When you get a bill at a restaurant, it will normally state that the service charge is 'discretionary'. This allows the customer the freedom to withhold payment. It also has a VAT benefit — VAT is not charged on discretionary service charges.
Why is this the case? Since the payment is optional, it is not considered as a taxable supply provided by the restaurant. If the service charge was mandatory, it would be subject to VAT. The same principle applies to tips — because they are freely given, they are outside the scope of VAT.
This is the basics of the VAT system, one of the most complex taxes.
Understanding VAT Basics
VAT applies to:
- a supply of goods or services
- by a taxable person (somebody registered or registerable for VAT)
- in the course or furtherance of a business.
The taxable amount is what is received in exchange for goods or services. Applying this to restaurants, the charge for food and drinks is subject to VAT as it meets the criteria above. However, discretionary service charges ar outside the scope of VAT because they are not directly linked to a supply.
When VAT becomes more complex
VAT rules do inevitably get more complex and controversial, and court cases continue to consider the amount that VAT is calculated on.
For example, recent cases have considered whether car parking overpayments should be subject to VAT. There seems little difference between a discretionary payment for a ‘service’ and an additional payment forced through a lack of proper change.
A key case involved National Car Parks Ltd, which had to pay VAT on overpayments amounting to £500,000. The company's payment machines displayed "no change given, overpayment accepted." The courts ruled that the full amount paid — regardless of what was displayed on the machine or ticket — was taxable. Where a customer pays £1.50, that is the amount received by the supplier and the amount for VAT purposes. This decision highlights that VAT law considers what is actually paid, rather than contract terms alone.
The wider VAT principle
The courts apply a broad approach to consideration for VAT purposes.
Arguably, the treatment of catering service charges is out of step with developing case law. But fundamentally, it is a great example of how VAT works: if you pay for something, that is the relevant amount for VAT purposes. If you give something voluntarily (eg. a tip), that is freely given and not consideration for VAT purposes.
The principle is important and applies more widely. If money is freely given, it is outside the scope of VAT. This can be useful when considering the VAT registration threshold: turnover should not include tips and so this might keep you under the registration limit if removed from turnover.
It it good to note that you can always find exceptions in the complexity of case law and wider interpretation.
The next step
If you are a restaurant operator and have been accounting for VAT on discretionary service charges or tips, then you may be able to claim a retrospective rebate from HMRC.
If you would like any advice about the topics covered in this article, please contact Sean Glancy or your usual UHY VAT adviser.
