Grant funding and VAT: when does a payment become consideration for a supply?

For many charities, grants are a vital source of funding. Grants are normally outside the scope of VAT where they are freely given donations. However, where the terms of a grant involve the charity recipient doing something in return, this can bring that payment within scope of VAT.

If a grant payment is treated as consideration for VAT-able goods or services, the charity recipient would be required to charge VAT to the funder and pay that VAT to HMRC. Understanding the factors that determine whether a grant is a genuine donation or payment for a supply is therefore essential.

Why does this matter?

VAT is a transactional tax. It applies where there is a 'supply' of goods or services in return for consideration. If a charity receives a grant and, in return, agrees to do something for the funder, that payment may be treated as consideration for a supply. This would mean that:

• the charity (as supplier) must account for VAT at 20% on the grant amount;
• the funder’s budget goes less far, because part of the grant is absorbed by the VAT payable; and
• both parties may have additional compliance obligations.

For charities and funders operating on tight margins, this can significantly impact project viability.

The key test: is there a direct link?

The courts have consistently applied the principle that VAT only applies where there is a direct link – in other words, a quid pro quo – between a payment and a service. In practical terms, charities should ask:

• Is the charity obliged to do something in return for the payment?
• Could the funder enforce the charity's performance under the terms of the grant agreement, and could the charity enforce the funder's obligation to make the grant payment?

If the answer is yes, the payment is likely consideration for a supply. If the payment is freely given, with no enforceable obligations beyond appropriate governance restrictions, it is more likely to be a donation.

Factors that point away from a VAT-able supply

Freely given payments: if the charity would carry out its activities regardless of the grant, and the donor simply contributes to costs, this suggests a donation.

Limited donor control: where donors only require high-level reporting and assurance that funds are used for charitable purposes, HMRC generally accepts there is no supply.

Stewardship-style clawback: returning unspent funds is acceptable if framed as stewardship, not damages for underperformance.

Clear internal governance: segregating donation income from trading income in accounts tends to support the position that grants are not fee consideration.

Factors that increase VAT risk

Detailed control by the funder: if the donor selects beneficiaries, sets targets, or imposes key performance indicators, this looks more like procurement.

Performance-linked clawback: repayment clauses that resemble contractual damages suggest a supply.

Pupil-specific or outcome-specific reporting: in education or welfare contexts, reporting on named individuals rather than aggregated data points towards a supply.

Commercial-style agreements: contracts that resemble service agreements – complete with liability clauses and VAT-inclusive pricing – create the impression of a commercial bargain, rather than a freely given donation.

Practical points for charities

If VAT applies, the charity must charge VAT at 20% to the grant funder. For example, if the funder makes a grant of £100,000, and this is treated as VAT-inclusive (either because the grant agreement is silent on VAT or because the agreement confirms the grant to be VAT-inclusive), the charity would need to extract the VAT element (£16,667) and pay it over to HMRC, leaving £83,333 available to support the intended project. This significantly reduces the net value received by the charity and may result in a funding shortfall and undermine the purpose of the grant.

An alternative approach would be for the funder to increase the grant to ensure the charity receives the full intended amount after VAT has been accounted for. To provide the charity with £100,000 of net value, the VAT-inclusive grant would need to be £120,000. In this scenario, the charity would retain £100,000 and pay £20,000 to HMRC as VAT. While this achieves the intended funding outcome, it requires the donor to increase their financial commitment and may not always be feasible.

To mitigate risk:

• Review grant agreements: avoid procurement-style language, such as detailed specifications, deliverables, or performance obligations.
• Emphasise charitable purpose: agreements should focus on supporting the charity’s objectives and, where possible, pre-existing programmes, rather than commissioning specific outcomes.
• Limit donor control: high-level reporting on how funds are used is reasonable but avoid detailed operational and monitoring requirements.

What charities should do next

The dividing line between a donation and a VAT-able supply is the presence of a direct link between a payment and the provision of goods or services. Charities should draft grant funding documentation to avoid creating enforceable obligations that look like a contract for services. Where possible, keep agreements simple, focused on charitable objects, and free from operational control.

For further information, please contact James Bromley, Amy Bowen or your usual contact at Farrer & Co.

This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.

© Farrer & Co LLP, March 2026