability and they must tell HMRC or include the interest on a return. If HMRC collects it through your tax code or a calculation letter, see P800 tax calculations and Simple Assessment.

How does this work in practice?

Illustration only. Jo earns a salary of £30,000 and has no other savings interest. A complaint that PPI was missold is upheld and the lender pays redress of £3,000 refunded premiums, £400 historic interest and £1,100 of 8% compensation interest.

  • The £3,400 of refunds is not taxable.
  • Tax of 20% is deducted from the £1,100: Jo receives £880 and £220 goes to HMRC.
  • As a basic rate taxpayer, Jo’s £1,000 Personal Savings Allowance covers £1,000 of the interest. Only £100 is taxable, at 20%: £20.
  • Jo can reclaim £200 on form R40.

If Jo had other interest using up the allowance, all £1,100 would be taxable and nothing would be reclaimable. Interest accrued over several years is taxed when it is paid; SAIM2090 shows interest built up over three years being charged in the single tax year of payment, which can affect which allowance and rate apply.

Which compensation interest is tax free?

  • Personal injury damages. Section 751 ITTOIA exempts interest on damages for personal injury or death included in a court award, a payment into court or an out of court settlement. It does not cover interest for the period between judgment and payment (SAIM2330).
  • HMRC repayment interest. Section 749 ITTOIA exempts repayment interest and repayment supplement paid by HMRC; compare HMRC late payment interest.
  • Missold personal pensions. Section 148 Finance Act 1996 and extra statutory concession A99 exempt compensation for missold personal pensions, retirement annuities and free standing additional voluntary contributions, including the interest element (SAIM2075).
  • Student loans. Interest repaid with an overpaid student loan is not taxable (SAIM2320).

Other compensation does carry taxable interest. SAIM2075 treats interest on refunded endowment premiums as taxable, and SAIM2090 treats amounts the Financial Services Compensation Scheme pays in place of lost bank interest as taxable interest; see FSCS protection.

What mistakes are common?

  • Declaring the whole payment as income. Only the interest element is taxable; the redress letter normally separates it.
  • Not reclaiming. Many basic rate taxpayers and people on low incomes can recover all of the tax deducted.
  • Ignoring higher rate tax. A large interest payment can push savings income above the higher rate threshold and reduce the Personal Savings Allowance from £1,000 to £500.
  • Assuming every settlement is the same. SAIM2070 stresses that out of court settlements must be analysed on their facts and documents to find any interest element.

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Reviewed by Christine Anderson, Broker, Solar Protect. Last reviewed 8 October 2026. Part of Accountapedia, the Solar Protect guide to UK tax and accounting. This page is general information, not personalised advice.