VAT bad debt relief: how to reclaim VAT when customers do not pay

Unpaid invoices are bad enough on their own. They damage cash flow, waste time and create awkward conversations with customers.

For VAT-registered businesses, they can also create another problem. If you use standard VAT accounting, you may have already paid VAT to HMRC on an invoice your customer has not paid.

That can feel especially painful. You have not received the money, but the VAT has already left your bank account.

In some cases, however, you may be able to claim that VAT back. This is known as VAT bad debt relief.

Here is how the rules work, when you can claim, and what records you need to keep.

What is VAT bad debt relief?

VAT bad debt relief allows a VAT-registered business to reclaim VAT it has already accounted for and paid to HMRC on a supply that has not been paid for by the customer.

In other words, if you have issued an invoice, declared the VAT and paid it over to HMRC, but the customer still has not paid you, relief may be available.

The detailed rules are set out in HMRC’s VAT bad debt relief guidance, but the basic idea is straightforward. Businesses may be able to claim relief where they have supplied goods or services and have not been paid, provided the conditions are met.

This does not mean every overdue invoice qualifies. There are conditions, time limits and record-keeping rules. But it is a useful relief, particularly for businesses that have suffered a genuine bad debt and are trying to protect their cash flow.

When can you claim VAT bad debt relief?

You cannot normally claim VAT bad debt relief as soon as an invoice becomes overdue.

HMRC says you must wait at least six months from the later of:

• The date payment was due and payable
• The date of the supply

You must also claim within four years and six months of the later of those two dates.

For example, suppose you issue an invoice on 1st March with 30-day payment terms. The payment is due on 31st March. If the customer still has not paid, the six-month clock normally runs from 31st March, not from the invoice date.

That means the debt may become eligible for VAT bad debt relief from 1st October, assuming the other conditions are met.

What conditions do you need to meet?

To claim VAT bad debt relief, you need to meet HMRC’s conditions.

For most current business situations, the main points are:

• You must already have accounted for the VAT and paid it to HMRC
• The debt must have remained unpaid for at least six months from the relevant date
• You must have written off the debt in your VAT accounting records
• You must have transferred the debt to a separate bad debt account
• The debt must not have been paid, sold or factored under a valid legal assignment.
• The value of the supply must not be more than the normal selling price.

This is an important practical point. A debt being overdue is not enough on its own. HMRC expects the debt to be written off properly in your VAT records.

That does not necessarily mean you stop chasing the customer. It means your VAT accounting records must show that the amount has been treated as a bad debt for the purposes of the claim.

How much VAT can you reclaim?

If the customer has paid nothing at all, the claim is usually based on the VAT you originally accounted for and paid to HMRC.

For example, if you invoiced a customer £1,000 plus VAT at 20%, the total invoice would be £1,200. If none of it has been paid and the conditions are met, the VAT bad debt relief claim would normally be £200.

Part payments make the calculation more complicated.

If the customer has paid part of the invoice, you can only claim relief for the VAT on the unpaid amount. HMRC says bad debt relief is based on the outstanding amount for the supplies concerned.

So, if a customer has paid some invoices but not others, or has made a general payment on account, you need to allocate the payment correctly before calculating the claim.

This is one reason good bookkeeping matters. If your records are vague, it becomes much harder to prove what has been paid, what remains outstanding and how much VAT can be reclaimed.

How do you claim VAT bad debt relief?

You claim VAT bad debt relief through your VAT return.

HMRC says the VAT you are claiming should be included in box 4 of the VAT return covering the period in which you become entitled to the relief.

Box 4 is the box for VAT reclaimed on purchases and other inputs. That can feel slightly unintuitive, because the bad debt relates to one of your sales invoices. However, this is how the claim is made.

If you want a quick refresher on VAT return procedures, take a look at how to file a VAT return.

What records do you need to keep?

HMRC expects you to keep clear records to support a VAT bad debt relief claim.

