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Tottel’s VAT Annual 2006/07 by John Price FCA

John Price examines the mechanics of an important VAT relief.You can claim bad debt relief for VAT charged to your customers, which they have not paid to you. The law is in s 36 and VAT Regulations (SI 1995/2518), Regs 165–172J.

For sales after 1/1/03, you no longer tell a customer that you are claiming relief. However, see Chapter 13, What Can I Recover Input Tax on? for the rule, which requires you to repay input tax on any invoice you have not paid to a supplier after six months.

Relief for bad debts can be claimed provided that:

• the debt is six months old from the date on which payment was due or, if later, that of the supply; and


• it has been written off in your accounts; and


• if the supply was of goods, ownership has passed to the customer.

Time limit for the claim

The claim must be made within 3 1/2 years of the date on which payment was due or, if later, that of the supply.

Writing off the bad debt

You must create a refunds for bad debts account. The description of this both in the VAT Regulations and in Notice 700/18 (December 2002) is confused. To comply with the law as written may be impractical because of the descriptive information to be kept in the account — beyond the capability of most computer systems. You need the dates and reference numbers of the original tax invoices, the sums of VAT charged, any payments on account received, details of the claim and (if applicable) a copy of the notice to the customer described above. Even with only one or two invoices outstanding and if your computer system will let you transfer the invoice detail, not just the outstanding balance, to a new account, will it allow the additional information and in a single account?

That word account in Reg 168 may mean file — the common sense answer. Attach copies of the original invoices to that of the notice to the customer.

In Alpha Leisure (Scotland) Ltd (EDN/03/14 No 18199), a claim was held to be valid despite it having been discharged as valueless as part of an agreement when two businesses were separated. Customs had claimed that the agreement extinguished the debt.

The pitfall of subsequent payments

How will you avoid the pitfall of failing to account for VAT on any payment which is subsequently received against a bad debt on which you have claimed relief? Any money which comes in subsequently includes VAT. You need a system for picking this up, since you normally account for output tax when the invoice is issued:

• either transfer the outstanding customer account to a bad debts section of your sales ledger; or


• will your system let you mark the account in some way so that the computer triggers a query when a payment is credited to the account?

As dividends in a bankruptcy or liquidation can arrive years afterwards, it would be all too easy to forget that bad debt relief had been claimed and fail to pay output tax at the appropriate VAT fraction on the net sum received.

How you make the claim

You add the refund to the input tax, which you are reclaiming for the period in which you make the claim. It is not a reduction of the output tax.

The amount of your claim

You claim for the output tax originally charged. It is irrelevant whether the rate of VAT has subsequently changed. Similarly, you pay VAT on any sums subsequently received at that rate, not at the one applicable when you get the payment.

If the customer has paid you sums on account, you can only claim for the VAT included in the outstanding balance. A typical example of the pitfall in this point is where a garage does accident repair work for a registered trader under an insurance claim. The customer is that trader but the net amount of the invoice is often paid direct to the garage by the insurance company.

If the customer never pays the VAT, the garage naturally thinks that the outstanding sum is all VAT. Sadly, that is not so! The insurance company’s cheque is a payment on account, which includes VAT. Bad debt relief can only be claimed on the outstanding sum at the VAT fraction.

Several tribunal cases confirm the point!

Enderby Transport Ltd (MAN/83/304 No 1607) sold goods for £10,200 plus VAT of £816. The customer only paid £10,200 and the company claimed bad debt relief of £816. The Tribunal held that the outstanding debt of £816 should be treated as a gross debt inclusive of VAT of which only the VAT element could be recovered.

In AW Mawer & Co ([1986] VATTR 87 No 2100) a firm of solicitors acted for a company in an action to recover damages following a fire at its premises. The company was awarded costs of £7,127 plus VAT of £709. The defendants’ insurers only paid £7,127. The company did not pay the bill and went into liquidation. Customs only allowed relief at the VAT fraction of the outstanding debt. The Tribunal agreed. The £709 was a debt owed to the solicitors by the client, and relief could only be given on the VAT element of it.

