VAT: Changes to the rules on bad debt relief for goods supplied on credit terms

This article concerns changes to the bad debt relief provisions in respect of claims relating to goods supplied on credit terms, including hire-purchase, conditional sale and credit sale agreements. The new rules reflect existing commercial accounting methods and result in a more accurate bad debt relief figure for the supplier.

Background

In VAT Information Sheet 05/04 we set out our policy on claims relating to overpaid VAT following conclusion of the litigation in the case of General Motors Acceptance Corporation UK Ltd. We then explained, in VAT Information Sheet 05/06, the changes we were making to close a loophole concerning goods sold, for a second time, by finance companies. We also announced in paragraph 6 of that Information Sheet that we intended to amend the bad debt relief rules to allow businesses to use the same basis for calculating bad debt relief as for the reduction of the original selling price. This article explains the changes we are now making to those rules.

Why payments for goods and credit affect computation of bad debt relief

Where a business supplies goods on credit they make two supplies – goods (taxable) and credit (exempt). The supplier must account for VAT on the supply of goods at the outset (the normal time of supply rules apply). However, sometimes agreements are terminated because customers default.

If a customer makes some of the periodic payments before defaulting, these payments will cover both the goods and interest. In order to work out the amount of bad debt relief claimable on the goods, the supplier will need to look back at the payments the customer made before defaulting and allocate them between the goods and interest. They will then be able to calculate how much remains unpaid for the goods and so how much of the output tax they previously paid can be reclaimed as bad debt relief.

New legislation

The new rules will be contained in regulation 170A of the Value Added Tax Regulations 1995 (SI 1995/2518) (as amended) which, in addition to the existing rule, now contains another method of calculation.

Interaction with existing commercial practice

Previously, the legislation used a ‘straight-line’ methodology. The new legislation will, for the first time, reflect existing commercial practice. Thus, for suppliers, the numbers you feed into the calculation will be based upon whatever commercial method you use, for example an actuarial method or the ‘Rule of 78’. The ultimate purpose of the calculation is to arrive at the amount outstanding in respect of the goods element, which is used for calculating the amount of bad debt relief. The new method will result in a figure which accurately reflects the commercial basis of apportionment adopted by suppliers.

Voluntary termination of agreements.

These provisions apply only to situations where, upon default, customers still owe money. If your customer invokes a right, for example under consumer credit law, to end the agreement early (so-called ‘voluntary terminations’), they will not normally owe any money and bad debt relief should not apply.

Bad debt relief claims for supplies made before 1 September 2006

When allocating payments made by defaulting customers between capital and interest, the existing calculation at paragraph 5 of regulation 170A must be used.

Bad debt relief claims for supplies made on or after 1 September 2006 and before 1 September 2007

For this transitional period, suppliers may choose between either the existing method (paragraph 5 of regulation 170A), or the new method (article 6 of regulation 170A). You do not have to notify your defaulting customers which method you have used, because they will continue to use the ‘straight-line’ method.

You may if you wish calculate claims using the old method initially and then re-compute the claim using the new method. You can then adjust the difference. This is of course, subject to the normal capping rules.

Bad debt relief claims for supplies made on or after 1 September 2007

When allocating payments made by defaulting customers between capital and interest, the new method of calculation at paragraph 6 of regulation 170A must be used.

Input tax to be repaid to HMRC by defaulting customers

If you are a defaulting customer who must repay to HMRC VAT you previously reclaimed on the goods, you are unaffected by these changes – you must continue to use the ‘straight-line’ method, whether the supplies were made before, on or after 1 September 2006.

Payments received by suppliers after termination of a credit agreement

If you receive payments after the termination of a credit agreement, these should be allocated between the goods and credit according to the proportion of the balances due at the time payment is made. You will then need to re-visit any bad debt relief claim you previously made since the amount outstanding in respect of the goods will have changed.

Reduction in the price of a supply after a bad debt relief refund

If you, as supplier, reduce your selling price after you have received a bad debt relief refund in relation to that supply, then you must repay the VAT element of the price reduction to HMRC. This is because, in reducing the selling price, you will be able to reduce the VAT you originally accounted for and therefore should not also receive bad debt relief as well.

Further information

For further information and advice, please contact HM Revenue & Customs’ National Advice Service.

Issued 13 February 2007.