What are discounts?

There are two types of discount a business may offer to its customers:
A trade discount may be offered to a customer for a number of reasons, including:

 buying in bulk
 the total price of an order exceeding a certain amount
 loyalty
 to promote a certain product.

An example of a trade discount is, a customer receiving 10% off the trade price for placing an
order of more than £500.
A prompt payment (or early settlement) discount may be offered to a customer to encourage
them to pay more quickly.
An example of a prompt payment discount is a customer being offered a reduction in the
amount payable of 3% if the payment is made within seven days.

How do I calculate VAT for trade discounts?

To calculate the VAT on a trade discount, deduct the discount from the net price before the VAT
is calculated.
How do I calculate VAT for prompt payment (early
settlement) discounts?
Calculating the VAT on a prompt payment discount is more complicated than the calculation for
a trade discount.
With a prompt payment discount the VAT is based on the actual amount received, but you
(the supplier) will need to account for the VAT and prepare the invoice before the amount is
received.
To calculate VAT on a prompt payment discount:

 decide which of the options below your business wishes to follow

 calculate the VAT in the normal way, i.e. net x VAT rate.

Choose one of the following two options:

Option 1. Issue a credit note - If the customer pays the lower amount (ie. takes advantage of
the prompt payment discount offered), issue a credit note for the amount of the discount (plus
VAT).
Option 2. Include further information on the original invoice - If you do not want to issue
a credit note each time a customer takes advantage of a prompt payment discount, then further
information must be included on the original invoice:

 a statement that the customer can only recover the VAT actually paid, and
 the terms of the prompt payment discount. HMRC recommends that we include the discounted
price, the VAT on the discounted price and the total amount due if the prompt payment discount
is taken up.

HMRC recommend the following standard wording: “A discount of X% of the full price applies if
payment is made within Y days of the invoice date. No credit note will be issued. On payment
you may only recover the VAT actually paid”.
 Calculating VAT on discounts can be done in one of the two ways. Extracts in
the attached invoices contain discounts shown as follows:
Option 1: Issue an invoice

 An invoice is prepared for the full amount. In this example the amount is £300.
 The rate of VAT is clearly shown (at 20%)
 The trade discount is calculated at 15% and deducted from the usual price (£300 -
£45.00 = £255)
 The VAT is calculated on the net: £255 x 20% = £51
 The amount payable if the prompt payment discount is not taken is shown (£306), along
with the terms of the prompt payment discount - 'A 3% discount applies if payment is
made within seven days of the invoice date.'

Option 1 - Issue a credit note

The customer pays the reduced amount, therefore a credit note is issued.

 The rate of VAT is clearly shown (at 20%)

 This is 3% of the net figure on the invoice: £255 x 3% = £7.65
 The VAT is calculated on the net: £7.65 x 20% = £1.53
 This is the amount by which the original invoice has been reduced. The customer paid
£296.82 (£306.00 - £9.18).

Option 2: Include further information on the original invoice

The invoice is prepared for the full amount of £300 with additional information:

 The rate of VAT is clearly shown (at 20%)

 The trade discount is calculated at 15% and deducted from the usual price (£300 - £45
=£255)
 The VAT is calculated on the net. £255 x 20% = £51
 The amount payable if the prompt payment discount is not taken is shown (£306), along
with the terms of the prompt payment discount - 'A 3% discount applies if payment is
made within seven days of the invoice date. No credit note will be issued. On payment
you may only recover the VAT actually paid.'

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Do I need to charge VAT on free gifts?
VAT is usually charged on the cost of goods, except in the following circumstances:

 business gifts costing less than £50 in total (per person per annum)
 a free meal to an employee.
 It may surprise you to know tax assessments worth millions have been
issued by the BIR simply because taxpayers failed to properly invoice
discounts. Even now, many big companies underestimate and neglect the
importance of good invoicing. Businessmen and accounting officers still
tend to overlook the value of properly filling out such a small piece of
paper, which could later on make or break their case.

HOW IS INCOME TAX AFFECTED BY DISCOUNT?

Universally, discounts are given as a marketing strategy to promote

sales or to encourage prompt payments. Discounts may be
cash/purchase discounts, quantity/volume discounts, or trade
discounts. Cash discounts are granted for early payment, volume
discounts are reductions in price for purchases made in large
quantities, while trade discounts pertain to percentage reductions from
the list price. Since these discounts reduce the selling price,
corporations treat them as deductions from gross sales in computing
income tax and VAT. However, the proper treatment of discounts is
not as straightforward as that.

