Millions of victims of payment protection insurance (PPI) mis-selling will have to pay tax on their payout, the Government has confirmed.

Anyone who gets interest back on top of the compensation amount is liable if they are a taxpayer. The compensation itself is not taxed so any money you owe will be a small proportion of the overall payout.

Some PPI sellers deduct tax from redress, but not all do, meaning many will have to make additional payments.

Banks, building societies, credit card firms and other lenders have paid out for mis-selling for years but there has been a huge build-up of momentum following the collapse of the banks' attempt to block automatic payouts in May.

Compensation could hit £9 billion as a result, while more than £600 million has already been paid this year for mis-sold PPI – designed to cover loan or credit card payments if you cannot work.

An estimated three million people could be due compensation, meaning a windfall for the Taxman.

Here's what you need to know.

What will I owe tax on?

PPI payouts are usually formed from three elements.

The first two constitute the compensation. They are:

  • A refund of the premiums paid
  • Interest you have paid on the premium

The third part is additional interest on the compensation at 8% per annum (not compounded, so no interest on interest). It is this part that is taxed.

Tax is owed for the tax year you are paid compensation in.

Who owes tax?

Interest on PPI compensation is treated the same way as savings so all taxpayers who are paid additional interest will owe tax.

This is because the idea of compensation is to put you in the place you would have been had you not been mis-sold.

Had you not paid out the PPI premiums it is assumed you'd have that cash in the bank. Additional interest is paid as compensation as it is assumed you'd get a return on that money in the bank.

Therefore, it is taxed as a savings account would be.

However, interest is not always paid on credit card PPI redress. Where it is not paid there is no tax owed.

How do I know if I've been paid interest?

It should be split out from the compensation on your redress offer letter from your lender.

How much tax will I owe?

You pay savings tax, and hence PPI tax, depending on what tax band you're in from your earnings.

A basic rate taxpayer (who pays 20% tax), for instance, will pay £20 for every £100 in interest.

Won't tax be automatically deducted?

Some providers deduct basic rate tax at source but you'll need to check, as if they don't, or if you owe more than they deduct, you'll have to organise a payment yourself (see below for how to pay).

Of the major banks, only RBS and Natwest deduct tax. Barclays (including Barclaycard), Halifax, HSBC, Lloyds TSB and Santander do not deduct tax.

If tax is deducted at 20%, higher and top rate payers will need to make a top-up payment.

What if I got a refund years ago?

You must declare any tax paid within the last six tax years, says HM Revenue & Customs (HMRC).

Many PPI reclaims will go back to 2006, while the bandwagon picked up momentum in 2007 when we launched our PPI reclaiming campaign, so most will owe tax as the majority of payouts happened over the past six years.

How do I pay tax owed?

If you owe money and you are an employee, let HMRC know by contacting your tax office or call its income tax helpline on 0845 300 0627.

It can then readjust your tax code, which lowers your personal tax-free allowance, so the additional cash can be collected via your wage packet.

If you fill out a self assessment form, you must declare any interest as savings interest on that form and pay money owed as part of your overall tax bill.

If you cannot afford to pay, contact HMRC as it can give you more time in exceptional circumstances.

What if the bank used my compensation to pay another debt?

As you still got compensation, as it means you owe less money on other debts, you still owe tax in exactly the same way.

So is it worth still reclaiming?

Of course it is. You should still get YOUR money back. You only pay tax on the additional interest on top of the actual compensation. What's more, tax will only be a small proportion of the overall redress.