The position if you assign or factor your debts

If you sell your debts without provision in the contract for reassignment of them back to you, bad debt relief is not available. If the contract does allow it, only once the debts have been reassigned to you can you claim relief.

Moreover, when you make your claim, the outstanding amount is net of any sums received by the assignee.

The payment from the factor for your debts is exempt and is therefore ignored for the purposes of bad debt relief.

If you have already claimed bad debt relief before you assign a debt, Reg 171(5) says you do not have to repay the VAT if the assignee subsequently receives a payment unless the assignee is a connected person as defined under ICTA 1988 s 839.

Since the law provides that it is only the claimant, the issuer of the original VAT invoice, who has the right to make a bad debt relief claim and has the liability to account for VAT included in sums subsequently received, the assignee is not liable for VAT on any sum collected. The possible advantage is limited given that the sum assigned, after bad debt relief has been claimed, will usually only be recovered in part. Of course, the assignee may gain but that will only happen if the total sum collected exceeds what was paid when the debt was taken over. You would have difficulty in exploiting that by assigning debt over six months old but which you expected to be paid; as already noted, you would be liable to pay VAT on sums collected by a connected person. Someone unconnected would only accept the debt at a discount.

The payment offset problem

Regulation 172(3) says where the claimant owes an amount of money to the purchaser which can be set off, the consideration written off in the accounts shall be reduced by the amount so owed.

In other words, one cannot claim bad debt relief on the gross value of one’s invoices if one also owes a debt to that customer. One can only claim on the net figure after taking account of what is owed in the other direction. There is usually no restriction in the commercial arrangements of the right to offset and the bad debt relief claim must reflect the legal liability for the net sum.

Perhaps a loan for a stated period could not immediately be offset; however there would then be a liability to pay the output tax again when the loan became repayable and the outstanding invoices were deducted from it — just when a payment is received after bad debt relief has been claimed.

Repayment under a guarantee does not count

Interlude Houses Ltd (EDN/94/65 No 12877) sold timeshare licences which the purchasers assigned to a bank as security for loans to them. Interlude bought back a license from the bank if the purchaser defaulted on the loan. Unsurprisingly, its claim for bad debt relief was rejected because its re-purchase of the licence from the bank was not a cancellation of its original sale.

The position if the business ownership has changed

The new owner of an unincorporated business is not entitled to make a bad debt relief claim for previous debts unless that owner has taken over the existing VAT number.

The same applies if you buy a business from a limited company rather than acquire its share capital.

Departure from a VAT group

A company, which made a sale whilst it was within a VAT group, can claim bad debt relief after it has left the group. It does not matter that the supply was originally accounted for by the representative member.

In Proto Glazing Ltd (LON/95/573 No 13,410) the Tribunal said it would be unfair to apply the VAT group returns system to the claim for bad debt relief. Output tax was paid on behalf of the company which had made the sale and which had then suffered the economic loss.

Goods supplied on hire purchase or conditional sale

Supplies made by hire purchase or conditional sale have two components: a supply of goods and the exempt interest charges. When claiming bad debt relief, Reg 170A allows the allocation of payments from defaulting customers to goods and to finance in the same ratio as the total sums due — thus increasing the VAT reclaim. This was originally a concession announced in Business Brief 19/2001 from 6/12/01.

HMRC also allow you not to deduct the sum you get from selling any repossessed goods from the outstanding debt if the sale of the goods themselves was standard-rated; that would be because the customer had acquired them for a business purpose or you changed their condition prior to selling them. If the sale was not subject to VAT, the proceeds must still be deducted from the debt.

A St John Price FCA
July 2006

A St John Price FCA is author of ‘Tottel’s VAT Annual 2006-07’, from which the above article is extracted. The book is part of ‘Tottel’s Core Tax Annuals 2006-07’. The series is due to be launched in September 2006. Each of the new Core Tax Annuals costs just £19.95, or all six cost just £99.50! The Core Set comprises:

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• Tottel's Income Tax 2006-07;


• Tottel's Inheritance Tax 2006-07;


• Tottel's Trusts and Estates 2006-07; and


• Tottel's Value Added Tax 2006-07.

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