Is car finance compensation taxable?

Car finance compensation is made up of two parts, and they’re treated differently. The refund of money you overpaid isn’t taxed as income. The interest added on top is taxed as savings income, and the lender deducts basic-rate income tax (22% from 6 April 2027) from it before paying you. Depending on your income, HMRC may owe you some or all of that tax back.

Update, 16 October 2026: The FCA has confirmed that the legal challenges to its motor finance compensation scheme will be heard from 16 to 26 February 2027, and lenders do not have to pay compensation under the scheme until the legal process ends (FCA). Under the scheme, simple interest is added to compensation at the annual average Bank of England base rate plus 1%, with a minimum of 3% a year (FCA). The government has also announced that tax on savings income rises by 2 percentage points from April 2027, while the allowances stay the same (GOV.UK). See our car finance compensation scheme latest update for the timetable.

The refund isn’t income

HMRC’s own guidance on compensation explains the principle with a PPI example. Refunds of amounts the customer had paid are not taxable, because they are simply money coming back. The interest the firm adds as compensation is taxable on the customer (HMRC SAIM2115).

Car finance compensation works the same way. The part that refunds what you overpaid isn’t income. The interest added for the time you were without that money is.

The interest is savings income

Interest on compensation is taxed as savings income, like interest from a bank account. The law requires the payer to deduct income tax at source from interest relating to compensation (HMRC SAIM9115). In practice, lenders deduct tax at the savings basic rate. That is 20% until 5 April 2027 and 22% from 6 April 2027, when Finance Act 2026 raises the tax rates on savings income by 2 percentage points and the rate withheld from interest moves to the savings basic rate (GOV.UK).

So it is the lender that takes the tax off, not HMRC. The lender deducts it at a flat basic rate (22% on payments from 6 April 2027), without knowing your income or allowances. That is why many people end up paying too much.

Allowances that can make the interest tax-free

Two allowances decide how much of the interest you should actually pay tax on (GOV.UK).

Personal Savings Allowance

• Basic-rate taxpayers: £1,000 of savings interest tax-free.
• Higher-rate taxpayers: £500.
• Additional-rate taxpayers: £0.

Starting rate for savings

If your other taxable income (not counting savings interest or dividends) is less than £17,570, you can get up to £5,000 of interest tax-free. This allowance falls by £1 for every £1 of other income above your Personal Allowance. Our guide to the starting rate for savings explains it, and our guide for pensioners shows why so many retired people are owed tax back.

Both allowances cover all your savings interest in the tax year, not only the compensation interest. Our guide to the Personal Savings Allowance and car finance compensation works through examples for each tax band. Bank and building society interest uses them up too. If you pay Scottish income tax, savings income still uses the UK rates and allowances.

How much you might get back

As general rules, where T is the tax the lender deducted:

• Non-taxpayers can usually reclaim all of it. See our guide for non-taxpayers reclaiming car finance tax.
• Basic-rate taxpayers can usually reclaim up to £220 on payments from 6 April 2027 (£200 before), which is the tax on a full £1,000 allowance.
• Higher-rate taxpayers can usually reclaim all of it if the interest is £500 or less (T of £110 or less on payments from 6 April 2027). Above that, the refund shrinks, and once the interest reaches about £1,050 there is usually nothing to reclaim. Some may have more to pay. Our guide to car finance compensation tax for higher-rate taxpayers explains why.

For example, if £500 of interest is paid and the lender deducts £100, a basic-rate taxpayer with no other savings interest could usually reclaim the full £100. These are general rules. Your own circumstances, including other interest in the same year, will change the result.

Quick answers

Do you pay tax on car finance compensation? Not on the refund itself. You are taxed only on the interest added to it, and the lender takes tax off that interest before paying you.

Is any more tax due on top of what the lender deducts? For a basic-rate taxpayer, the basic-rate tax the lender deducts normally covers any tax due on the interest. A higher- or additional-rate taxpayer whose total savings interest is above their allowance may owe more, which HMRC usually collects through their tax code or tax return. If you file a Self Assessment return, the interest goes on it.

Is the refund part taxed? No. HMRC’s guidance treats refunds of money you paid as money coming back, not income (HMRC SAIM2115).

How long do I have to claim the tax back? Four years from the end of the tax year in which you were paid. Our guide to which tax year compensation counts in has the deadlines.

How the tax is reclaimed

Form R40. If you’re not in Self Assessment, overpaid tax on savings interest is reclaimed from HMRC using form R40. A claim needs a document from the lender showing the gross interest, the tax deducted and the net interest (see how to read your car finance compensation letter and our checklist of documents you need for a car finance tax rebate). Claims can be made for the current tax year and the previous four, with a separate claim for each year (GOV.UK). See also our guides to the tax deduction certificate and how long an HMRC refund takes.

Self Assessment. If you’re registered for Self Assessment, R40 isn’t used. The gross interest and the tax deducted go on your tax return, and the overpayment is dealt with there. See Self Assessment and car finance compensation.

When you use our service, we check whether you’re likely to be owed anything, work out the right tax year or years, prepare and submit the R40 as your agent, deal with any HMRC queries and pay you the balance after our fees. Our how it works page sets out the process, and our charges are on our fees page. You can also submit an R40 to HMRC yourself.

Your next step

Use our calculator to estimate whether you’re owed tax back on the interest in your compensation, and roughly how much.