Not many businesses operate without a bit of bad debt, although hopefully it is just the odd one!
However, for tax purposes, there are different rules depending on the tax involved.
VAT Relief On Bad Debts
There are detailed instructions for VAT relief on bad debts which is set out in VAT Notice 700/18, accessible at https://www.gov.uk/guidance/relief-from-vat-on-bad-debts-notice-70018.
Effectively the rules state:
| 1. | You must already have accounted for the VAT on the supplies and paid it to HMRC. |
| 2. | You must have written off the debt in your day-to-day VAT accounts and transferred it to a separate bad debt account. |
| 3. | The value of the supply must not be more than the customary selling price. |
| 4. | The debt must not have been paid, sold, or factored under a valid legal assignment. |
| 5. | The debt must have remained unpaid for a period of 6 months after the later of the time payment was due and payable and the date of the supply |
If you meet the conditions, then the amount of the VAT claim is entered into box 4 of the next VAT return due after the conditions have been met. You must inform your customer of your claim, and also keep records. Both the form of the customer notification and the records to be kept are listed in the VAT Notice.
Income and Corporation Tax Rules for Bad Debts
For income and corporation tax purposes, it is a bit simpler. The amount of the bad debt will be set against your profits for the year and so reduce the income or corporation tax due. However, you must consider, the likelihood of a full or partial recovery of the debt; and if a debtor is simply a “slow” payer, then no relief would be due. Tax relief is also only given to specific bad debts; if you have a general provision – i.e., assume that a certain proportion of your customers will default – then no relief is given. As with VAT, you must have the documentary evidence to show that the debt is real, but the rules are not quite so prescriptive.
If the debt is in fact subsequently paid then the receipt would be included in the turnover for the year of receipt.
Corporation Tax and Cash Basis Accounting
It should be noted that for Corporation Tax, bad debts are dealt with in accordance with the “Loan Relationship” rules but the effect on the tax due is the same.
Some businesses use something called the “Cash Basis” to calculate their profits. In this circumstance you bring into account only the amounts received at the time of receipt, so the bad debt question is dealt with automatically – if you don’t receive it, then it is not included.