How do I calculate VAT on discounts and refunds?

Understanding VAT when prices change

Value Added Tax (VAT) feels straightforward when a customer pays the ticket price and you apply the correct VAT rate. The confusion usually starts when the original price changes after the fact—because you apply a discount, issue a refund, accept a return, or provide a credit note. In these situations, the key question becomes: what is the “taxable amount” now that the customer is paying less (or paying nothing at all)?

VAT is ultimately a tax on consumption. If the customer’s final consumption value is lower than the original invoice, then the VAT due should generally be lower as well. That sounds simple, but the mechanics depend on how your prices are quoted (VAT-inclusive or VAT-exclusive), how the discount is structured (percentage vs fixed, before payment vs after), and whether you are refunding the entire transaction or only part of it (e.g., one item on a multi-item invoice, shipping, or a restocking fee).

This guide walks through the practical calculations you need for VAT on discounts and refunds. It focuses on the arithmetic and logic you can apply day-to-day, including clean formulas, step-by-step examples, and common traps that cause incorrect VAT reporting.

Start with two essential concepts: VAT-exclusive vs VAT-inclusive prices

Before doing any VAT calculations on discounts or refunds, you must know whether the amounts you are working with include VAT or exclude VAT. Many mistakes happen because someone applies a VAT rate to a VAT-inclusive figure, which effectively charges VAT “on VAT.”

VAT-exclusive pricing

In a VAT-exclusive model, your listed price is the net amount (sometimes called the taxable value). VAT is calculated on top:

Gross (VAT-inclusive) = Net + VAT

VAT = Net × VAT rate

Gross = Net × (1 + VAT rate)

VAT-inclusive pricing

In a VAT-inclusive model, your listed price is the gross amount the customer pays. VAT is embedded in it. To extract VAT or net from a VAT-inclusive amount, you use a fraction:

Net = Gross ÷ (1 + VAT rate)

VAT = Gross − Net

Or equivalently:

VAT = Gross × (VAT rate ÷ (1 + VAT rate))

That last formula is extremely useful for refunds when you only know the VAT-inclusive amount you returned to the customer.

What VAT is based on when discounts apply

VAT is calculated on the amount actually charged for the supply of goods or services, subject to local VAT rules. In practical bookkeeping terms, you typically reduce the taxable amount when you provide a discount that genuinely reduces the consideration paid by the customer. The VAT should be reduced proportionally in line with the reduced price, assuming the discount is directly linked to the sale.

Discounts that reduce the selling price

The simplest case is a discount that lowers the selling price of an item, such as “10% off” or “£20 off.” In that case, the taxable amount becomes the discounted net amount (or the discounted gross amount, if your prices are VAT-inclusive), and VAT is computed from that discounted amount.

Discounts that act like a separate payment (coupons funded by third parties)

Some discounts are not “true discounts” from a VAT standpoint because the supplier still receives full consideration—part from the customer and part from someone else (such as a manufacturer reimbursement). The VAT treatment can be different when a third party subsidizes the price. The arithmetic might still look similar, but the taxable amount could remain closer to the full price if you are effectively being paid by someone else. Because rules vary by jurisdiction, always confirm how such schemes should be recorded in your VAT system. For everyday calculations, make sure your accounting setup correctly distinguishes a price discount from an externally funded subsidy.

How to calculate VAT on a discount: VAT-exclusive prices

Let’s start with VAT-exclusive pricing because it’s the most direct. You have a net price, you apply a discount to the net price, and then you compute VAT on the discounted net.

Percentage discount on net price

Suppose:

Net price = 100.00

VAT rate = 20% (0.20)

Discount = 10%

Discounted net = 100.00 × (1 − 0.10) = 90.00

VAT = 90.00 × 0.20 = 18.00

Gross = 90.00 + 18.00 = 108.00

Notice what changed: VAT decreased from 20.00 to 18.00 because the taxable amount decreased from 100.00 to 90.00.

