How Does VAT Work on Deposits and Prepayments

Many businesses ask when VAT becomes due on deposits or prepayments, particularly in industries where customers pay before goods are delivered or services are completed. HMRC treats deposits, advance payments, and part payments as taxable events, which means VAT may need to be charged before the final sale. Understanding these rules ensures your VAT returns are accurate and prevents potential errors during inspections. This article explains how VAT works on deposits and prepayments, when to account for it, and what happens if a sale is cancelled or refunded.

When VAT Becomes Due on Deposits or Prepayments

Under UK VAT law, VAT is normally due at the earlier of:

  1. The date the goods or services are supplied.

  2. The date payment is received (including deposits or prepayments).

  3. The date an invoice is issued.

This rule means that if a customer pays a deposit or full prepayment before you provide the goods or services, VAT becomes due at the time you receive the money, not when you deliver the product or complete the job.

For example, if a customer pays a £500 deposit in January for a service to be completed in March, you must account for VAT on the £500 in your January VAT return.

Deposits as Part of the Total Payment

A deposit is typically a portion of the total price paid upfront to secure goods or services. HMRC considers deposits to be advance payments, so VAT must be charged on the amount received if the sale is taxable.

When the final payment is made, VAT is charged on the remaining balance, but only on the net amount still due after the deposit.

Example:
You sell a piece of equipment for £1,200 plus VAT. The customer pays a £200 deposit to reserve it.

  • VAT on the deposit (£200 × 20%) = £40, due when the deposit is received.

  • The remaining £1,000 balance is charged VAT when the goods are delivered.

Both amounts are included in the total VAT you must declare, but the timing of when VAT is accounted for is split between payments.

Prepayments for Goods and Services

If a customer pays in full before receiving goods or services, the payment is treated as a prepayment for VAT purposes. VAT is due on the date you receive the money, even if delivery or completion occurs later.

You must issue a VAT invoice showing the amount paid and the VAT charged at that time. When the goods or services are provided, you do not charge VAT again unless the price changes.

Example:
A training company charges £1,200 for a course starting next month. A client pays in full today. The business must account for VAT now, not when the course begins.

When No VAT Is Due on Deposits

There are some circumstances where VAT does not need to be charged on a deposit:

  • The deposit is held as security and will be refunded if the contract is fulfilled.

  • The payment is non-returnable only if the customer fails to meet conditions, such as not showing up for a booking.

In these cases, VAT is not due until it becomes clear that the deposit will be retained.

For instance, a hotel taking a £100 refundable deposit for potential damage does not charge VAT initially. If no damage occurs and the deposit is refunded, no VAT applies. If the deposit is kept to cover damages, VAT becomes due at that point because the payment has effectively become part of the sale or service.

Cancellations and Refunds

If a customer cancels an order and you refund the deposit, you can adjust your VAT records to reclaim or remove the VAT previously accounted for.

If the deposit is non-refundable, HMRC generally treats it as a payment for a supply that has still taken place, meaning VAT remains due even though the customer receives no goods or services.

Example:
A holiday rental company requires a 20 percent deposit at booking, which is non-refundable if cancelled. If the customer cancels, the company keeps the deposit and must still account for VAT on the amount retained.

Deferred or Staged Payments

For staged or milestone payments where a project is completed over time, VAT is due on each payment as it is received or invoiced.

If the contract clearly defines payment stages, each stage is treated as a separate taxable supply. Businesses in construction, consultancy, and manufacturing often use this approach to manage cash flow and VAT timing.

Example:
A design agency agrees a £10,000 contract payable in four instalments. VAT is charged and accounted for each time a stage payment is received or invoiced, not at the end of the project.

Deposits in the Flat Rate Scheme

If your business uses the Flat Rate VAT Scheme, VAT on deposits and prepayments is accounted for at the flat rate percentage when the payment is received. You do not separately reclaim input VAT on purchases, so the flat rate calculation simplifies how deposits are handled.

It is important to ensure that all advance payments are included in your gross turnover figures for the period in which they are received.

Exported Goods and Deposits

If you receive a deposit for goods that will be exported outside the UK, VAT treatment depends on whether the sale qualifies as a zero-rated export.

You can only zero-rate the deposit if you can provide evidence that the goods will be exported within the required time frame, usually three months. Until export documentation is complete, you may need to charge VAT at the standard rate and adjust later once the export is confirmed.

How to Record Deposits and Prepayments in Your VAT Returns

When recording deposits or prepayments in your accounting system:

  1. Record the payment as income in the period it is received.

  2. Calculate the VAT due and include it in your VAT return for that period.

  3. When issuing the final invoice, deduct the deposit from the total and adjust the VAT accordingly.

  4. Keep clear records linking the deposit to the final sale for audit purposes.

Accurate bookkeeping ensures you report VAT in the correct period and avoid discrepancies if HMRC reviews your returns.

Common Mistakes to Avoid

VAT errors often arise from misclassifying deposits or failing to recognise when VAT becomes due. Avoid these common mistakes:

  • Treating refundable deposits as taxable when no supply has occurred.

  • Forgetting to charge VAT on prepayments.

  • Delaying VAT accounting until goods are delivered.

  • Failing to issue VAT invoices for advance payments.

  • Not adjusting VAT after refunding a deposit.

Maintaining consistent processes and using VAT-compliant accounting software can help you avoid these issues.

How an Accountant Can Help

A VAT accountant can help ensure your treatment of deposits and prepayments complies with HMRC’s complex rules. They can:

  • Review your terms and conditions to determine when VAT is due.

  • Set up accounting software to automate VAT recognition for advance payments.

  • Advise on cash flow management when VAT is due before services are delivered.

  • Correct VAT errors and handle HMRC audits or queries.

Professional guidance is particularly useful for businesses with large advance payments or those operating in sectors like construction, travel, or hospitality.

Summary

VAT becomes due on deposits and prepayments at the time the payment is received, even if goods or services are supplied later. Refundable deposits held as security are not subject to VAT unless retained. Non-refundable deposits, however, are always taxable.

By recording payments correctly, issuing VAT invoices promptly, and adjusting for refunds where necessary, you can stay compliant and avoid penalties. Working with an accountant helps ensure that all advance payments are handled accurately and efficiently within your VAT returns.