How Does VAT Work on Deposits and Prepayments

As a chartered accountant running my own firm, I see VAT mistakes around deposits and prepayments far more often than people realise. In many cases, the business has done nothing deliberately wrong. They have simply assumed that VAT only becomes due when the work is finished or when the final invoice is raised. Unfortunately, VAT does not work like that.

Deposits and prepayments have their own VAT rules, and HMRC apply them very strictly. Get this area wrong and VAT can quietly fall into the wrong VAT period, leading to interest, penalties, and stressful investigations later on. Get it right and VAT becomes predictable and manageable.

In this article, I am going to explain clearly and practically how VAT works on deposits and prepayments in the UK. I will cover when VAT becomes due, how tax points work, how deposits differ from advance payments, what happens if work is cancelled, and the most common mistakes I see HMRC challenge. This is written exactly how I explain it to clients, in plain UK English, with real world examples.

The basic VAT principle you need to understand first

Before looking at deposits specifically, there is one core VAT principle that everything else flows from.

VAT is triggered by the tax point.

The tax point is the point in time when VAT becomes due to HMRC. It determines which VAT return the VAT must be included on.

For most supplies, the tax point is the earlier of:

• The date you issue a VAT invoice

• The date you receive payment

This rule is what causes most problems with deposits and prepayments.

What HMRC mean by deposits and prepayments

In everyday language, people use deposit and prepayment interchangeably. HMRC do not always see them the same way.

In VAT terms:

• A prepayment is money paid in advance for a supply that will take place later

• A deposit is also money paid in advance, but it may or may not be refundable depending on the contract

From a VAT perspective, both usually trigger VAT when they are received.

The label you use does not override the VAT rules.

When VAT becomes due on a deposit

In most cases, VAT becomes due when you receive the deposit.

If a customer pays you a deposit towards a future supply, and that payment is linked to a specific supply, VAT is normally due at that point.

This applies even if:

• The work has not started

• The goods have not been delivered

• The final price is not yet known

• The job may not be completed for months

Once you have received payment, a tax point is created.

A simple example to make this clear

You are VAT registered and you agree to carry out work for a client for £10,000 plus VAT.

The client pays a £3,000 deposit in advance.

At the point you receive the £3,000, VAT is due on that amount.

You should account for:

• £3,000 net

• £600 VAT at 20 percent

That £600 must be included on your VAT return for the period in which the deposit was received.

You cannot wait until the job is finished to account for that VAT.

Deposits versus security deposits

There is one important exception that needs careful handling.

A true security deposit does not usually trigger VAT when it is received.

A security deposit is money held purely as security, not as payment for a supply.

Common examples include:

• Property damage deposits

• Equipment hire deposits

• Performance bonds

For VAT purposes, a security deposit does not create a tax point if:

• It is genuinely refundable

• It is not intended to be used as payment for the supply

• It is only retained if certain conditions are breached

However, if the deposit is later used as payment, VAT becomes due at that point.

Why HMRC challenge security deposits

In practice, HMRC are sceptical of deposits described as security deposits.

If the deposit is automatically offset against the final invoice, HMRC are likely to argue that it was always a prepayment and VAT should have been charged when it was received.

Clear contracts and wording matter a great deal in this area.

Advance payments and VAT

Advance payments are treated very clearly under VAT law.

If a customer pays you in advance for goods or services, VAT is due when you receive that payment.

This applies regardless of how far in advance the payment is made.

Advance payments almost always create a tax point.

Issuing invoices for deposits and prepayments

If you receive a deposit or prepayment, you should usually issue a VAT invoice for that amount.

The invoice should show:

• The amount received

• The VAT rate applied

• The VAT amount

• A description making it clear it is a deposit or advance

This keeps your records clear and avoids confusion later.

Failing to issue VAT invoices for deposits is a common HMRC criticism.

Deposits and the final invoice

When the job is completed and the final invoice is raised, VAT is only due on the remaining balance.

Using the earlier example:

• Total contract value, £10,000 plus VAT

• Deposit paid, £3,000 plus VAT

• Balance due, £7,000 plus VAT

The final invoice should:

• Show the full contract value

• Deduct the deposit net amount

• Deduct the VAT already charged on the deposit

• Charge VAT only on the remaining balance

This ensures VAT is not charged twice.

VAT periods and timing issues

One of the biggest risks with deposits is VAT falling into the wrong VAT period.

If you receive a deposit near the end of a VAT quarter and fail to include it, HMRC will treat this as underdeclared VAT.

Even small timing errors can lead to:

• Interest

• Penalties

• Increased HMRC scrutiny

This is why businesses with deposits need strong bookkeeping processes.

Deposits under the cash accounting scheme

The cash accounting scheme does not change the basic rule for deposits.