Fixed-amount discount on net price

Suppose:

Net price = 100.00

VAT rate = 20%

Discount = 15.00 (fixed amount)

Discounted net = 100.00 − 15.00 = 85.00

VAT = 85.00 × 0.20 = 17.00

Gross = 85.00 + 17.00 = 102.00

Multiple items with a discount applied across the invoice

The arithmetic becomes more delicate when you apply one overall discount to a basket containing different VAT rates (for example, standard-rated and reduced-rated items), or items that are exempt/zero-rated. In most VAT systems, you cannot simply apply the entire discount to one item unless the discount is specifically linked to that item. Instead, you typically need to apportion the discount across the items in a fair way, usually in proportion to the net values of each VAT category.

Example with two VAT rates:

Item A (20% VAT): net 80.00

Item B (5% VAT): net 20.00

Total net = 100.00

Invoice-level discount = 10.00 net (or a discount that reduces the net by 10.00)

Apportion discount based on each item’s share of the total net:

Item A share = 80.00 / 100.00 = 80%

Item B share = 20.00 / 100.00 = 20%

Discount allocated to A = 10.00 × 80% = 8.00

Discount allocated to B = 10.00 × 20% = 2.00

Discounted net A = 80.00 − 8.00 = 72.00

VAT on A = 72.00 × 20% = 14.40

Discounted net B = 20.00 − 2.00 = 18.00

VAT on B = 18.00 × 5% = 0.90

Total VAT = 15.30

This method preserves the correct VAT rate for each item and ensures the discount reduces VAT proportionately across rates.

How to calculate VAT on a discount: VAT-inclusive prices

VAT-inclusive discounts are where people often slip up. If the customer sees a discount applied to the final checkout price (which includes VAT), you can do the calculations from the gross amount, but you must extract the VAT correctly.

Percentage discount on a VAT-inclusive price

Suppose:

Gross price (VAT-inclusive) = 120.00

VAT rate = 20%

Discount = 10%

Discounted gross = 120.00 × (1 − 0.10) = 108.00

Now extract VAT and net from the discounted gross:

Net = 108.00 ÷ 1.20 = 90.00

VAT = 108.00 − 90.00 = 18.00

The result matches what you would have gotten under VAT-exclusive pricing because the math is consistent.

Fixed-amount discount on a VAT-inclusive price

Suppose:

Gross price = 120.00

VAT rate = 20%

Discount = 12.00 off the gross total

Discounted gross = 120.00 − 12.00 = 108.00

Net = 108.00 ÷ 1.20 = 90.00

VAT = 18.00

Be careful: if someone instead tried to subtract 12.00 from the net and then recalculate VAT, they would be mixing gross and net figures incorrectly.

Apportioning VAT-inclusive discounts across different VAT rates

When your basket includes multiple VAT rates and your discount is given as a VAT-inclusive amount (for example, “£10 off your order” at checkout), you typically need to allocate the discount across VAT categories based on the VAT-inclusive amounts in each category, then extract net and VAT category by category. This preserves the correct VAT per rate.

Example:

Category 1 (20% items): gross 96.00

Category 2 (5% items): gross 21.00

Total gross = 117.00

Discount on total gross = 11.70 (10% off total gross, or a coupon worth 11.70)

Allocate the discount by each category’s share of the gross:

Cat 1 share = 96.00 / 117.00 ≈ 82.0513%

Cat 2 share = 21.00 / 117.00 ≈ 17.9487%

Discount allocated to Cat 1 ≈ 11.70 × 82.0513% ≈ 9.60

Discount allocated to Cat 2 ≈ 11.70 × 17.9487% ≈ 2.10

Discounted gross Cat 1 = 96.00 − 9.60 = 86.40

Discounted gross Cat 2 = 21.00 − 2.10 = 18.90

Now extract VAT from each discounted gross category:

Cat 1 net = 86.40 ÷ 1.20 = 72.00; VAT = 14.40

Cat 2 net = 18.90 ÷ 1.05 = 18.00; VAT = 0.90

Total VAT = 15.30

Again, you end up consistent with the VAT-exclusive example, but the route is adapted to VAT-inclusive figures.

Refunds: what you are actually doing to the VAT

A refund typically reverses all or part of the original sale. If you fully undo the sale, you should generally undo the VAT in the same proportion. If you partially undo the sale (such as refunding one line item, refunding shipping, or offering a partial goodwill refund), the VAT adjustment should match the portion you reversed and the VAT rate(s) that applied.

