Can You Claim VAT on Prepayments? What HMRC Allows?

VAT on prepayments refers to the HMRC-defined requirement to account for VAT at the time a business receives an advance payment, creating an actual tax point under VAT Notice 700.

UK suppliers use this rule to determine when VAT becomes due on deposits, retainers, staged payments, and annual subscription fees.

Prepayment VAT rules apply across sectors, including construction contracts, accommodation bookings, and software licensing arrangements, where the date of payment, not the delivery of the service, triggers the VAT liability.

HMRC’s framework ensures accurate reporting by treating each advance payment as a taxable supply with its own enforceable tax point, reducing compliance risks for businesses operating with large or recurring invoices.

Defining the VAT Tax Point

To truly master the application of VAT on prepayments, one must first understand the concept of the ‘tax point’.

The tax point is the precise date when a supply of goods or services is legally deemed to have taken place for VAT purposes, determining the period in which the VAT must be accounted for by the supplier and, conversely, reclaimed by the customer.

In standard VAT accounting, there are two primary types of tax points:

1. The Basic Tax Point (BTP): This is the default position: the date the goods are delivered or the service is completed.

2. The Actual Tax Point (ATP): This is the date that supersedes the BTP. It is defined as the earliest of two events: the issue of a VAT invoice or the receipt of payment.

It is the Actual Tax Point that transforms the accounting treatment of prepayments into a critical VAT compliance issue.

According to the Value Added Tax Act 1994, Schedule 11, paragraph 6, if a payment is received before the goods or services are delivered or performed, that payment creates an immediate, actual tax point for the amount received.

This is the cornerstone rule: VAT on advance payments is not delayed until the supply occurs; it is triggered the moment the funds arrive in the supplier’s bank account.

The Accounting versus VAT Dichotomy

In standard accruals accounting, a prepayment received is often recorded on the balance sheet as a liability (Deferred Income or Income in Advance) until the revenue is earned. Similarly, a prepayment made is recorded as an asset (Prepaid Expenses).

However, for VAT purposes, HMRC cares about cash flow, not accruals. The receipt of funds for a taxable supply immediately creates a tax liability.

This distinction is vital for accurate VAT return preparation, regardless of how the transaction is being treated for Corporation Tax or Income Tax purposes.

Can You Claim VAT on Prepayments?

Yes, but only if all of the following are true:

1. Supplier is VAT-registered.
   Input VAT can only be reclaimed if supplier charges valid VAT.
   
2. A proper VAT invoice is issued.
   Per HMRC, invoices must show tax point, VAT number, amount, etc. No valid invoice = no reclaim.
   
3. Payment is made for business purposes.
   Only prepayments used in the course of taxable business activity are reclaimable.
   
4. Goods or services are genuinely expected.
   If there’s no intention to supply, VAT can’t be reclaimed.
   

If you meet the above, you can reclaim VAT on a prepayment in the period when the deposit is paid and the VAT invoice is received.

What Do We Mean by Prepayments?

Prepayments (also known as deposits, advance payments, or instalments) are amounts paid by a customer before receiving the goods or services. They commonly appear in:

• Construction contracts
• Event bookings
• Professional fees (e.g., consultants, designers)
• Long-term supplies (e.g., catering, bulk orders)

In accounting, these prepayments are initially recorded as liabilities or prepaid income. They’re only recognised as revenue when the service or goods are delivered.

Supplier Responsibilities: Accounting for Output VAT

For the VAT-registered entity receiving a prepayment, the obligation is clear and immediate. This applies whether the payment is labelled a deposit, a retainer, or an advance instalment.

Do you pay VAT on advance payments?

Unequivocally, YES.

When a supplier receives an advance payment from a customer for a supply that is standard-rated or reduced-rated, they must account for the VAT on the payment in the VAT period in which the cash is received.

Example Scenario: A construction firm accepts a £60,000 advance payment (inclusive of VAT) in September 2024 to begin work on a project scheduled for completion in January 2025.

The September VAT return (due November 2024) must include the output VAT element of the £60,000 received. The VAT tax point is September 2024, four months before the basic tax point (completion).

Is a prepayment invoice a VAT invoice?

