Every business deals with unpaid invoices from time to time. Chasing late payments isn’t just frustrating — it can impact your cash flow, tax position, and VAT returns.
So when an invoice hasn’t been paid, what are your options from a VAT perspective? Can you issue a credit note to reclaim the VAT, or do you need to go down the bad debt relief route?
Let’s explore the difference between the two — and when each one applies.
When to Use a Credit Note
A credit note is a formal document used to adjust or cancel all or part of a previously issued invoice. It is typically used when:
- There was an overcharge or billing error
- Goods were returned
- A post-invoice discount is applied
In all of these cases, the credit note must be issued to the customer, and both you and the customer adjust your VAT returns accordingly.
Importantly, a credit note should not be used to deal with non-payment or bad debts. It only applies when the original invoice needs to be corrected due to a change in the commercial terms.
Also, the credit note must be sent to the customer, as they will need it to adjust their input VAT if they are VAT-registered.
When to Claim VAT Bad Debt Relief
Bad debt relief (BDR) allows you to reclaim VAT on a supply if you have not been paid — even though you’ve already paid that VAT to HMRC.
To make a BDR claim, the following conditions must be met:
- VAT has been accounted for and paid to HMRC
- The amount has been written off in your accounts and transferred to a bad debt account
- The invoice has not been factored or sold to another party
- The value of the debt does not exceed the usual selling price
- The debt remains unpaid for at least six months from the later of:
- The invoice due date
- The date of supply
If these conditions are met, you can claim BDR on your next VAT return.
However, if the customer eventually pays the invoice, you must repay the VAT you reclaimed through BDR on your next return.
Is There a Third Option?
Yes — in certain circumstances, a VAT adjustment can be made under Regulation 38 of the VAT regulations.
This applies when:
- There is a genuine reduction in price after the invoice has been issued
- A refund is issued to the customer
- A credit note is sent within 14 days of the reduction
- The adjustment is accounted for in the VAT period in which the change occurs
- If the customer is VAT-registered, they must also reduce the VAT they claimed
So, if a price adjustment has been agreed after invoicing — for example, as part of a commercial negotiation — you can use Regulation 38 to reduce your VAT liability, provided the correct process is followed.
Time Limits: Credit Notes vs Bad Debt Relief
- Credit notes (including Regulation 38 adjustments) can be issued at any time, even for invoices several years old, provided the commercial circumstances justify the change.
- Bad debt relief, on the other hand, must be claimed no earlier than six months after the invoice becomes due. If that window passes without the conditions being met, you may lose the ability to claim.
Common Mistake: Using a Credit Note for an Unpaid Invoice
It’s tempting to issue a credit note just to remove an unpaid invoice and reclaim the VAT. But unless there’s been a genuine pricing error, return or renegotiation, this can land you in hot water with HMRC.
A credit note issued for an unpaid invoice, without any change to the agreement or supply, would not be valid. If challenged, HMRC may refuse the VAT adjustment and impose penalties.
Practical Advice
- Always check why the invoice hasn’t been paid before deciding on a course of action
- Use a credit note only if the invoice is incorrect or the sale is being reversed or adjusted
- Use bad debt relief if the invoice was correct and unpaid after six months
- Keep detailed records to support either route, especially when making a BDR claim
Need Help Managing VAT on Unpaid Invoices?
Choosing the wrong option between credit notes and bad debt relief can have VAT consequences — especially if HMRC reviews your returns.
If you’re not sure which approach to take, or want to make sure your records are in good order, get in touch.
Speak to Jon and the team today and we’ll help you take the right steps to recover VAT the right way.
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Any questions?
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