Think of a refund as a negative sale. The easiest way to stay accurate is to link the refund to the original invoice lines and VAT rates. Many accounting and e-commerce platforms do this automatically, but it’s still important to understand the underlying math so you can reconcile, spot issues, and handle edge cases.

How to calculate VAT on a full refund

A full refund means the customer returns everything and you return the full amount paid (or you cancel before supply, depending on the scenario). The VAT adjustment should reverse the original VAT charged.

Full refund where your original sale price was VAT-exclusive

Original sale:

Net = 200.00

VAT rate = 20%

VAT = 40.00

Gross = 240.00

Full refund issued:

Net refunded = 200.00

VAT refunded = 40.00

Gross refunded = 240.00

In bookkeeping, you typically reduce your net sales by 200.00 and reduce your VAT due by 40.00.

Full refund where your original sale price was VAT-inclusive

Original gross paid = 240.00, VAT rate 20%. If you refund the same 240.00, the VAT embedded in the refund is:

VAT refunded = 240.00 × (0.20 ÷ 1.20) = 240.00 × 0.1666667 = 40.00

Net refunded = 240.00 − 40.00 = 200.00

This is the core “VAT extraction” method for gross refunds. It is particularly useful when your payment processor or platform reports refunds only as gross figures.

How to calculate VAT on a partial refund

Partial refunds are more common than full refunds: a customer keeps some items, returns others, receives a price adjustment, or you issue a goodwill credit. The VAT calculation depends on what exactly you are refunding and whether the refund relates to specific goods/services and their VAT rates.

Partial refund of a specific item line

If you refund a specific item that had a clear VAT rate, you can simply reverse that line’s net and VAT.

Example:

Item sold net 50.00, VAT 20% = 10.00, gross 60.00

Customer returns item, you refund the full line gross 60.00

VAT to reverse = 60.00 × (0.20 ÷ 1.20) = 10.00

Net reversal = 50.00

Partial refund as a percentage of the original gross total

Sometimes you refund “20% of the order” due to a service issue, or you refund a fixed amount that isn’t tied to one specific item. In those cases, you should determine what portion of the taxable amount the refund represents and apply VAT accordingly. If the original order had only one VAT rate, the math is straightforward. If multiple VAT rates were involved, you should apportion the refund across VAT categories.

Single VAT rate example (VAT-inclusive):

Original gross = 120.00, VAT rate 20%

Goodwill refund = 30.00 gross

VAT portion of refund = 30.00 × (0.20 ÷ 1.20) = 5.00

Net portion of refund = 25.00

So you reduce VAT due by 5.00.

Partial refund on a multi-rate order

Assume:

20% category gross = 96.00

5% category gross = 21.00

Total gross = 117.00

Refund = 23.40 (20% of the total gross)

Allocate the refund across categories by their gross shares:

20% share = 96.00 / 117.00 ≈ 82.0513%

5% share = 21.00 / 117.00 ≈ 17.9487%

Refund allocated to 20% cat ≈ 23.40 × 82.0513% ≈ 19.20

Refund allocated to 5% cat ≈ 23.40 × 17.9487% ≈ 4.20

Extract VAT by category:

VAT reversed (20%) = 19.20 × (0.20 ÷ 1.20) = 3.20

VAT reversed (5%) = 4.20 × (0.05 ÷ 1.05) = 0.20

Total VAT reversed = 3.40

This method ensures the VAT reversal matches the original VAT composition of the sale.

Discounts after the sale: credit notes and retrospective rebates

Not all discounts happen at the time of sale. Businesses often agree rebates based on volume, loyalty, or performance that are calculated later. Alternatively, you might issue a “make-good” discount after invoicing due to a complaint. In many VAT systems, if a discount is granted after the supply and it reduces the amount the customer ultimately pays, you adjust VAT via a credit note (or equivalent document) and record it in the period it is issued, subject to local reporting rules.

The calculation is the same as any other reduction in consideration: determine whether the credit note amount is net or gross, apply the VAT rate(s) that were on the original supply, and adjust your VAT accordingly.

Retrospective discount on a VAT-exclusive invoice

Original invoice net 1,000.00 at 20% VAT. Later you agree a 5% rebate on net:

Rebate net = 1,000.00 × 5% = 50.00

VAT reduction = 50.00 × 20% = 10.00

Credit note gross = 60.00

Retrospective discount given as a VAT-inclusive amount

If you instead agree “£60 credit” and that credit is VAT-inclusive at 20%:

VAT reduction = 60.00 × (0.20 ÷ 1.20) = 10.00

Net reduction = 50.00

Same result, different starting point.

