HMRC revised their bad debt relief policy in VAT Info Sheet 05/04, following the litigation in GMAC UK Ltd. Further changes were made in VAT Info Sheet 05/06 to close a loophole concerning goods sold for a second time by finance companies. Notice was also given that changes would be made to allow businesses to use the same basis for calculating bad debt relief as for the reduction of the original selling price. HMRC are now making those changes.
HMRC advise that where a business supplies goods on credit, it makes two supplies - goods (taxable) and credit (exempt). The supplier must account for VAT on the supply of goods at the outset, but 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.
Previously, the legislation used a ‘straight-line’ methodology. The new legislation will instead reflect existing commercial practice. Thus, for suppliers, the numbers fed into the calculation will be based on the commercial method used (e.g. an actuarial method or the ‘Rule of 78’). The new rules only apply to situations where, upon default, the customers still owe money.
If the customer invokes a right to end the agreement early (voluntary termination), they will not normally owe any money and bad debt relief should not apply. When allocating payments from defaulting customers for supplies made before 1 September 2006, the existing calculation must be used. Payments from defaulting customers for supplies made in the 1 September 2006 to 1 September 2007 transitional period can be allocated using the existing or new calculations, but payments from defaulting customers for supplies made after 1 September 2007 must be allocated using the new calculation only.
Defaulting customers who must repay the VAT previously reclaimed on goods are unaffected. The ‘straight line’ method applies regardless of when the supply was made. Payments received after termination of an agreement change the amount outstanding, and will need an adjustment to be made to the relief claimed.