For a customer to be able to reclaim input tax on a prepayment, the supplier must issue a valid VAT document. This leads to the critical question: Is a prepayment invoice a VAT invoice?

The answer is yes, provided it meets the statutory requirements outlined in VAT Notice 700, section 16. The document must clearly show:

• A unique identifying number.

• The supplier’s name, address, and VAT registration number.

• The date of issue (which acts as the tax point).

• The customer’s name and address.

• A description of the goods or services to which the prepayment relates.

• The total amount payable (the gross prepayment amount).

• The VAT rate and the amount of VAT charged.

Even if the invoice covers only a partial payment, it must detail the VAT attributable to that specific payment. Without such a document, the customer cannot legally recover the VAT, and the supplier has failed in their compliance duty.

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Is There VAT on Train Tickets in the UK?

Specific Case: Vat on deposits Forfeitable vs. Refundable

The treatment of deposits is often nuanced, resting on whether the deposit is truly non-returnable.

Non-Refundable (Forfeitable) Deposits:

If a deposit is taken to secure a supply and the business fully intends to keep that amount if the customer cancels, it is treated as consideration for that supply from the outset.

• Action: The supplier must immediately account for output VAT upon receipt. The amount of VAT on deposits is non-adjustable if the customer subsequently forfeits the money (i.e., cancels the contract and the supplier retains the cash). HMRC deems the retention of the cash as payment for the right to secure the booking, which is a taxable supply.

Fully Refundable Security Deposits:

Where a sum is held purely as security against potential damage or breach of contract (e.g., a deposit for hiring plant machinery or a tenancy security deposit), and is intended to be returned in full, it is generally not considered consideration for a taxable supply.

• Action: No VAT is due upon receipt. VAT only becomes chargeable if the security deposit is later retained in whole or in part (i.e., forfeited) to cover costs or losses. At the point of forfeiture, the retained amount becomes payment for a supply, triggering the tax point.

Customer Perspective on Reclaiming Input VAT

From the customer’s side, prepayments represent potential input tax, which is vital for managing cash flow and accurate financial reporting. The key query for any VAT-registered business making an advance payment is: can you claim VAT on prepayments?

The Mechanism for Input Tax Recovery

Provided the prepayment is for a taxable supply that will be used for the purpose of the customer’s business, the VAT element is reclaimable.

• Can you claim vat on prepaid expenses? Yes, absolutely. The ability to reclaim is linked to the Actual Tax Point (ATP). Since the supplier must account for the VAT upon receipt of the money (the ATP), the customer is simultaneously entitled to reclaim that VAT in the same period, provided they hold a valid VAT invoice documenting the transaction. It is not necessary to wait until the goods or services are delivered.

What is prepaid vat? Understanding the Terminology

When a customer pays an amount including VAT to a supplier for future services, the VAT portion is often referred to in accounting circles as “prepaid VAT”.

This is simply the input tax amount embedded within the prepayment. Because the VAT is reclaimable immediately (assuming an ATP is created by payment/invoice), it is critical that the customer processes this input tax claim immediately, rather than waiting for the goods or service to be physically received.

This immediate reclaim capability is a significant cash flow benefit for businesses making substantial advance payments for items like annual maintenance contracts, software licences, or machinery deposits.

Are prepayments net or gross of vat?

This is a fundamental point of clarity. When a price is quoted by a supplier who is VAT-registered, that price is often quoted gross (inclusive of VAT), unless explicitly stated otherwise.

Therefore, the payment remitted to the supplier for the advance invoice or deposit is almost always the gross amount.

For instance, if a business pays a £1,200 prepayment for a standard-rated service, the transaction breaks down as:

• Net Value: £1,000

• VAT (20%): £200

• Gross Prepayment: £1,200

When processing the transaction:

• The supplier records £1,000 as Deferred Income (Balance Sheet) and £200 as Output VAT (due to HMRC).

• The customer records £1,000 as Prepaid Expense (Balance Sheet) and reclaims £200 as Input VAT (from HMRC).

Therefore, the transactional payment is gross of VAT, and both parties must account for the VAT element immediately.

Advanced Compliance and Specific Scenarios

To provide the view of an expert tax advisor, we must delve into scenarios that complicate the straightforward rules.

