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A little known loophole regarding the VAT Flat Rate Scheme and bad debts has come to our attention.

Under the Flat Rate Scheme (FRS) a business still charges normal vat (currently 17.5%) on their sales, but they pay a reduced rate to HMRC in return for not claiming any Input Vat on expenses.

EG on a sales invoice for £1,000 net, they would add £175 vat and seek to collect £1,175 from their customer, but (using an example of a 10% flat rate band – it varies by business sector) they would only pay £117.50 to HMRC.

What happens if the customer doesn’t pay and theres a bad debt? Well, its not as you would expect.

Cash accounting – under cash accounting you only pay vat when your customer pays you, so if theres a bad debt you never get the £1,175 so you never pay HMRC £117.50. But under the vat bad debt relief scheme, you are entitled to a full 17.5% relief for your bad debt, so you can claim on your vat return £175 (relief due) less £117.50 (relief automatically given) = £57.50.

Invoice accounting – under invoice accounting you pay your vat when you raise an invoice, so you will have paid vat of £117.50 to HMRC . You can claim £175 back on your vat return.

Section 14 of Vat Notice 733 gives more detail on the bad debts and the Flat Rate Scheme.

Section 18 of Vat Notice 700 explains the general rules for eligibility for vat bad debt relief – broadly that you’ve written the debt off in your accounts and its more than six months old.