BAD DEBT RELIEF - 12.12.2019

VAT flat rate scheme users missing out on bad debt relief

Bad debt relief

Where a customer doesn’t pay your invoice and eventually you write off the debt it “impairs” your profit. The impairment counts as a tax deductible expense. So while the sale still shows as income it’s balanced by a tax deduction. You should also make a corresponding adjustment to your VAT records to reflect that you’re not going to receive the VAT charged on your invoice. Usually, that’s the end of the matter, but in certain circumstances you’ll need to make an additional bad debt deduction in your accounts

For detailed commentary VAT on bad debt relief, visit http://tipsandadvice-tax.co.uk/download (TX 20.06.07).

Bad debts and the FRS

If you use the flat rate scheme (FRS), the amount of VAT you account to HMRC for on a sale is at a reduced rate (depending on the nature of your business). This is applied to the VAT-inclusive amount of a sale, e.g. you make a sale of £5,000 and bill your customer for £6,000 (£5,000 + £1,000 for VAT at 20%). The FRS rate for your type of business is 12%, so you account to HMRC for VAT of £720, i.e. £6,000 x 12%. There’s a corresponding adjustment if the invoice becomes a bad debt.

Bad debt relief. If your customer didn’t pay the £6,000 bill referred to above, then after six months you can treat it as a bad debt for VAT purposes. On your next VAT return to recover the correct amount of VAT from HMRC you would deduct £6,000 from the sales and so reduce the VAT payable by £720.

Tip. If you use the VAT cash-based method rather than the normal method, you don’t usually have to worry about bad debts because you only account to HMRC for VAT on sales for which you get paid, but there’s a catch.

Trap. If you use the FRS as well as the cash-based method, you must make an extra adjustment for bad debts to account for the difference between the FRS rate of VAT (12% in our example) and the rate you charged your customer or you can be out of pocket.

Example. Alan uses the FRS for which he is required to account to HMRC for VAT at 12% of all supplies. He also uses the cash-based method of accounting. His VAT returns are for calendar quarters.

Alan invoiced a customer for £5,000 plus £1,000 VAT on 30 June 2019 which he writes off as a bad debt on 31 January 2020. Because he uses the cash-based method of VAT accounting he claims VAT bad debt relief using the method explained above. He claims VAT bad debt relief using the method explained above. However, to ensure that he obtains full tax relief against his profits for the bad debt he has to make an additional deduction of £280 because:

• the £1,000 VAT shows as gross sales in his accounts while
• the bad debt relief deduction includes only £720 VAT; meaning
• that the difference of £280 will otherwise be taxed as profit (see The next step ).

For another example of the special adjustment required, visit http://tipsandadvice-tax.co.uk/download (TX 20.06.07).