Continuous Supplies and Prepayments

A continuous supply is one where the service is provided over a period of time, such as utility supplies, leased equipment, or long-term consultancy contracts.

While the basic rule for VAT on prepayments still applies (payment received triggers the tax point), special rules apply to regular invoicing.

For continuous supplies, the tax point is normally the date of issue of a VAT invoice or the date of payment, whichever occurs earlier.

If a business prepays for an entire year’s continuous supply (e.g., an annual subscription), the tax point for the entire prepayment is the date the payment is received, and the full VAT amount is due/reclaimable immediately. Periodic invoicing should follow the same pattern, ensuring the tax point is aligned with the invoice or payment date.

The Cash Accounting Scheme Impact

For businesses that elect to use the VAT Cash Accounting Scheme (generally available to those with VATable turnover below £1.35 million), the timing rules are simpler but often misunderstood in the context of prepayments.

The scheme allows businesses to account for output VAT only when they receive cash from customers, and reclaim input VAT only when they pay their suppliers.

• Supplier (Cash Accounting): The standard rule that VAT on advance payments is due upon receipt still holds true, as the core of the scheme is the receipt of cash.

• Customer (Cash Accounting): A business operating the cash scheme can only reclaim what is prepaid VAT when the actual payment is made to the supplier, which perfectly aligns with the prepayment itself.

The key benefit of the Cash Accounting Scheme is preventing a tax liability from arising merely upon the issue of an invoice that hasn’t yet been paid, but it does not delay the liability caused by cash receipt.

Dealing with Cancellations and Refunds

What happens when a supply is cancelled after a prepayment has been made and VAT has been accounted for?

Full Refund Issued:

If the supplier fully refunds the prepayment to the customer, they must issue a credit note to adjust the VAT charged. Both parties must reverse the original VAT entries:

• Supplier: Reduces Box 1 (Output VAT) and Box 6 (Net Sales) on their next VAT return.

• Customer: Reduces Box 4 (Input VAT reclaimed) and Box 7 (Net Purchases) on their next VAT return.

Forfeited Deposits (Non-Refundable Retentions):

As established, if a customer cancels and the non-refundable Vat on deposits is retained by the supplier, no adjustment is necessary.

The original output VAT remains due, as the retention is consideration for the supply of the right to the goods/service. The supplier must not issue a credit note, and the customer’s original input tax claim remains valid.

Partnerships and VAT Liability

A common query from firms with complex legal structures is: Does VAT apply to partnerships?

The answer is yes, but crucially, VAT applies to the entity carrying out the taxable supplies. A partnership, as defined by UK law, is a separate legal person for VAT purposes (as long as it is registered).

Therefore, prepayments made or received by the partnership are subject to all the rules outlined above. The individual partners are irrelevant to the partnership’s VAT accounting responsibilities, which are handled by the nominated representative or managing partner.

Key Compliance Mistakes to Avoid

1. Delayed Output Tax: The most frequent error is treating a prepayment as a balance sheet liability for too long, failing to remit the output VAT until the goods/services are delivered. This results in under-declaration of VAT and potential penalties from HMRC.

2. Invalid Invoicing: Issuing a simple “Receipt” or “Proforma Invoice” for a prepayment instead of a full VAT on advance payments invoice. This jeopardises the customer’s ability to reclaim the input tax.

3. Incorrect Gross/Net Treatment: Misunderstanding that the full payment received is Are prepayments net or gross of vat and failing to correctly extract the VAT element (e.g., dividing by 5 instead of 6 for the 20% rate).

4. Misclassifying Deposits: Assuming a deposit is not VATable when it is non-refundable or retained following cancellation.

Strategic Management: When and How to Reclaim

The power of immediate input tax recovery on prepayments is often underutilised. A well-managed finance function should:

1. Demand a Valid Invoice: Always insist on a full VAT invoice at the time of making the prepayment. Without this, you cannot reclaim the VAT, even though the supplier is legally obliged to have accounted for it.

2. Track Prepayments Separately: Ensure your accounting software automatically posts the VAT element of a prepayment to Box 4 (Input Tax) and the net amount to Box 7 (Net Purchases) immediately upon receipt of the invoice, allowing you to can you claim VAT on prepayments without delay.