Returns, refunds, and the difference between reversing VAT and charging fees

Real-world refunds often include complications: restocking fees, non-refundable shipping, cancellation charges, or service fees. These details matter because they change what portion of the original consideration is actually being returned to the customer. VAT generally follows the consideration that remains with the supplier and the consideration that is reversed.

Non-refundable shipping

If shipping was charged and is not refunded, then the taxable amount for shipping is not reversed, and neither is the VAT related to it. If shipping is refunded, then you reverse shipping VAT accordingly. The critical point is to treat shipping as its own line with its own VAT treatment rather than lumping it into the item refund without thought.

Restocking fees or cancellation charges

A restocking fee means you do not refund the full original consideration. In effect, you are still charging the customer something, and VAT may apply to that fee depending on the VAT rules for that type of charge and the nature of the supply. Practically, you can think of it as: original sale minus refund equals amount retained. Your VAT should align with the amount retained.

Example (single VAT rate, VAT-inclusive):

Original gross paid = 120.00 at 20%

You refund 100.00 and retain 20.00 as a restocking fee

VAT on amount retained = 20.00 × (0.20 ÷ 1.20) = 3.33 (rounded according to your rules)

VAT reversed = original VAT − VAT retained

Original VAT = 120.00 × (0.20 ÷ 1.20) = 20.00

VAT reversed = 20.00 − 3.33 = 16.67

In documentation, it can be clearer to show the refund lines and a separate fee line so that the VAT is transparent.

Rounding: the quiet source of VAT discrepancies

Rounding is one of the most common reasons your VAT totals don’t match your payment totals or why your VAT return doesn’t reconcile neatly with sales reports. Discounts and refunds amplify rounding issues because you may be recalculating net and VAT on smaller amounts, across multiple lines, and across multiple VAT rates.

Line-level vs invoice-level rounding

Some systems round VAT per line item and then sum; others compute VAT on the total taxable amount and round once. Both can be acceptable depending on the jurisdiction and your accounting method, but mixing methods within the same workflow creates discrepancies.

If your platform calculates VAT per line, then a discount that changes line values should also be applied per line to keep the VAT consistent with the system’s rounding behavior. If you apply a discount at invoice level but your VAT is line-level, you may need to apportion the discount across lines and then let each line’s VAT be recalculated and rounded.

Rounding refunds back to the original VAT

When refunding, the safest approach is to reverse the original VAT amounts as recorded (especially if the refund corresponds to a specific line). If you recompute VAT from scratch using extraction formulas, you may get a one-cent difference due to rounding, particularly when the original invoice used line rounding and the refund is processed as a single gross amount. Good systems store the original net/VAT split per line and use that to generate credit notes.

If you must compute from a gross refund amount, apply consistent rounding rules and document your approach so your finance team can explain minor rounding variances during reconciliation.

Worked examples you can reuse

Below are reusable templates. You can plug in your own numbers and VAT rates.

Template 1: VAT-exclusive price with a percentage discount

Inputs:

Net = N

VAT rate = r

Discount rate = d

Steps:

Discounted net = N × (1 − d)

VAT = Discounted net × r

Gross = Discounted net × (1 + r)

Template 2: VAT-inclusive price with a fixed discount

Inputs:

Gross = G

VAT rate = r

Discount gross amount = D

Steps:

Discounted gross = G − D

Net = Discounted gross ÷ (1 + r)

VAT = Discounted gross − Net

Template 3: Gross refund with one VAT rate

Inputs:

Refund gross amount = R

VAT rate = r

Steps:

VAT reversed = R × (r ÷ (1 + r))

Net reversed = R − VAT reversed

Template 4: Allocate a gross discount or refund across two VAT categories

Inputs:

Category A gross = GA with VAT rate rA

Category B gross = GB with VAT rate rB

Total gross = GT = GA + GB

Discount/refund gross amount = X

Steps:

Allocate to A: XA = X × (GA ÷ GT)

Allocate to B: XB = X × (GB ÷ GT)

VAT reversed/discounted for A: VATA = XA × (rA ÷ (1 + rA))

VAT reversed/discounted for B: VATB = XB × (rB ÷ (1 + rB))

Total VAT adjustment = VATA + VATB

Then compute net adjustments as XA − VATA and XB − VATB.

