Some businesses are concerned they will lose customers after the pandemic unless they offer discounts and credits as an incentive to trade. How is VAT dealt with here, and what happens with bad debts?
VAT on consideration
The ideal situation for any business deal is that you will raise an invoice for, say, £100 plus £20 VAT and get paid for the full amount, i.e. £120. But what happens if the amount paid by the customer is different from the value of the invoice? In such cases, VAT is payable according to the consideration received for goods or services supplied to a customer. A reduced payment could be evident for a number of reasons, the most obvious being:
Goods are returned – for example, if they are obsolete or damaged, or the customer took them on a sale or return basis. Alternatively, the invoice might include a pricing error, usually too high, so the customer is entitled to a credit.
Bad debts – the customer cannot afford to pay you the full amount because of their own cash-flow problems.
Discount is taken – the most common discount is for a prompt payment deal, e.g. “pay within 14 days and you will get 5% off your bill” .
Pro advice. You must never raise a credit note in a bad debt situation. A supply of goods or services has taken place, so the sales invoice being raised, and a bad debt outcome does not change that.
Prompt payment discount (PPD)
Until March 2015 it was acceptable for you to raise a sales invoice where a PPD was offered, and only charge VAT on the discounted amount, irrespective of whether their customer took advantage of the discount or otherwise. But that rule no longer applies.
Now, the original sales invoice raised by you must charge the full amount of VAT, even if a PPD is offered to their customer. If the customer takes advantage of the discount, you have two options. They can raise a credit note to balance the books, so to speak. But the easier option is to include a clear instruction on the sales invoice that the customer must reduce their input tax claim if the discount is taken.
Example. Jane sells some teapots to Mike for £5,000 plus VAT, offering a 10% “coronavirus recovery discount” if Mike pays the invoice within 14 days. The invoice value will be for £6,000 but Jane should include a note on the invoice as follows: “ A discount of 10% of the full price applies if payment is made with 14 days of the invoice date. No credit note will be issued. Following payment, you must ensure you have only recovered the VAT actually paid. ” If Mike pays £5,400 his input tax claim will be £900, i.e. £5,400 payment x 1/6 VAT fraction. Jane will account for the same amount as output tax.
Pro advice. This option will save you a lot of time and effort raising credit notes. Their sales invoices must include the terms of the PPD. In other words, the percentage being offered and the time deadline to which it applies. The wording above is not prescribed in law but was used by HMRC in Revenue and Customs Brief 49 (2014) (see Follow up ). If you use HMRC’s preferred words, they cannot go wrong.
Trade or loyalty discount
The VAT treatment here is more straightforward. The relevant discount is applied on the original sales invoice, with no subsequent adjustment being necessary. For example, if you trade as a builders’ merchant and offers a 15% trade discount to all builders, they will charge £85 plus VAT on their invoice to a builder rather than £100 plus VAT to a non-builder.
Pro advice. There is no problem if you show the gross value of the sale in their accounting records, with a separate expense account for “discounts given”. The VAT and accounting issues are independent, although HMRC might query why the sales figure in the accounts exceeds the outputs declared on VAT returns submitted within the financial year.
Credit note or bad debt relief?
Why is it so important to be clear whether non-payment of an invoice by a customer relates to bad debts or credit notes? As well as the obvious answer mentioned above, i.e. you cannot raise a credit note for a bad debt situation, another reason is because the legislation for raising credit notes and adjusting bad debts have different time periods.
Credit notes. These can be raised at any time to correct an invoice. For example, if you charged £100 plus VAT per hour for their services in 2015, instead of £80 plus VAT, and the error did not come to light until 2021, they can still raise a credit note to their customer to reduce the original invoice by £20 plus VAT per hour in 2021.
Bad debts. A claim for bad debt relief is time barred at four years and six months from the date of the original supply or due payment date if later.
You can claim bad debt relief as long as two conditions are met: the invoice in question is more than six months overdue for payment; and it must be written off in their accounting records, i.e. the debt is written off in the customer’s sales ledger account and charged as a bad debt expense on the profit and loss account. Bad debt relief is claimed in Box 4 of the VAT return, i.e. an increase in the input tax figure rather than a reduction in output tax.
If you use the cash accounting scheme, then bad debt relief is not an issue because output tax is only included on a VAT return when customers pay their dues. To use the scheme, their expected taxable sales must be anticipated to be less than £1.35m excluding VAT in the next twelve months. The downside of the scheme is that they cannot claim input tax until they have paid their suppliers.
Case law
In the First-tier Tribunal (FTT) case of Barlin Associates Ltd v HMRC [2014] TC04070 (see Follow up ), the key issue was whether a reduction in the amount owed by a customer related to a bad debt or a credit note situation.
Barlin (B) was a trade mark attorney and made sales of £871,000 including VAT of £127,000 to Autonomy Corporation (AC) between 2005 and 2010, all of which were unpaid because AC disputed the basis of charging, until legal proceedings resolved the issue. The end result of the dispute was that AC had to pay £260,000 to B, including VAT of £45,000. B issued a credit note (which included £82,000 of VAT) and sought to reclaim this VAT from HMRC. The company had actually ceased to trade in the previous year and deregistered from VAT. HMRC’s view was that the reduction from £871,000 to £260,000 did not represent a reduction in the value of supplies from B to AC but a bad debt situation which was effectively time barred.
The FTT allowed B’s appeal, saying “ HMRC are wrong to say that there is a bad debt… Autonomy owes Barlin nothing… there is no debt so there is nothing to write off. “
Pro advice. The Barlin case highlights an important point: in most bad debt situations, the customer is “unable to pay” an invoice rather than “refusing to pay”. You should check that your clients are clear about the reasons for the non-payment before dealing with the VAT issues.
Input tax adjustments
If you have not paid a supplier within six months of the invoice or due payment date, whichever is the later, they must reduce their input tax on their next VAT return. Again, this is not an issue if you use the cash accounting scheme because input tax is only claimed on paid invoices. The challenge is to ensure you review the 180+ days column in their aged creditors report.
Pro advice. Always be clear that the key date to adjust input tax is not based on six months from the invoice date but when the invoice is due for payment if this is later. The key date for an invoice raised by a supplier on 31 January 2021 on 60-day payment terms is 30 September 2021 rather than 31 July.
If you offer a prompt payment discount, you must include clear wording on your sales invoices about the need for the customer to reduce their input tax if the discount is taken. The cash accounting scheme should be considered to avoid your clients having to worry about claims for bad debt relief.
The next step
Barlin Associates Ltd v HMRC [2014] TC04070
Revenue & Customs Brief 49 (2014)
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