Scenario	Supplier Action (Output VAT)	Customer Action (Input VAT)	Key VAT Term
Payment Received	Account for VAT immediately.	Reclaim VAT immediately (with invoice).	Actual Tax Point
Non-Refundable Deposit	Account for VAT immediately.	Reclaim VAT immediately (with invoice).	Vat on deposits
Fully Refundable Deposit	No VAT accounted for upon receipt.	No VAT reclaimable upon payment.	Security (Not Supply)
Cancellation (Deposit Kept)	No VAT adjustment (VAT remains due).	No VAT adjustment (Input tax claim stands).	Forfeiture is Taxable
Cancellation (Full Refund)	Issue Credit Note, adjust VAT returns.	Adjust VAT returns (reverse original claim).	Credit Note Requirement

FAQs: VAT on Prepayments

 

Q1: Can I reclaim VAT on a deposit if I don’t receive the final VAT invoice for the whole supply yet?

Yes, provided you have a valid VAT invoice or receipt that specifically relates to the deposit/prepayment amount and shows the supplier’s VAT number and the VAT element charged.

The deposit itself triggers an Actual Tax Point for that amount, allowing you to reclaim the VAT in that period, regardless of when the final invoice for the full supply is issued. This ability to can you claim VAT on prepayments is a key feature of UK VAT law.

Q2: Does VAT apply to partnerships?

Yes. If a partnership is VAT registered, it is treated as a single taxable entity. All VAT rules, including those concerning VAT on prepayments, apply to the partnership firm itself. The individual partners’ personal VAT statuses are irrelevant to the firm’s obligations.

Q3: Is a prepayment invoice a VAT invoice?

It must be, if VAT is charged. A document issued by a VAT-registered supplier detailing an advance payment and correctly stating the required statutory information (VAT number, date, amount, VAT charged) serves as a valid VAT invoice for the value of the payment received. Failure to issue such a document is a compliance breach and prevents the customer from reclaiming what is prepaid vat.

Q4: How does a non-refundable deposit affect my output VAT?

A non-refundable Vat on deposits is deemed consideration for the right to secure a supply. VAT must be charged immediately upon receipt of the deposit. If the customer subsequently cancels and the deposit is forfeited (retained), the original output VAT is still due to HMRC, and you do not issue a credit note.

Q5: Are prepayments net or gross of vat?

The total cash payment made for the prepayment is the gross amount (inclusive of VAT), assuming the supply is standard-rated. For example, a £500 VAT on advance payments is £416.67 net and £83.33 VAT. The gross amount is the cash that changes hands.

Q6: I am a supplier. Do you pay VAT on advance payments if I am using the Cash Accounting Scheme?

Yes. The Cash Accounting Scheme requires you to account for output VAT when you receive cash. Since a prepayment is cash received, it immediately creates a tax point and the VAT must be declared in the period of receipt.

The Bottom Line

The fundamental rule remains simple: the cash movement dictates the VAT liability. The moment you ask, Are prepayments vatable? the answer is contingent on whether that payment is consideration for a taxable supply.

For all standard-rated goods and services, the prepayment is indeed VATable immediately upon receipt.

Businesses often struggle with the fact that they do you pay VAT on advance payments? before the service has even been rendered, a consequence of the early tax point rules overriding the basic tax point. This is why strict compliance is mandatory.

In conclusion, effective management of VAT on prepayments requires vigilance from both the supplier and the customer. The supplier must issue a compliant prepayment invoice, a document that legally functions as a VAT invoice, to trigger the customer’s right to reclaim.

The customer, knowing they can you claim VAT on prepayments, must ensure they hold the necessary documentary evidence.

Understanding when and how VAT on advance payments is triggered, particularly how this relates to whether are prepayments net or gross of vat, separates compliant businesses from those facing HMRC scrutiny.

The complexity of what is prepaid vat is merely a reflection of the UK’s commitment to taxing consumption based on the flow of funds, rather than abstract accounting concepts.

By adopting the principles detailed here, specifically in regard to Vat on deposits and the conditions under which you can you claim vat on prepaid expenses, businesses can navigate this tricky area of VAT law with confidence and expertise.