Common scenarios and how to handle them

Scenario: “Buy one get one free” (BOGO)

BOGO deals are effectively a discount, but the correct VAT treatment can depend on whether you treat one item as free or you spread the discount across both items. Practically, many businesses allocate the total consideration across the items supplied so that each item has a reduced taxable amount. If both items are the same VAT rate, this is easy. If they differ, apportionment becomes important to keep VAT correct per category.

Example (same VAT rate, VAT-exclusive):

Two items normally net 50.00 each at 20% VAT, total net 100.00.

BOGO means customer pays net 50.00 total.

Allocate net 25.00 to each item, VAT 5.00 each, gross 30.00 each, total gross 60.00.

This approach avoids showing one item at full price and one at zero, which can create distortions in margin reporting and returns processing.

Scenario: Refund after a discounted sale

When an item was discounted at the time of sale and later refunded, you refund what the customer paid, not the pre-discount list price. VAT reverses based on the discounted amount. The best method is to refund exactly the original line’s net and VAT split (or the gross paid and extracted VAT) so the credit matches the original transaction.

Scenario: Partial return from a multi-item order with an order-level coupon

This is a classic VAT headache. Suppose the customer bought three items and applied a single order-level coupon, then returns one item. How much of the coupon “belongs” to the returned item? Your VAT and refund should align with your commercial policy and your platform’s allocation method.

A common approach is to allocate the coupon proportionally across all items at checkout. Then each item has an effective discounted price. When one item is returned, you refund that item’s effective discounted price and reverse VAT accordingly. This is fair, consistent, and avoids over-refunding or under-refunding compared to what the customer actually paid.

Scenario: Deposits, cancellations, and partial forfeitures

If you take a deposit and later cancel, the VAT treatment depends on whether the deposit is refunded, applied to a supply, or forfeited as a cancellation fee. In pure calculation terms:

If fully refunded, reverse VAT on the refunded amount.

If partly retained, VAT may apply to the retained amount depending on the nature of that retention (for example, whether it is treated as consideration for a service or compensation outside the scope of VAT, which varies by jurisdiction). From a numerical standpoint, treat the refunded portion as a reversal and the retained portion as consideration that remains, then apply the appropriate VAT rule to that retained portion.

Practical checklist for accurate VAT on discounts and refunds

When you are about to calculate VAT on a discount or a refund, run through these steps:

1) Identify whether the amounts you have are VAT-exclusive (net) or VAT-inclusive (gross).

2) Identify the VAT rate(s) that apply to the goods/services involved.

3) Determine whether the discount/refund is linked to specific line items or applies to the whole invoice/order.

4) If multiple VAT rates are involved and the discount/refund is invoice-level, apportion the discount/refund fairly across VAT categories (often proportionally by gross or net, depending on how the discount is expressed).

5) Calculate VAT consistently using either net × rate (for net amounts) or gross × rate/(1+rate) (for gross amounts).

6) Apply consistent rounding rules (per line or per invoice) and stick to them.

7) Document the adjustment with the correct commercial document (credit note/refund receipt) so your VAT reporting matches your accounting trail.

Common mistakes and how to avoid them

Mistake 1: Applying VAT rate to a VAT-inclusive discount

If you discount a VAT-inclusive amount and then multiply by the VAT rate as if it were net, you overstate VAT. Fix it by extracting VAT from gross using the fraction method: VAT = Gross × r/(1+r).

Mistake 2: Not apportioning discounts across different VAT rates

If a basket contains multiple VAT rates and you apply the entire discount to the standard-rated portion (or worse, to a zero-rated portion) without a justified commercial link, your VAT will be wrong. Fix it by allocating the discount proportionally across categories, then computing VAT per category.

Mistake 3: Recomputing VAT on refunds without reference to original line splits

Recomputing can introduce rounding discrepancies. If possible, refund based on the original invoice line net/VAT amounts or generate a credit note that mirrors the original VAT breakdown. If you must compute from gross, be consistent in your rounding approach.