Section 27 (A) of the Tax Code defines gross income as gross sales
less sales returns, discounts and allowances and cost of goods sold.
Discounts are treated as reductions from gross receipts or gross sales
to arrive at gross income, which in turn is reduced by operating
expenses to compute taxable income. For income tax purposes, it
appears there is no invoicing requirement. As long as a discount is
given, it is treated as a deduction.

However, the same does not apply for VAT purposes. The Tax Code
and BIR issuances provide more specific and rigid invoicing
requirements. Expressly, the Tax Code states that, to be deductible,
sales discounts: (a) must be granted and indicated in the invoice at
the time of sale; and (b) should not depend upon the happening of a
future event (Section 106 [D]). Also, sales discounts should be
excluded from gross sales within the same quarter it was given.

In various rulings, the BIR has strictly implemented these invoicing

requirements.

If the discount is not granted and indicated in the invoice at the time
of sale, the sales discount is automatically disallowed. When the
discount is indicated in the invoice, but depends on a contingency
(e.g., a cash discount which depends on early payment by the
customer), the sales discount is also disallowed. The BIR has a
stringent unwavering position on nothing less than religious
 compliance with the requirements of the Tax Code.

The law requires deductible discounts must be granted and indicated in

the invoice only (and not in both invoice and official receipt). Invoice,
as provided in law, is given a technical meaning in the law on VAT, and
is issued for sale of goods or properties. While an official receipt is
issued for sale of service or lease. Sales discounts must be
unconditional. It should be indicated from the issuance of the invoice.
At this time, the taxpayer’s VAT liability is already fixed, and the
customer may already claim the input VAT. This avoids situations
where a discount is subsequently withdrawn without payment of the
corresponding output VAT, or where input VAT on the undiscounted
price is claimed but a discount is subsequently granted. This ensures
the VATable amount upon issuance of the invoice will be the same
amount upon payment. The rules on the issuance of an official receipt
are different since it is issued upon payment, and the VATable amount
will already reflect the actual discount granted.

Interestingly, the CTA, in one case, allowed sales discounts given to

senior citizens even if supported merely by cash slips. Although this
may be used as an argument against failing to issue VAT invoice, it
still does not dispense with the requirement that the discount is
separately indicated, and the same is not conditional on a future
event.

It pays for taxpayer to be well-versed with the invoicing requirements

for discounts provided by the Tax Code and BIR issuances to prevent
future tax assessments. Taxpayers should never discount the value of
proper invoicing.

RECORDING PROCESS

There are two primary types of discounts that might occur in your small business -- trade
discounts and cash discounts. A trade discount occurs when you reduce your sales price for a
wholesale customer, such as on a bulk order. This type of discount does not appear in your
accounting records or on your financial statements. A cash, or sales, discount is one you offer to
a customer as an incentive to pay an invoice within a certain time. You must record cash
discounts in a separate account in your records and report the amount on your income statement.

1. Debit the accounts receivable account in a journal entry in your records by the full invoice
amount of a sale before a cash discount. Credit the sales revenue account by the same amount in
the same journal entry. A debit increases accounts receivable, which is an asset account. Unlike
an asset account, sales revenue is increased by a credit. For example, assume your small business
sold $100 in products to a customer who will pay the invoice at a later date. Debit $100 to
accounts receivable and credit $100 to the sales revenue account.

2. Subtract the amount of the sales discount from the full invoice amount to determine the
amount of cash you receive when the customer pays the invoice. In this example, assume your
customer received a 1 percent discount, or $1, for paying early. Subtract $1 from $100 to get $99
in cash.

3. Debit the cash account in a new journal entry in your records by the amount of cash you
received from your customer. Debit the sales discounts account by the amount of the discount. A
debit increases both of these accounts. In this example, debit cash by $99 and debit sales
discounts by $1.

4. Credit the accounts receivable account in the same journal entry by the full invoice amount.
This removes the invoice amount from accounts receivable. In this example, credit accounts
receivable by $100.

5. Report the amount of total sales discounts for an accounting period on a line called “Less:
Sales Discounts” below your sales revenue line on your income statement. For example, if your
small business had $200 in discounts during the period, report “Less: Sales discounts $200.”

6. Subtract the total sales discounts from the gross sales revenue you earned in the period before
accounting for discounts. Report your result as “Net sales” below the sales discounts line on your
income statement. The amount of net sales is the actual revenue you earned after accounting for
discounts. Using the previous example, assume you had $20,000 in gross revenue during the
period. Subtract $200 from $20,000 to get $19,800 in net sales. Report “Net sales $19,800”
below the sales discounts line.