Service charge or gratuity: how can you save VAT?

Service charge

When a service charge is added to an invoice or bill, it follows the same VAT rate as the service being supplied, i.e. standard-rated in most cases. So, for example, if you trade as a restaurant and add a 10% service charge to your customers’ bills, the 10% charge will include VAT.

If your customers give you an extra amount of money on top of this - a “tip” - this will be outside the scope of VAT because their payment is being given on a voluntary basis.

You will exclude the tip money from Box 6 of your VAT returns - the outputs box - because it does not relate to any supply of goods or services.

Alternative wording

A service charge is a compulsory payment and you will have made it clear to your customers that it will be due on, perhaps, the menu if you are a restaurant business, or any other contract or order terms. However, if you change the wording to one of the following phrases, you will not have to pay VAT because your customers will then be making a voluntary payment:

• discretionary service charge - the word discretionary gives the customer the option to not pay it
• optional service charge
• gratuity.

However, if you opt for any of these wordings, you must not insist on payment from your customers if they decide not to pay. In other words, the customer is in complete control about whether they pay or not. The phrase used in HMRC’s manual is that the payments must be freely given.

Compromise solution?

There is no reason why you cannot mix and match your service charge arrangements. For example, you might decide to add a compulsory service charge to any party of ten or more people, e.g. on the basis that bigger parties require more time and effort from you and your staff, but a discretionary service charge for parties of fewer than ten people. The priority is to ensure that you are clear about your service charge policy, which must be clearly communicated to your customers.

Your till system will need to be able to differentiate between taxable service charges and non-taxable optional payments so that you don’t under or overpay output tax on your VAT returns.

Deposits

If your business receives an advance deposit from a customer for a supply of goods or services, output tax will be payable on the VAT return that includes the date of the payment. The receipt of the deposit creates a tax point, even though it is being received before you have made any supply.

If you subsequently refund a deposit to your customer, perhaps because they have cancelled their booking with your consent, you can adjust your output tax on your return.

If you retain the deposit, you cannot reduce your output tax even if the customer has not received any supply of goods or services from you.