VAT and Coronavirus: How Can I Help My Clients Handle Bad Debts and Improve Cashflow?
Introduction: Why Do I Need To Worry About Bad Debts Right Now?
Alongside the tragic loss of life which the coronavirus crisis has brought to these islands is the inevitable economic downturn which will follow, even if the Lockdown is lifted relatively soon.
As a result, many of our clients will be struggling to get paid as customers stay at home, suffer loss of cash-flow or even, in some cases, close their doors completely.
What this will mean, unfortunately, is a rise in the level of bad debts many of our clients suffer.
While the Government has announced a temporary moratorium on the collection of VAT, inevitably the time will come when HMRC is once again focused on getting money in. If there is a serious recession, as is being predicted, then this focus will be all-consuming.
In those circumstances, it’s important that we can advise our clients as to their rights and ensure that they are not paying over any more VAT than they have to. It is also vital that, in advising them, we “keep them right” so that there is no opportunity for HMRC to issue penalties for errors, etc.
One of the most important reliefs available to taxpayers in difficult economic times is Bad Debt Relief (“BDR”). The basic principle is very simple, but there are certain key conditions which must be met to ensure a BDR claim stands.
I’ve set out the key points below.
Note also that there are some special considerations for users of the Flat Rate Scheme. These are addressed below.
Note that for businesses in the Cash Accounting Scheme, bad debts are effectively relieved automatically. For some businesses, a move to the Cash Accounting Scheme may be worth examining. The main things to bear in mind are discussed in section 4 below.
The tax point rules also offer some possible avenues to improving cash flow where clients’ circumstances permit, and section 5 looks at these.
Finally, in section 6, I address another issue which may crop up for businesses having a hard time paying their bills, on the input tax side: namely, the requirement to repay input VAT on unpaid invoices.
BDR Basics: How Can I Claim Relief For Bad Debts? Where Do I Need To Take Care?
For any business which is VAT-registered and not using Cash Accounting (and is not in the Flat Rate Scheme), there are four key conditions to be met to make a successful claim for BDR.
- The debt must not have been sold, factored or paid under a valid legal assignment. In other words, there must still be an economic risk to the business if the debt is not paid by the customer
- HMRC must have actually received the output VAT on the sales invoice. This should be borne in mind given the current deferment provisions
- The sales invoice in question must be more than six months overdue for payment. This means that the terms for payment are relevant in calculating when a claim can be made
- The outstanding debt has been written off in the supplier’s books. This requires a formal entry in the accounting records, so that there is a credit set against the customer’s debtor account on the Balance Sheet, and a debit appearing in the Profit & Loss account under Bad Debts
Assuming all of these conditions are met, then a claim for BDR can be made.
Of course, as ever, there are deadlines to be aware of. The Regulations (Reg 165A for the really keen) state that the deadline for making a claim is 4 years and 6 months from the later of:
- The date on which the payment for the debt which has been written off becomes due, and
- The date of the supply
In other words, where a business offers 30 days payment terms on the face of the VAT invoice, the clock starts running from 30 days after the supply, rather than the invoice date. This is very important, as a debt which is 6 months old would not qualify for BDR if the payment terms effectively gave the customer 30 days to pay.
I have included an example below to set out the kinds of issues which may arise when clients are faced with bad debts arising from the coronavirus crisis.
Example 1: Normal VAT Rules
Ashley runs Twelve Oaks Ltd, which supplies bespoke furniture to high-end home furnishings stores.
Business had been going very well right up to the Lockdown, and he is now, in November 2020, finding it difficult to make ends meet. Many of his best customers are taking a long time to pay and a number have gone out of business entirely. He offers customers a standard 1 month to pay on all his sales invoices.
Ashley’s stagger group is January/April/July/October, and the last VAT return he filed and paid was on 7 March 2020.
He availed of the coronavirus deferment for VAT payment on his return for April 2020, and is planning to make the payment before 31 March 2021, as the scheme allows. The July 2020 quarter was very quiet and he ended up with a repayment. In October, things have picked up a bit, but business is still slow and his cash position is not strong.
He has four sales invoices which are outstanding, as follows:
By 31 October 2020 (the end of the latest VAT quarter), the 6-month period has passed for all four invoices, as can be seen above. He has also not sold or factored any of the debts.
However, the other relevant conditions are not met for all four invoices.
The customers for invoices 17 and 34 have gone out of business, and he has written these debts off completely in his accounts. However, as he has not paid over the VAT on invoice 34, he cannot make a BDR claim in respect of it.
He should be able to make a claim after March 2021, once the deferment period for the coronavirus ends, but is likely to end up simply with a net nil position. He may want to consider making a payment slightly early and netting the BDR claim off on the same VAT return to avoid a temporary cash outflow.
For invoices 23 and 41, he expects that the customers will eventually be able to pay him, albeit it may take some time. For invoice 23, he has already paid over the VAT, but for invoice 41, he has not.
As a result, he decides to write invoice 23 off in his books as well, but to leave invoice 41 as is, not least as he is concerned that his balance sheet should not look too weak for his year-end accounts, which are to be prepared as at 31 October.
