The VAT bad debt relief rules seek to deal with issues that can arise when an invoice has been issued to a customer and no payment has been received after a significant period of time has elapsed. The relief allows businesses to claim bad debt relief and reclaim the VAT paid to HMRC, subject to meeting certain criteria.

The Upper Tribunal recently overturned a decision of the First-tier Tribunal who had rejected a taxpayer's claim in a case which considered whether a taxpayer was entitled to claim full bad debt relief on unpaid invoices which showed a VAT-only amount.

The taxpayer in this case was a firm of solicitors practising in Edinburgh whose main work revolved around the provision of legal services in respect of insurance claims. The solicitors firm has been registered for VAT since 1973 and prior to 1 January 1985 had sent fee notes directly to the insurers who instructed them with the expectation that the insurers would pay VAT on all their fees and outlays as well as the fees and outlays themselves. 

This method of invoicing changed in February 1985, following an agreement between the then HM Customs and Excise, the British Insurance Association and other insurance bodies. The agreement allowed policy-holders who were VAT registered to count as input tax the VAT incurred on legal services supplied to them in connection with an insurance claim relating to their business. The invoicing procedure adopted by the firm of solicitors changed and where an insured party was registered for VAT, the solicitors firm issued duplicate fee notes, one to the insurer requesting payment of the net amount, and a duplicate to the insured party requesting payment of the VAT amount (recoverable as input VAT).

Where the VAT amount was not paid by the insured person, the taxpayer claimed bad debt relief on the full VAT-only amount. Between 1985 and 2007 HMRC visited the appellants approximately every three years to carry out an inspection of their VAT records and procedures. The issue of how bad debt relief was claimed was never raised.

However, following a HMRC visit in 2007, an assessment was issued on the basis that bad debt relief was limited to the VAT element of the total debt. The taxpayer appealed the decision arguing that the VAT legislation justified treating the whole of the amount contained in a VAT-only invoice as unpaid VAT and therefore refundable as part of a bad debt relied claim.

The First-tier Tribunal upheld HMRC's assessment. However, the Upper Tribunal reversed this decision and allowed the taxpayer's appeal holding that as the consideration written off was all VAT and that bad debt relief refund should be calculated accordingly. This decision allowed the taxpayer to claim bad debt relief on the total unpaid VAT-only amount.