Mistake 4: Confusing refunds with compensation

Not every payment back to a customer is necessarily a price reduction. Some payments might be compensation, damages, or ex-gratia amounts that may have different VAT implications. In everyday operations, the best practice is to clearly label whether the payment relates to a reduction in consideration for a supply (refund/discount) or is a separate matter. Your VAT calculation should follow that classification.

Putting it all together: a detailed end-to-end example

Imagine you sell an order containing two items and shipping. Prices are VAT-inclusive at checkout, and there is a coupon applied to the total. Later, one item is returned and shipping is not refunded.

Order at checkout (VAT-inclusive):

Item 1 (20% VAT) gross: 60.00

Item 2 (5% VAT) gross: 42.00

Shipping (20% VAT) gross: 12.00

Subtotal gross = 114.00

Coupon: 14.00 off the order gross

Total paid gross = 100.00

Step 1: Allocate the coupon across categories based on gross values.

First, group gross by VAT category:

20% category gross: Item 1 (60.00) + Shipping (12.00) = 72.00

5% category gross: Item 2 (42.00)

Total gross = 114.00

Allocate coupon to 20% category: 14.00 × (72.00 ÷ 114.00) ≈ 8.84

Allocate coupon to 5% category: 14.00 × (42.00 ÷ 114.00) ≈ 5.16

Step 2: Compute discounted gross by category.

Discounted gross (20% category) = 72.00 − 8.84 = 63.16

Discounted gross (5% category) = 42.00 − 5.16 = 36.84

Check: 63.16 + 36.84 = 100.00 (matches total paid)

Step 3: Extract VAT by category for reporting.

20% VAT portion = 63.16 × (0.20 ÷ 1.20) ≈ 10.53

20% net portion = 63.16 − 10.53 = 52.63

5% VAT portion = 36.84 × (0.05 ÷ 1.05) ≈ 1.75

5% net portion = 36.84 − 1.75 = 35.09

Total VAT on the order ≈ 12.28, total net ≈ 87.72 (net + VAT = 100.00)

Step 4: Customer returns Item 1 only. Shipping is not refunded.

Now you need Item 1’s effective discounted gross to determine the refund. Because the coupon was allocated by VAT category, you should also allocate within the 20% category between Item 1 and shipping based on their gross amounts:

Within 20% category:

Item 1 gross = 60.00

Shipping gross = 12.00

20% category gross total = 72.00

Coupon allocated to 20% category ≈ 8.84

Allocate coupon within 20% category:

Item 1 share = 60.00 / 72.00 = 83.3333%

Shipping share = 12.00 / 72.00 = 16.6667%

Item 1 coupon share ≈ 8.84 × 83.3333% ≈ 7.37

Shipping coupon share ≈ 8.84 × 16.6667% ≈ 1.47

Effective discounted gross:

Item 1 discounted gross ≈ 60.00 − 7.37 = 52.63

Shipping discounted gross ≈ 12.00 − 1.47 = 10.53

Now, if Item 1 is returned and shipping is not refunded, the gross refund is Item 1 discounted gross ≈ 52.63 (subject to rounding rules and your platform’s exact allocation).

VAT reversed on the refund (20%) = 52.63 × (0.20 ÷ 1.20) ≈ 8.77

Net reversed = 52.63 − 8.77 = 43.86

This example shows why allocation matters: if you refunded the undiscounted 60.00 you would over-refund compared to what the customer actually paid for that item after the coupon. And if you reversed VAT on 60.00, your VAT reporting would not match the economics of the sale.

Summary: the safest way to stay correct

To calculate VAT on discounts and refunds accurately, focus on the final consideration actually paid for each taxable supply and keep net and gross amounts separate. For net amounts, VAT is net × rate. For gross amounts, VAT is gross × rate/(1+rate). When discounts or refunds apply across multiple VAT rates, allocate them proportionally across the relevant categories (and ideally down to line items) and then calculate VAT per category. Consistency in rounding and in how you allocate order-level discounts is what keeps your VAT returns, sales reports, and payment processor totals aligned.

If you build your process around those principles, discounts and refunds stop being mysterious. They become a controlled reversal or reduction of the taxable amount—calculated transparently, documented properly, and easy to reconcile at month-end.