For years, UK consumers received compensation for mis-sold Payment Protection Insurance (PPI). While the refund of the original premiums and associated charges does not generally trigger a tax liability, the statutory 8% interest added to these payouts is fully taxable as savings income.
Understanding Payment Protection Insurance (PPI) Tax is crucial for tax professionals advising clients in the 2026/27 tax year. Many taxpayers unknowingly overpay tax on this interest because banks automatically deduct it at source. This guide explores the legislative framework, the available allowances, and the mechanisms for reclaiming overpaid tax.
Why Does PPI Compensation Incur Tax?
When banks pay PPI compensation, they typically calculate it by refunding the historical premiums and adding simple interest at 8% per annum. This interest compensates the claimant for the time they were deprived of their money.
The First-tier Tribunal in NHS Mid & South Essex ICB v The Commissioners for HMRC confirmed that this 8% addition constitutes interest properly so called and is taxable under section 369(1) of the Income Tax (Trading and Other Income) Act 2005 (ITTOIA 2005).
Furthermore, section 874(5A) of the Income Tax Act 2007 (ITA 2007) strictly classifies this interest as “yearly interest”, regardless of the period over which it accrued.
“For the purposes of subsection (1) a payment of interest which is payable to an individual in respect of compensation is to be treated as a payment of yearly interest (irrespective of the period in respect of which the interest is paid).”
The 20% Automatic Deduction at Source
Because the law classifies PPI interest as yearly interest, the institution paying the compensation (the bank) has a statutory duty to deduct income tax at the basic rate in force at the time of payment.
For the 2026/27 tax year, the basic rate of tax applied to savings income is 20%. Therefore, the bank automatically deducts 20% from the 8% interest element before paying the net compensation to the taxpayer. The taxpayer receives a letter showing the gross interest and the tax deducted.
Using Allowances to Offset PPI Tax
Although banks deduct tax automatically, many taxpayers do not actually owe this tax due to their available allowances. For the 2026/27 tax year, two primary allowances can shelter PPI interest from tax.
1. The Personal Savings Allowance (PSA)
The Personal Savings Allowance, governed by section 12B of ITA 2007, grants taxpayers a nil rate band on their savings income based on their marginal income tax rate.
| Taxpayer Status (2026/27) | Personal Savings Allowance (PSA) |
|---|---|
| Basic Rate Taxpayer | £1,000 |
| Higher Rate Taxpayer | £500 |
| Additional Rate Taxpayer | £0 (Nil) |
If a basic rate taxpayer earns less than £1,000 in total savings interest across the tax year (including the PPI interest), they owe no tax on that income.
2. The Starting Rate for Savings
Taxpayers with a low earned income may also benefit from the starting rate for savings. Section 9 of the Finance Act 2026 freezes the starting rate limit for savings at £5,000 for the tax years 2026/27 through to 2030/31. If a taxpayer’s non-savings income falls below their personal allowance plus £5,000, this 0% band applies to their savings income.
How to Reclaim Overpaid PPI Tax
If a bank deducts 20% tax from the PPI interest, but the taxpayer’s total savings interest falls within their PSA or the starting rate band, the taxpayer has overpaid tax.
Taxpayers can reclaim this overpaid tax in two ways:
- Form R40: Individuals who do not normally complete a Self-Assessment tax return can claim a repayment of the tax deducted by completing and submitting form R40 to HMRC.
- Self-Assessment: Taxpayers already registered for Self-Assessment must declare the gross interest and the tax deducted in the “other income” section of their main tax return. The system will automatically calculate the overpayment and credit it against their overall tax liability.
Looking Ahead: Rates Increasing in 2027/28
While the savings rates for 2026/27 remain at 20% (basic), 40% (higher), and 45% (additional), the Finance Act 2026 introduced significant changes for the following year. From April 2027, the savings rates will increase to 22%, 42%, and 47% respectively. Higher and additional rate taxpayers receiving compensation in the 2027/28 tax year will face a larger further liability to pay on their PPI interest.
Consider reviewing the client’s total savings income for the tax year to ensure the £1,000 or £500 Personal Savings Allowance has not already been fully utilised by standard bank or building society interest before submitting an R40 claim.
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