It is important to be clear about the difference between a ‘credit’ situation and a ‘bad debt’ outcome.?Put simply, a credit situation involves a whole or part reduction in the invoice amount. A bad debt is where you expect the customer to pay, but they don’t. You do not issue a credit note in bad debt situations. You can claim any output tax you account for on a VAT return back on a future return as long as two conditions are met:

• the sales invoice for the original sale is at least six months overdue for payment; and
• the invoice has been written off in the accounts of the supplier, i.e. a credit to debtors and a bad debt expense entry is made in the profit and loss account.

Bad debt relief claims are subject to time limits, and if HMRC reclassifies a credit as a bad debt, it might be too late to claim relief. Be clear that the key date is?six months after the due payment date, not six months from the date of the sales invoice. So, if an invoice is raised on 31 March 2017 on 60-day payment terms, the earliest possible date for a bad debt claim for VAT purposes is the VAT return that includes 30 November 2017.?If a business uses the cash accounting scheme, then bad debt relief is automatic.

CREDIT NOTES

A credit note is used to wholly or partially offset the amount of a sales invoice. This can include VAT, but will not in all situations. The document raised must clearly state: ‘

Example

John is a clothes wholesaler and sold five dresses to retailer Samantha for ?100 + VAT each, i.e. a total invoice of ?500 + VAT. One of the dresses is the wrong colour and is returned for a refund, and another is slightly damaged so John agrees to give a 50% discount for this item. John will raise a credit note to Samantha for ?150 + VAT. If John and Samantha are both VAT registered, the credit note can be raised without any VAT, i.e. with no adjustment to the VAT originally paid. In this case, the credit note must clearly state ‘This is not a credit note for VAT’.

One of the key reasons that it is imperative to distinguish between a credit adjustment and a bad debt is that bad debt claims are time barred at four years and six months from the date of the original supply, whereas credit adjustments have no time limit.?HMRC will look closely at any large transaction that results in output tax being reduced. If it has been wrongly classed as a credit adjustment instead of a bad debt, there would be no relief if the time limit has passed.

NON-REFUNDABLE FEES

What is the situation where a non-refundable fee is charged in advance of a supply, and ultimately the supply never occurs? This situation relates to an important VAT principle, namely that ‘the right’ to benefit from goods or services is a supply in its own right. VAT liability is based on the know facts at the time of supply, i.e. the full payment is standard-rated and there will be no scope to reduce output tax following a later cancellation.

CANCELLATION CHARGES

This is different from circumstances where a security deposit is subject to forfeiture. Imagine the following situation: a business hiring out bikes always receives an extra payment from customers before the hiring takes place to cover the cost of any potential damage.?If the bike is returned in good condition, the customer is fully refunded their deposit. In this situation, there is no output tax issue because the initial deposit does not relate to a taxable supply of goods or services.?Even if the customer forfeits their deposit, there is no output tax to pay because the payment is effectively compensation to the business owner for the time and cost they will incur repairing the bike, i.e. the deposit retention is outside the scope of VAT.

PROMPT PAYMENTS

You may offer customers a discount for early payment of an invoice, e.g. a 5% reduction in exchange for payment within 30 days. The rules regarding the VAT treatment changed with effect from 1 April 2015.?VAT must be paid to HMRC according to the amount paid by the customer in cases where a prompt payment discount is offered by a supplier. The previous rules allowed VAT to be charged on the discounted amount, irrespective of whether the customer took advantage of the discount.

A major concern when these rules were introduced was that a business could need to issue a lot of credit notes to customers taking advantage of the discounts. But?Revenue and Customs Brief 49 (2014)?confirms that this is not necessary – as long as a supplier gives a clear instruction on their sales invoice that a customer must reduce their input tax if they take advantage of the discount. The supplier can then reduce their output tax as well, without the extra administration.

Example

Joan sells goods to Sue for ?2,000 plus VAT, offering a 10% prompt payment discount if Sue pays within 30 days. Joan?s original invoice will charge ?400 VAT, i.e. 20% of the full selling price. She will reduce her output tax by ?40 if Sue takes advantage of the discount. As long as Joan makes it clear on her original invoice that Sue must reduce her input tax if the discount is taken, then Joan will not need to issue a credit note.

The law does not specify the wording to include on your sales invoices where a prompt payment discount is offered. But HMRC suggests the following: ‘A discount of X% of the full price applies if payment is made within Y days of the invoice date. No credit note will be issued. Following payment you must ensure you have only recovered the VAT actually paid.’