Credit note or bad debt?

July 27th 2021

A regular customer owes you a lot of money and has offered to pay half now if you agree to accept it as full payment for all outstanding invoices. But how do you deal with the bad debt? Our VAT expert John Craig explains in greater detail.

The VAT rules are different according to whether your business has suffered a bad debt on a deal or whether it is giving credit to a customer against invoices previously issued. For example, if you deliver 60 units of goods to a customer, and they return 20 because they are faulty, the correct approach is to issue a credit note. But you cannot issue a credit note for a bad debt situation – that requires different VAT treatment.

If your customer is VAT-registered and can fully claim input tax, you can agree with them not to issue a credit note and not to adjust the original VAT charge. You can issue a document to reduce the original invoice with the comment “This is not a credit note for VAT.

Bad debt relief
A bad debt situation means that a customer owes your business an amount of money, and that amount is correctly due, but they have refused to pay some or all of it. If you charged VAT on the original invoice(s) and have declared the VAT to HMRC on a return, you can only reclaim this VAT if all the following conditions are met:

• The invoice is more than six months overdue for payment
• If there is no payment date shown on the invoice, the six-month window is based on the invoice date
• The invoice must be written off in your accounting records, i.e., charged to a bad debt expense account; and
• The debt must not have been paid, sold, or factored under a valid legal assignment.

If your business uses the cash accounting scheme, then bad debt relief is automatic because output tax is not declared on a return until the customer has paid. You can join if your taxable sales in the next twelve months are expected to be less than £1.35m.

However, you cannot claim input tax with the cash accounting scheme until you pay your suppliers.

In summary
If you agree to give a price reduction to your customers on their unpaid invoices in return for a payment of the outstanding balance, this is a credit note rather than bad debt outcome. According to HMRC, you can issue a credit note where there is “an agreed reduction in the value of your supply”. This means that you can issue credit notes to your customer and adjust the VAT on your next return. With a bad debt situation, you would have to wait until the debt was at least six months overdue for payment.

There is another advantage of a credit note adjustment (not relevant to this scenario but worth noting). A claim for bad debt relief must be made within four years and six months of the later of the payment or invoice date. A credit note adjustment is not time barred.

Therefore, you can issue credit notes to your customer if you agree to adjust the price on the original invoices. If not, you can still claim the VAT after six months with a claim for bad debt relief on your VAT return.