Bad debts refer to raised sales invoices your customers fail to pay.
For debt to be considered ‘bad’ you must be able to demonstrate there is little hope of receiving payment.
Bad debts must be distinguished from ‘doubtful debts’.
To re-classify a ‘doubtful debt’ into a ‘bad debt’ you must take reasonable steps proving there is little hope of ever receiving the money owed to you.
In this post we offer advice on applying for bad debt relief.
Income or corporation tax relief for bad debts
HMRC allows businesses to classify bad debt as an expense item on their tax return for the year in which the bad debt occurred. This prevents businesses from paying tax on unpaid sales invoices. Businesses may also claim back any income or corporation tax paid on written-off earnings. To quality for this relief you must retain all transactional documentation relating to the bad debt. These documents include invoices, receipts, any written contract, and evidence of your attempts to enforce payment of the debt.
You must not exclude the debt from your sales ledger. Instead you must off-set the debt by creating a ‘debit entry’ on a separate bad debt ledger and by making a ‘credit entry’ against your sales ledger. A professional bookkeeping company is able to complete this task for you. HMRC also expects you to take reasonable steps in recovering the debt before you apply for tax relief. The size of the bad debt in question has a bearing on what is regarded as ‘reasonable’. If the debt is for millions of pounds HMRC will expect you to have received a County Court judgement for the amount in question. If the debt is for a few hundred pounds sending a few letters requesting payment may suffice.
A winding-up order together with a receiver’s note saying you will not receive payment for your debt is ample evidence entitling your to various bad debt reliefs.
You must retain documentation demonstrating the steps you took to recovery the debt. These include emails, letters, telephone notes, solicitor’s letters and court proceedings. If your customer later pays his or her debt you must declare this income on your tax return or risk facing a penalty.
VAT relief on bad debts
Businesses may also claim VAT relief on bad debts. This is not applicable for businesses paying VAT via a cash accounting VAT scheme since VAT is only due on paid-up invoices, not the earlier date when the invoice was raised. VAT relief is likewise not applicable for businesses who require upfront payment for their goods and services.
To be eligible to receive VAT relief on bad debts you must comply with the below requirements:
- You must already have accounted for the VAT on the supplies and paid it to HM Revenue and Customs
- You must have written off the debt in your day to day VAT accounts and transferred it to a separate bad debt account
- The value of the supply must not be more than the customary selling price
- The debt must not have been paid, sold or factored under a valid legal assignment
- The debt must have remained unpaid for a period of six months after the later of the time payment was due and payable and the date of the supply
- The debt must not be older than four years and six months
Include the sum total you wish to claim in Box 4 of your VAT return. Do not reduce the amount of VAT due in Box 1.
Click here to read HMRC’s official guidance on VAT relief for bad debts.