Companies and self-employed businesses with a turnover exceeding £150,000 a year are obliged to prepare their accounts using the ‘accrual’ basis of calculating profits i.e. recognising the income received and expenses paid on an invoice basis, regardless of whether or when the cash is received. Such a method of calculation may result in some customers not paying their dues and a business may have to write off that payment as a bad debt.
HMRC have specific rules on how to treat a bad debt for tax relief to be claimed, whether that claim is under income tax or corporation tax or VAT. Most importantly, a review of each debt must be made and once the potential bad debts are identified, HMRC will only allow a claim if a reasonable effort has been made to recover the amounts owed. Every business should have a system in place to chase and record bad debts. Relatively small debts may constitute a few automated chaser letters and, if no payment is received, apply bad debt relief; the likelihood is that HMRC will accept a claim. Debts of more significant amounts say, £10,000, will require the claimant to do more e.g. employing a debt collector.
Bad debt relief is given in the period that the business decides a debt is irrecoverable, preferably in the same period that the invoice was issued; this way tax will not be payable on unpaid invoices. If the debt is not identified as irrecoverable until the next period, a full year may go by before the relief is given.
Sometimes the debtor is unable to repay the debt in cash and looks to repay using other assets such as property or shares. In this situation the property is treated as transferred for a consideration not greater than its market value. Where the market value of the asset is less than the amount of the outstanding debt, the difference may be allowed as a deduction, provided the debtor agrees that any excess of the disposal proceeds be treated as a trading receipt in their accounts on disposal of the asset. That agreed amount will not be included in any subsequent capital gains tax calculation.
You will have to bring that receipt in for the year in which you get paid, but you won’t have to make any adjustment to the earlier year for which you thought the debt was bad.
VAT on a bad debt can be claimed when an invoice has remained unpaid, or partly unpaid, for six months after the due date for payment. If the debt is subsequently repaid the VAT is declared on the next tax return.
Also, have a look at: VAT bad debt relief
HMRC Business Income Manual – BIM42701
s35, s259 Income Tax (Trading and Other Income) Act 2005
s55, s303, s479 Corporation Tax Act 2009