Do you charge VAT on late payment interest

Interest and charges you claim because a customer has paid late are compensation for the delay, not payment for anything you supply, so they are outside the scope of VAT and you add no VAT to them. The position changes only where you agree in advance to let a customer pay after the time of supply in return for an extra charge: that charge is payment for an exempt grant of credit, while a charge for paying later but still before delivery is simply part of the price.

Why is late payment interest outside the scope of VAT?

VAT is charged only on supplies made for a consideration, and there has to be a direct link between what is supplied and what is paid. When a customer pays late, the supplier has already been paid, or is owed, the price of its goods or services. Interest for the delay buys the customer nothing further.

HMRC’s VAT Supply and Consideration manual states the position directly. At VATSC06810, which deals with disputes over payment for supplies, it says that where a customer pays the amount claimed, that sum is consideration for the supply, but no tax is due on any interest awarded or agreed because of the late payment, which is outside the scope of VAT as compensation for payment being delayed.

VAT Notice 701/49 on finance makes the same point for penalties. Paragraph 4.4 says that if you do not explicitly allow customers to defer payment and you impose a penalty because they have not paid by the due date, the penalty is not consideration for a supply and is outside the scope of VAT. Paragraph 2.11 adds that where a supplier charges a customer for a dishonoured cheque or direct debit, having borne the bank charges, that charge is also outside the scope.

Does statutory interest under the Late Payment Act follow the same rule?

Under the Late Payment of Commercial Debts (Interest) Act 1998, a business can claim statutory interest when another business pays late. GOV.UK sets the rate for business to business transactions at 8% plus the Bank of England base rate, and says statutory interest cannot be claimed where a contract sets a different rate. A business can also claim a fixed sum for the cost of recovering the debt: £40 for debts up to £999.99, £70 for £1,000 to £9,999.99 and £100 for £10,000 or more.

Statutory interest is interest because of late payment, which VATSC06810 places outside the scope. The fixed recovery sums arise only because the customer did not pay on time, which puts them in the same position as the late payment penalties in Notice 701/49 paragraph 4.4. Neither buys the customer a further supply, so no VAT is added. Our guide to statutory interest and compensation covers how to calculate and claim them.

When is a charge for extra time to pay exempt instead?

The answer depends on whether the customer was given the right to pay later, before the debt fell due. Item 2 of Group 5 of Schedule 9 to the VAT Act 1994 exempts the making of any advance or the granting of any credit. Note (3) to that Group says item 2 includes credit a supplier gives in connection with its own supply of goods or services, where a separate charge is made and disclosed to the customer.

HMRC’s VAT Finance manual at VATFIN3170 explains how this applies. Following the Court of Justice judgment in Muys (Case C-281/92), a supplier that allows a customer to defer payment after delivery in return for an additional charge is making an exempt grant of credit. The goods or services themselves keep their normal treatment. Notice 701/49 paragraph 4.5 puts it the same way: where you agree to defer payment beyond the time of supply and make an additional charge, that charge is consideration for an exempt supply of credit.

HMRC’s example in VATFIN3170 is a leisure club membership. The customer can pay £1,200 at the start of the year or defer it and pay £100 a month plus £25 a month. If the customer chooses to defer, the £25 is consideration for exempt credit. Disclosure need not be explicit: it is enough that the customer could reasonably be expected to know that deferring costs more.

When is a payment terms charge just part of the price?

Two situations take the extra charge back into the main supply.

• Deferral only up to the time of supply. Notice 701/49 paragraph 4.5 says that if the charge relates to periods before and up to the time of supply, it is not a charge for credit but further consideration for the goods or services, so it takes their VAT rate.
• No real option. VATFIN3170 says that where the customer can only pay in instalments and is not given the option to defer, there is no grant of credit and any additional charge is further consideration for the main supply.

Labels do not decide the answer. VATSC05840 warns that a payment called a fine or penalty may in fact be a further payment for fulfilling the contract, in which case it follows the liability of the supply. A late return charge for hired goods, for example, can be payment for a longer hire. HMRC’s car parking guidance draws the same line: a contract that lets the driver stay longer for a further payment produces taxable consideration, whereas a punitive charge for breaking clear terms is outside the scope.

How does this work in practice?

Illustration only. A VAT registered design studio invoices a client £6,000 plus £1,200 VAT on 30 day terms.

• The client pays 60 days late. The studio claims statutory interest and the £70 fixed sum. It issues a demand for those amounts without VAT, because they are outside the scope.
• For a different client, the studio agrees before delivery that the fee can be paid in six monthly instalments after the work is handed over, for an extra £180 shown separately in the agreement. The £6,000 fee is standard rated as usual. The £180 is consideration for exempt credit.
• For a third client, the studio adds £180 to the fee because the client wants to pay in stages during the project, with the final stage due on handover. That extra relates to the period up to the time of supply, so it is part of the standard rated fee and carries VAT.

What else should you watch for?

Exempt income can affect how much input tax you recover. Notice 701/49 reminds businesses that input tax relating to exempt supplies cannot normally be deducted, and that businesses making both taxable and exempt supplies must apportion. A business that starts charging separately for credit should check its position under the partial exemption rules. Our guide to the financial services exemption covers the exemption more widely.

Services you buy to chase debts are a separate question. Notice 701/49 paragraph 5.10 says supplies by a debt collection agency are taxable, even where they involve some negotiation with the debtor, so expect VAT on a collector’s fees.

The time at which a supply of credit takes place also differs from goods and services. Notice 700 says a supply of credit is treated as taking place each time a payment, such as interest, is received, unless HMRC has approved an earlier date. See our guide to the time of supply.

What mistakes come up most often?

• Adding VAT to interest or recovery costs. These amounts are outside the scope, so adding VAT overcharges the customer and puts a VAT figure on your paperwork that has no basis.
• Treating an agreed credit charge as outside the scope. If you offered deferred terms at a price before the debt fell due, the extra is exempt credit, not compensation.
• Calling part of the price a penalty. A charge the contract allows the customer to incur in exchange for more of the service is consideration, whatever it is called.
• Confusing this with dispute settlements. When a disputed invoice is settled, the amount paid for the supply carries VAT even though interest does not. Our guide to VAT on compensation and termination fees covers settlements and early exit fees.

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Related Accountapedia entries

• VAT late payment penalties and interest
• HMRC Late Payment Interest Explained
• When inheritance tax is due and interest on late payment
• Self Assessment late payment penalties and interest
• Interest on late and overpaid corporation tax

Sources

• GOV.UK: Manual page VATSC06810
• GOV.UK: Vat notice 70149 finance
• GOV.UK: Late commercial payments interest debt recovery
• legislation.gov.uk: Act 1998 c. 20
• GOV.UK: Manual page VATFIN3112
• GOV.UK: Manual page VATFIN3170
• GOV.UK: Manual page VATSC05840
• GOV.UK: Vat guide notice 700
• GOV.UK: Vat rates

Reviewed by Christine Anderson, Broker, Solar Protect. Last reviewed 24 October 2026. Part of Accountapedia, the Solar Protect guide to UK tax and accounting. This page is general information, not personalised advice.