These include:

• A copy of the VAT invoice, or equivalent evidence if no VAT invoice was issued
• The amount written off as a bad debt
• The amount of VAT you are claiming
• The VAT period in which you are making the claim
• The VAT period in which you originally accounted for the VAT
• Any payments received
• The customer’s name
• The date and number of the invoice

You must also keep a separate bad debt account showing the relevant details. HMRC says records for the claim must be kept for four years from the date you make it, although this does not replace the normal requirement to keep VAT records for six years.

In practice, this means you should be able to show a clear trail from the original invoice, through the VAT return on which the VAT was paid, to the write-off and the later relief claim.

What if the customer pays later?

Sometimes a customer pays after you have claimed VAT bad debt relief.

If that happens, you do not get to keep the VAT relief permanently.

HMRC says that if you receive payment after claiming relief, you must repay the VAT element included in the payment. The repayment is made through box 1 of your VAT return for the period in which you received the payment.

For example, if you claimed relief on a fully unpaid invoice and the customer later pays half of it, you will normally need to repay the VAT relating to that half-payment.

Again, accurate records matter. Your bad debt account should show the later payment and the VAT adjustment.

What if you use the VAT cash accounting scheme?

VAT bad debt relief is mainly an issue for businesses using standard VAT accounting.

Under standard VAT accounting, you normally account for VAT when invoices are issued, not when customers pay. That is why an unpaid invoice can create a VAT cash-flow problem.

The VAT cash accounting scheme works differently. Under cash accounting, you usually account for VAT when your customer pays you. Bad debts are therefore relieved automatically in many ordinary cases, because if the customer never pays, you never account for the VAT.

That can be useful for businesses with slow-paying customers. However, cash accounting is not right for everyone. It can also delay when you reclaim VAT on purchases, because you usually reclaim input VAT only when you have paid your supplier.

So, as with most VAT schemes, the right answer depends on how your business actually works.

Remember the other side of the rule

There is another point businesses sometimes miss.

VAT bad debt relief does not only affect suppliers who are owed money. It can also affect customers who have not paid their own suppliers.

If you reclaim input VAT on a purchase but do not pay your supplier within six months of the relevant date, you may have to repay that input VAT to HMRC. HMRC refers to this as repayment of input tax, or clawback.

This matters if your business has old unpaid purchase invoices sitting in the accounts. It is not only your sales ledger that needs attention. Your purchase ledger may also have VAT consequences.

Do not use credit notes to fix unpaid invoices

A credit note is not the right way to deal with a bad debt.

HMRC says you may not issue a credit note simply because a customer has not paid. A credit note should only be used where there has been a genuine mistake, overcharge or agreed reduction in the value of the supply.

That distinction matters. If the customer still owes the money, but has not paid, the correct route is normally bad debt relief, assuming the conditions are met.

Issuing credit notes just to tidy up old debtors can create VAT errors and make your records harder to defend if HMRC asks questions later.

How to reduce the problem in future

VAT bad debt relief is helpful, but it is still a remedy after the damage has been done.

It is better to reduce the risk of bad debts in the first place. That means keeping your invoicing and payment processes clean.

For example, it’s a good plan to:

• Agree on payment terms before work starts
• Make sure invoices are accurate and sent promptly
• Use the correct legal customer name
• Include purchase order details where required
• Keep evidence of delivery or completed work
• Chase overdue invoices consistently
• Review aged debtors before cash-flow pressure builds

The government has been looking at tougher late payment rules, including proposals designed to improve payment behaviour between businesses. However, even stronger rules will not remove the need for good records, clear terms and disciplined accounts processes.

How THP can help

VAT bad debt relief can be valuable, but the rules need care.

You need to check that the debt qualifies, calculate the claim correctly, keep the right records and make the adjustment in the right VAT return period. You also need to deal properly with any later payment from the customer.

THP’s VAT returns service can help you prepare and submit accurate, MTD-compliant VAT returns. We can also review your VAT records, check whether a bad debt relief claim is available, and help you avoid common mistakes.

If unpaid invoices are creating VAT problems for your business, please get in touch. We’ll be happy to help.