Where does all of this leave Ashley?
The result of the above is that a valid BDR claim may be made for invoices 17 and 23, for a total VAT refund of £1,300.00. This is claimed as a positive amount in Box 4 of the VAT return. Hopefully, Ashley’s recently installed online accounting software will be able to handle it properly…!
Ashley should also note that, if invoice 23 is eventually paid, he does not get a VAT windfall. He is required to reverse the entry in his VAT account and pay over the output VAT in the return for the period in which the monies are received. If he is paid in stages, then the same applies to each payment as they come in.
How Does Bad Debt Relief Work in the Flat Rate Scheme?
One interesting feature of the Flat Rate Scheme (“FRS”) is that a bad debt claim can give rise to a VAT windfall.
In many respects this operates as a natural outflow from the built-in advantage where the FRS rate applicable to the business is less than the 1/6th of the gross invoice value paid over by the end customer.
The Cash Accounting rules do not apply to the FRS; rather there is a “cash-based turnover” method, which is similar to (but not identical to) the Cash Accounting scheme for normal VAT registrations.
The rules allow the taxpayer to claim the windfall on an unpaid invoice which has been written off which they would normally receive under the FRS, even if they have not paid over the output VAT to HMRC.
The example below shows how this operates.
If the FRS trader uses the basic turnover method (i.e.: it is calculated on the invoice date basis), then the windfall is paid over by HMRC as well, albeit the method by which it is received is slightly different. The taxpayer, having paid over the FRS percentage initially, makes a refund claim for the full 1/6th of the gross value of the sales invoice.
The result is that, in cash terms, the taxpayer ends up in the same position.
Example 2: Flat Rate Scheme
This example is in two parts, the only difference between (a) and (b) being that in (a) the business operates the cash-based turnover method.
(a) FRS: Cash-Based Turnover
Melanie is a sole trader and runs a small shop selling hand-made toys and decorative items to the public. She also makes some sales to other shops which sell them on to tourists.
Her gross turnover in the year to 31 March 2020 was £160,000, so she was still within the FRS turnover limits (no more than £150,000 to enter the FRS, and less than £230,000 to remain within it once registered).
She expects to see a drop in her turnover in the year to March 2021.
Like Ashley, she is now doing her return for the q/e October 2020. As most of her business is retail “not listed elsewhere”, on her accountant’s advice she has been applying the 7.5% FRS rate to all of her sales, including those which are effectively wholesale.
She has one invoice which has not been paid by a tourist shop in her local area which hasn’t reopened after the Lockdown. The invoice details are as follows:
Six months have now passed, and she has written the debt off in her books. As she is applying the cash-based turnover method, she has not yet paid over the VAT on the sale to HMRC.
Nevertheless, the FRS bad debt rules allow her to make a claim for her “FRS surplus”. This is calculated as follows:
|Sale Value (Gross)
|FRS VAT due (@7.5%)
|VAT due from customer
|FRS VAT Uplift
Melanie can therefore claim £92.00 in Box 4 on her October 2020 VAT return.
This is set out in VAT Notice 733, paragraph 14.2.
(b) FRS: Basic Turnover Method
The facts are as above, except Melanie applies the basic turnover method and paid over the FRS VAT amount of £75.00 on her VAT return for q/e January 2020.
In this scenario, Melanie would make a BDR claim for the full £167.00 VAT amount in Box 4, and thus her net position would end up at a VAT “surplus” of £92.00, as above.
Note that the BDR rules apply as normal to an FRS-registered trader who is not using the “cash-based turnover” method.
Cash Accounting Scheme: How Can it Help My Clients?
For those businesses which are already in the Cash Accounting Scheme, bad debt relief for VAT will not be a pressing concern, since VAT is only paid over when sales invoices are paid by the customer.
The obvious downside of the Scheme is that input VAT can only be reclaimed once the invoice has been paid.
Most businesses which could apply the Cash Accounting Scheme, but don’t, will (hopefully!) be doing so because it is advantageous not to.
This might be because any of the following apply:
- Their outputs are zero-rated, and their inputs are subject to VAT
- Their sales are largely “cash” sales and their level of debtors is low, while they tend to avail of full credit terms on their inputs
- They are not making much in the way of sales at present, but they are incurring expenses (and input VAT)
The Cash Accounting Scheme is open to businesses which meet the following limits:
- If they have not started to apply the Scheme, their sales are expected to be below £1.35m (net of VAT) over the next 12 months
- If they are already in the Scheme, their sales over the past 12 months have not exceeded £1.6m net of VAT. Note that sales for these purposes are broadly defined, and even “lumpy” items such as the disposal of capital assets are included in the figure
Entering the Scheme is actually very easy.
If the business meets the conditions, it can apply the Scheme from the beginning of any VAT period. Generally speaking, this is relatively straightforward, especially where records are as good as they are supposed to be.
New sales (and purchases) are handled on the cash basis, while the older sales and purchases continue to be dealt with on the accruals basis.
