Tax relief for when a debt goes wrong

With ongoing economic pressure across a number of business sectors, bad debts are becoming an increasingly frequent problem for businesses taxed on an accrual basis (i.e., when invoiced), rather than on a cash basis (i.e., when payment is received). Such businesses include companies and unincorporated traders above the £150,000 turnover threshold. Where debts are confirmed as irrecoverable, bad debt relief may be available for both direct tax and VAT purposes, but only if specific conditions are met.

Relief is claimed as a deduction against income tax and corporation tax in the accounting period in which the debt is written off. To qualify: the debt must have arisen wholly and exclusively for the purposes of the trade; the income must have previously been included in turnover; the debt must be specifically identified (relief cannot be claimed for a general provision); and the debt must be written off as irrecoverable in the accounting records.

VAT bad debt relief

VAT relief operates under separate statutory rules. A claim is made by including the VAT element in Box 4 (the input tax box) of the VAT return, but only if the following conditions are satisfied:

• The invoice is more than six months overdue.
• The debt has been written off in the accounting records.
• The debt must not have been sold, factored or paid under a valid legal assignment. Importantly, the six-month period starts from when payment was due, rather than from the invoice date. For example, if an invoice is issued on 31 March 2026 with 60-day payment terms, the earliest claim date is 30 November 2026. Businesses should keep a dedicated bad debts account recording the dates and reference numbers of the original tax invoices, the VAT charged, any payments on account received, and details of each claim.

Proving a bad debt

HMRC scrutiny typically focuses on whether debts are genuinely irrecoverable or merely slow-paying. Proof that a review of each debt has been made will be required and once the potential bad debts have been identified, HMRC will only allow a claim if a reasonable effort has been made to recover the amounts owed. What constitutes ‘reasonable’ will depend on the size and circumstances of the amount.

For small debts, reminder letters and formal demands may be sufficient proof. For more material sums, proof of stronger action may be required (e.g., engagement of a debt collection agent or the initiation of legal proceedings).

Debts more than four years old

As has been seen, if the debt is more than four years old, a bad debt relief is time-barred. However, if there is a valid reason why a debt remains unpaid after four years, a ‘Regulation 38’ adjustment may be considered. This adjustment applies where there is an agreed change in the value of consideration between the parties.

Such circumstances may arise where: goods supplied under a hire-purchase, conditional sale or lease-purchase agreement are returned; the customer becomes entitled to a contingent discount; or Goods are found to be defective, and a reduced price is negotiated and agreed.

In such cases, the supplier issues a credit note and reduces the Box 1 (output tax) figure on the next VAT return accordingly. Note that there is no time restriction for a Regulation 28 adjustment. A five-year-old invoice can still be corrected with a credit note, if appropriate, but it will be out of time for any potential bad debt relief claim.

Practical tip

A frequently overlooked issue concerns the treatment in the debtor’s accounts. If a VAT-registered business fails to pay a supplier within six months, it must repay any input VAT previously claimed on that purchase. Failure to make the necessary adjustment will count as an error on the VAT return.