Bad Debt Relief or Credit Note?

If one of your customers is about to go under owing you a lot of money and you’ve agreed to write off part of the debt if the balance is paid immediately, how soon can you get a refund on the VAT you’ve paid on the bad debt?

Unless you use the cash accounting scheme (CAS) you must account to HMRC for VAT you charge your customers on the return, covering the date when you made the sales and not when your customer paid you. You can eventually reclaim any VAT on sales you’ve not been paid, for but there’s more than one way to do this.

The timing of VAT recovery for unpaid invoices depends on how you treat the debt in your books, i.e., either as a bad debt or as a reduction in the sale’s value. The accounting and VAT rules are different for these, but we’re concerned with the latter here. You can recover VAT you’ve accounted for on a debt you believe you won’t be paid for. There are conditions that must apply:

  • invoice is more than six months overdue for payment
  • if no payment date on the invoice, the 6-month window starts on the invoice date
  • the bad debt amount must be written off in your accounts, e.g., debit your profit & loss with bad debt expense and credit balance sheet trade debtors
  • the debt must not have been paid or transferred to another party, e.g., a debt factoring company.

To obtain bad debt relief, adjust the VAT in your return for the period in which all the conditions are met. You must notify the customer you’re claiming bad debt relief. Alternatively, reduce the value of the sales and so the corresponding VAT liability by issuing a credit note to your customer. A credit note must be issued within 14 days from the date the reduction in your invoice is agreed. Recovery of the resulting reduction in VAT should be made in the return for the VAT quarter in which you issue the credit note.

Issuing a credit note can allow you to recover VAT sooner or avoid having to account for it in the first place. For example, if your VAT quarter ends on 30 September and includes a sales invoice issued in early July, a credit note issued on or before 30 September reduces the original VAT charge so that you only must account for VAT on the reduced sale’s value.

While a claim for bad debt relief must be made within four years and six months from the date of the original invoice or due date for payment of that invoice (whichever is later), a credit note adjustment is not time limited. Therefore, if you missed the deadline for claiming bad debt relief you can still get the VAT on the unpaid invoice back by issuing a credit note.

In sum…

There are two methods for recovering VAT you’ve already accounted for, on a sale if you expect not to be paid, or only partly paid: either claim bad debt relief or issue a credit note. Bad debt relief can only be made after six months whereas a credit note can be issued at any time and so speed up VAT recovery.

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