Under cash accounting:

• VAT is still due when payment is received

• Deposits and prepayments still trigger VAT

The difference is that VAT on sales is not due until payment is received, but a deposit is payment.

So VAT is still due at that point.

Deposits under the Flat Rate Scheme

Under the Flat Rate Scheme:

• You still charge VAT on deposits

• You still account for VAT when payment is received

• You apply your flat rate percentage to the VAT inclusive amount received

The flat rate scheme does not delay VAT on deposits.

I regularly see businesses misunderstand this and underpay VAT as a result.

Prepayments for goods and VAT

Prepayments for goods follow the same basic rule.

If a customer pays in advance for goods, VAT is due when the payment is received.

This applies even if:

• The goods are bespoke

• The goods are not yet manufactured

• Delivery will take place much later

The key point is that the payment relates to a specific supply.

What happens if the price is not finalised

Sometimes a deposit is paid before the final price is agreed.

In these cases, VAT is still due on the amount received.

If the final price changes later:

• VAT is adjusted on the final invoice

• Credit notes may be required if the price reduces

Uncertainty over pricing does not delay VAT.

Deposits for zero rated or exempt supplies

The VAT treatment of the deposit follows the VAT treatment of the underlying supply.

If the supply is:

• Zero rated, VAT is charged at 0 percent on the deposit

• VAT exempt, no VAT is charged on the deposit

• Standard rated, VAT is charged at 20 percent on the deposit

The deposit does not change the nature of the supply.

Deposits and cancelled contracts

This is another area that causes confusion.

If a contract is cancelled and the deposit is refunded in full:

• Any VAT charged should be refunded

• A credit note should be issued

• VAT should be adjusted on the VAT return

If the deposit is retained, the VAT position depends on why it is retained.

Retained deposits and VAT

If a deposit is retained as compensation for cancellation, HMRC may treat it as consideration for a supply or for agreeing to cancel.

In many cases, retained deposits are subject to VAT.

HMRC take the view that the customer has received something in return, such as:

• The right to cancel

• Compensation for lost business

This area has been the subject of case law, and HMRC often challenge retained deposits.

Advice is strongly recommended where deposits are regularly retained.

Deposits and vouchers

Deposits should not be confused with vouchers.

Vouchers have their own VAT rules, particularly where they can be redeemed for multiple supplies.

Calling something a deposit does not make it a voucher, and vice versa.

The VAT treatment depends on what the customer is actually paying for.

Deposits in construction and long term projects

Construction businesses are particularly exposed to deposit VAT issues.

Large contracts, stage payments, and advance payments are common.

Each payment usually creates a tax point.

Failing to account for VAT on stage payments is one of the most common errors HMRC identify in construction VAT inspections.

Deposits and international supplies

For cross border supplies, deposits can create additional complexity.

VAT treatment depends on:

• Where the supply takes place

• Whether the supply is of goods or services

• Reverse charge rules

• Export or zero rating conditions

The receipt of a deposit does not override place of supply rules.

How HMRC check deposits and prepayments

HMRC commonly check deposits by reviewing:

• Bank statements

• Customer receipts

• Sales ledgers

• Contracts and terms

• Timing of invoices versus payments

If payments appear in the bank before VAT is declared, HMRC will ask questions.

Common mistakes I see with deposits and VAT

In practice, the same errors appear again and again.

These include:

• Not charging VAT on deposits

• Treating deposits as outside the scope incorrectly

• Accounting for VAT only on the final invoice

• Poorly worded contracts

• Confusing security deposits with prepayments

• Missing deposits near VAT period ends

Most of these errors are avoidable.

How to protect yourself from VAT problems with deposits

Based on my experience, good practice includes:

• Clear contract wording

• Clear distinction between deposits and security deposits

• Issuing VAT invoices promptly

• Regular bank to sales reconciliations

• Reviewing deposits at VAT quarter ends

Simple controls make a big difference.

What to do if you have made mistakes

If you discover that VAT on deposits has been missed:

• Quantify the error

• Identify the affected VAT periods

• Consider voluntary disclosure to HMRC

• Correct processes going forward

Early disclosure significantly reduces penalties.

Final thoughts from real world experience

VAT on deposits and prepayments is one of those areas that feels counterintuitive until you understand the tax point rule. Once you do, everything becomes clearer.

The key takeaway is simple. If money comes in before the work is done and it relates to a specific supply, VAT is usually due at that point. Waiting until the job is finished is almost always too late.

In my experience, businesses that deal with deposits confidently are not the ones that try to delay VAT. They are the ones that understand the rules, price correctly from the start, and build VAT into their cash flow planning.

Get this right, and deposits stop being a VAT risk and become just another routine part of doing business.