Where difficulties can arise is where record-keeping isn’t quite as good as it should be, or where bookkeepers get confused and tying figures together can be tricky. However, it is to be hoped that this won’t be an issue too often…
However, on leaving the Scheme, the position is different. The rules are explained in detail in VAT Notice 731, paragraphs 6.4 and 6.5, but in summary the position is as follows.
All output VAT on bills issued must be brought up to date. Similarly, input VAT can also be claimed, but for many businesses, clearly, this could cause a serious cashflow squeeze. As a result, there is provision for spreading the necessary adjustment out over a 6-month period.
It is also worth noting that this rule applies even if the business is obliged to leave the Scheme. In other words, exceeding the turnover threshold could give rise to a cashflow problem, and in borderline cases planning for such an eventuality would seem prudent.
Note that some businesses cannot qualify for the 6-month adjustment period, although in practice this is likely to be rare. VAT Notice 731 should be consulted in cases of doubt.
Are There Any Alternatives for Boosting Cash-flow?
There are certain other approaches which can be of value for businesses for whom the Cash Accounting Scheme is either unavailable or unattractive.
For example, where businesses are supplying continuous supplies of services, the “time of supply” permit a different method of working out when the tax point arises.
Under the Regulations (Reg 90) the time of supply is determined as follows:
- Where services are supplied for any period for a consideration the whole or part of which is determined or payable periodically or from time to time, then
- The services are treated as separately and successively supplied each time payment is received or a VAT invoice relating to the supply is issued by the supplier, whichever is the earlier
Some businesses avail of this provision by issuing a “request for payment” to their customers, while a VAT invoice is not issued until payment is received.
This has the potential benefit of deferring payment of output VAT until the invoice has been paid, without affecting the reclaiming of input VAT (as would be the case under the Cash Accounting Scheme).
Note that HMRC can take a sceptical view of invoicing which is done on this basis, and so this treatment should not be applied without due care.
In particular, it is important that the services being supplied really can be regarded as falling within the terms envisaged by the Regulations.
There are also some anti-avoidance and advanced invoicing rules which should be taken into account by businesses which use this approach, or which are considering moving to such an approach where their circumstances suggest it would be suitable.
It is also important to note that this can only apply to the supply of services. The tax point rules for goods are much less flexible.
How Do I Handle Input Tax On Unpaid Bills?
Given that HMRC are virtually certain to be seeking to maximise the tax take once the Lockdown ends, businesses which are struggling to pay their bills should bear in mind that the Regulations (Regs 172F et seq) require the repayment of any input VAT refunded to them by HMRC where the underlying invoice is still unpaid by the later of:
- 6 months after the date of the supply, or
- The due date for payment of the invoice
An adjustment (a negative figure in Box 4) should be made in respect of the input tax to be refunded.
Note that input VAT on part-paid invoices should be repaid in proportion to the amount of the bill which remains unpaid. Once the bill has been paid in full, the input tax can then be reclaimed in the VAT return for the relevant period.
HMRC summarise the rules in VAT Notice 700/18, paragraph 4.
It should be noted that where businesses are in the Cash Accounting Scheme, these rules should not be relevant, since input tax can only be reclaimed once the bill has been paid. For businesses in the FRS, input tax is rarely in point except for certain specific forms of expenditure.
Summary: What Are The Key Points I Need to Remember?
It is unfortunately likely that many of our clients will be facing some difficult times ahead, and cash-flow is therefore likely to be under strain.
The BDR rules operate to allow affected businesses to reclaim VAT from HMRC on unpaid bills where the conditions set out above are met. Note that one of the conditions is that the VAT has in fact been paid to HMRC, which may not be the case owing to the coronavirus VAT deferment arrangements. Note also that the “clock” starts from the due date on a particular bill, not the date of the initial supply. Given that HMRC are likely to be seeking revenue quite proactively later in the year, making sure that the BDR conditions are all met is vital to ensure that penalties are not incurred (and that the refund claimed actually arrives).
Some smaller businesses are in the FRS and the bad debt rules for those in the “cash-based turnover method” permit a VAT refund claim even when no VAT has been paid over to HMRC. While this is a definite benefit of the FRS, it flows logically from its operation.
For businesses which meet the tests and understand the rules, the Cash Accounting Scheme may well be worth a look, at least for a time. However, the adjustments required on exiting the Scheme must be borne in mind when considering whether to switch from the normal VAT accounting rules.
It is also worth noting that some businesses in the services sector which make continuous supplies of services, but which cannot or do not want to apply the Cash Accounting Scheme, may be able to benefit from the special time of supply rules provided for in the Regulations.
Finally, it should be remembered that the VAT rules relating to bad debt cut both ways, and the Regulations require repayment of a proportionate amount of input tax on bills which have been unpaid for more than 6 months, as explained above.
HMRC’s guidance in this area can be found in the relevant VAT Notices as follows:
- VAT Notice 700/18: Bad Debt Relief and Repayment of Input Tax for Unpaid Bills
- VAT Notice 733: Flat Rate Scheme
- VAT Notice 731: Cash Accounting Scheme
Hopefully this Update has been helpful, and should you wish to discuss any of the issues arising – or indeed anything else VAT-related – please don’t hesitate to contact me for a free, no obligation initial enquiry.