What Are Late Payment Penalties?

Late payment penalties are charges that a creditor can impose on a debtor when an invoice is not paid by the agreed due date. In the UK, the Late Payment of Commercial Debts (Interest) Act 1998 gives businesses a statutory right to charge interest and claim compensation on overdue B2B invoices, even when the original contract does not mention penalties.

The statutory framework

The Late Payment of Commercial Debts (Interest) Act 1998 (as amended) applies to all commercial contracts for the supply of goods or services. It does not apply to consumer transactions.

Key provisions

• Applies automatically unless the contract provides a substantial remedy for late payment
• Cannot be contracted out of (a contract term that tries to exclude the right to statutory interest is void unless it provides an adequate alternative)
• Covers interest and fixed compensation sums
• Applies regardless of the size of the business

Statutory interest rate

The statutory interest rate for late commercial payments is:

8% above the Bank of England base rate

This rate is set in two reference periods each year:

Calculating statutory interest

The formula for calculating statutory late payment interest is:

Outstanding amount x (Base rate + 8%) / 365 x Number of days overdue

Example: An invoice of £5,000 is 45 days overdue. If the Bank of England base rate is 5%:

£5,000 x 13% / 365 x 45 = £80.14

Interest accrues from the day after the payment due date until the date the debt is paid.

Fixed compensation sums

In addition to interest, the creditor is entitled to claim a fixed sum as compensation for the cost of recovering the debt:

These fixed sums are intended to cover the administrative cost of chasing overdue payments. They apply per invoice, not per debtor, so multiple overdue invoices from the same customer generate multiple compensation claims.

Reasonable debt recovery costs

Beyond the fixed compensation sums, creditors can also claim reasonable costs incurred in recovering the debt, provided these exceed the fixed compensation amount. This can include:

• Costs of instructing a solicitor to send a demand letter
• Debt recovery agency fees
• Court fees for issuing proceedings
• Administrative time spent on collection activities

The creditor must be able to demonstrate that the costs claimed are reasonable and were actually incurred.

When do late payment penalties apply?

Late payment penalties begin to accrue from the day after the payment due date. Determining the due date depends on what was agreed:

If payment terms are agreed

The due date is whatever was specified in the payment terms , whether net 30, net 60 or another period.

If no payment terms are agreed

The statutory default is 30 days from the later of:

• The date the invoice is received by the buyer
• The date the goods or services are delivered

For public authority contracts

The maximum payment term for contracts with public authorities is generally 30 days.

Contractual vs statutory penalties

Businesses can include their own late payment terms in contracts, but these must provide a substantial remedy for the creditor. If the contractual terms are less favourable than the statutory provisions, the statutory right prevails.

Many businesses choose to include contractual late payment terms that mirror or exceed the statutory provisions, making the position clear to customers from the outset.

How to apply late payment penalties

Step 1: Confirm the payment is overdue

Check the payment terms and calculate the due date. Do not apply penalties prematurely.

Step 2: Send a payment reminder

Before applying penalties, send a formal payment reminder referencing the overdue invoice and stating your intention to charge interest if payment is not received by a specified date.

Step 3: Calculate the charges

Apply:

• Statutory interest from the day after the due date
• The applicable fixed compensation sum
• Any additional reasonable recovery costs

Step 4: Issue a supplementary invoice or statement

Issue a separate invoice or add the charges to a statement showing:

• The original invoice reference
• The overdue period
• Interest calculated
• Fixed compensation claimed
• Total now due

Step 5: Escalate if necessary

If payment including penalties is not received, escalation options include:

• Further payment reminders with increasing urgency
• Formal letter before action
• Debt recovery agency
• County Court claim (Money Claim Online for debts up to £100,000)
• Statutory demand (for debts over £750, as a precursor to insolvency proceedings)

Accounting treatment

Recording late payment interest income

When interest is charged:

Debit:  Trade receivables
Credit: Interest income (other operating income)

Recording fixed compensation

Debit:  Trade receivables
Credit: Other operating income

When cash is received

Debit:  Bank
Credit: Trade receivables

Late payment interest should only be recognised as income when it is probable that it will be collected. If recovery is uncertain, recognise it only when received.

VAT on late payment charges

Statutory late payment interest is generally treated as outside the scope of VAT since it is compensation for late payment rather than consideration for a supply. The fixed compensation sums are also outside the scope of VAT.

However, if late payment charges are structured as part of the consideration for the supply (for example, a contractual surcharge), they may be subject to VAT. Businesses should take advice on the VAT treatment of any non-standard late payment arrangements.

Late payment and credit notes

When a credit note has been issued against an invoice, late payment interest should be calculated on the adjusted amount (original invoice less credit note), not the original invoice total. The fixed compensation sum is based on the original invoice amount.

The Prompt Payment Code

The Prompt Payment Code is a voluntary code of practice administered by the Office of the Small Business Commissioner. Signatories commit to:

• Paying 95% of invoices within 30 days (with a target of 100%)
• Working towards 30-day payment as standard
• Not altering payment terms retrospectively
• Providing clear guidance to suppliers on payment procedures

Large companies (with over 250 employees) are required to report their payment practices twice yearly, including:

• Average time to pay invoices
• Percentage of invoices paid within 30, 60 and over 60 days
• Percentage of invoices not paid within agreed terms

This reporting requirement increases transparency and public accountability for payment behaviour.

Practical considerations

When not to charge penalties

While the right exists, many businesses choose not to charge late payment penalties in every case:

• Valued long-term customers where the relationship is more important than the penalty
• Genuine disputes over the invoice amount or quality of goods/services
• First-time late payers who respond promptly to a reminder
• Customers in financial difficulty where a payment plan may be more productive

When penalties are appropriate

• Serial late payers who consistently ignore payment terms
• Large outstanding amounts where the interest cost to your business is significant
• Customers who are unresponsive to reminders and informal follow-up
• Contractual requirement where your terms explicitly state penalties will be applied

The decision to charge late payment penalties should be part of a considered credit control policy rather than applied inconsistently.