As business owners, ending up with unpaid bills is a harsh reality. Small businesses often have to make a judgement call between being cautious or taking risks, and sometimes the risks just don’t pay off. If a debt is ends up being written off, then tax relief on that debt could provide a valuable cash flow boost.
For a VAT registered business, any debt owed by its customers is made up of two components:
- Value of service or goods (which is part of your Sales)
- VAT on above (which is reclaimed by the debtor in their VAT return)
Tax relief is available for both, but the procedure is very different.
Income tax relief on bad debts
What can I write off as a bad debt?
The debt written off must be a trade debt and you are required to keep evidence e.g. invoices, contracts, purchase orders etc. An irrecoverable loan cannot be treated as a bad debt.
You can only claim relief for bad debt, if the amount is irrecoverable. No provision can be made for a slow paying customer. Therefore, if there is a likelihood that the outstanding amount will eventually be paid, then a bad debt claim cannot be made. You can, however, charge the customer interest as per the Late Payment of Commercial Debts (Interest) Act, 1998.
What evidence should I keep?
The debt must be written off in accounts and the business must keep evidence of how and when it assessed the debt to be uncollectible.
Such evidence could include:
- Phone records
- Copies of letters or notices and any legal action taken to pursue the customer
- Internal evidence e.g. memos of meetings regarding the matter
- Correspondence with solicitors, banks or factoring agencies
- Reports concerning the financial position of the customer
Needless to say, the effort would be in proportion to the amount of debt being recovered.
When can I claim?
You can claim the write-off when an assessment is made which can be after the balance sheet date but before finalisation of the accounts. If the assessment is made after the accounts are finalised, it will be available in the next accounting period.
What else do I need to consider before making a claim?
- The debtor and creditor must not be connected. Debts owed by related parties such as family members, business partners, shareholders or connected companies are not tax deductible.
- The goods or services must have been supplied. If goods are confiscated, appropriate deductions should be made.
- The debt should not have been paid, sold or factored under a valid legal assignment, which holds true for income tax relief too.
- Any amount recovered subsequently is taxable in the year of recovery.
Reclaim of VAT on bad debt
While it is simple to write off the value of supply, a VAT reclaim is more complicated.
A claim for VAT paid to HMRC can be made only if following additional conditions are fulfilled:
- The VAT has been accounted for and paid to HMRC
- 6 months have elapsed since the due date for payment (in accordance with your payment terms)
What else do I need to know?
- Businesses registered on the Flat Rate scheme can claim VAT relief at 20%.
- Some relief is also available to unincorporated businesses operating on a cash basis of accounting.
- You must maintain appropriate records for 4 years from write off for inspection.
- HMRC monitors bad debt claims and if there are significant claims then a VAT or tax investigation can be opened up, therefore appropriate records should be maintained.
As a fully qualified tax adviser and accountant and with an impressive history in the corporate environment; Sonal brings significant experience and expertise to RightCue Tax Advisers, where she has the role of Managing Partner. If you would like further advice on any of the above, please contact Sonal on 01256 406601 or [email protected].