Cancellations, refunds, bad debts and other Covid-related adjustments - how do we deal with the VAT?
posted 11th June 2020
The past few months have been a real test for any business, and the conversations I've been having with businesses this year have rapidly changed from excitement about the start of summer seasons to how best to weather the storm of Covid. Many questions I've been asked have related to cancellations, refunds and other related adjustments, so I have put together some comments on the VAT treatment of these adjustments which I hope are useful!
Cancellation income (non-TOMS)
The treatment of cancellation income outside of TOMS changed from March 2019. Previously, cancellation income was treated as outside the scope of VAT, the reason being that in order for a payment do be within the scope of VAT, it must relate to a "supply". Essentially, "something" must be done in return for that payment. If that "something" is cancelled, it follows that no supply has been made so no VAT should be due (this is still the view of many, but unfortunately not HMRC!).
Revisions came following the October 2018 Budget announcement that VAT would be due on deposits and pre-payments for "unfulfilled supplies". What this means in practice is that, where a supply is cancelled, any monies retained for that supply will now be subject to VAT at the rate at which the original supply would have been, at the time the deposit is paid.
This means that, where you retain cancellation income for services not within TOMS, VAT must be accounted for as if the service had gone ahead. If you accounted for VAT originally upon the payment from your customer (which is often the correct time to account for the VAT), you are unfortunately not able to get this back from HMRC as a refund.
Cancellation costs (non-TOMS)
Similarly, if you have paid a supplier and they later retain some or all of the amount as a cancellation fee, you should ensure that you obtain a VAT invoice from the supplier for the amount they have retained and recover the input VAT as appropriate. The amount retained by the supplier is VATable (assuming that the service which was to be provided is also VATable). So, they should still account for the output VAT, and you should recover the input VAT, subject to normal rules.
It seems to be a common problem with hotels and some other leisure suppliers that a VAT invoice is not provided at the time of booking, and instead a pro forma only is given. This is not technically correct - a VAT invoice should be provided once a payment is made, but I know from speaking with many of you the difficulties faced with this! As such, as soon as a cancellation fee is agreed, you should be asking for a VAT invoice for this amount so that you can recover the VAT.
Assuming that the amount retained is VAT inclusive (i.e. you originally paid "£x + VAT"), the VAT should be taken out of the cancellation fee, and not added on as an additional payment.
Cancellation income and costs within TOMS
For sales within TOMS, the rules on cancellation income are different. (In fact, the opposite). Where the service which had been booked falls under TOMS, any cancellation income retained is not VATable and does not form part of TOMS turnover, assuming that you are using the "departure date" basis for TOMS accounting. This is because, unlike normal VAT rules, the only "tax point" for TOMS services is departure date (under normal VAT rules, it is the earlier of payment, invoice fate and service date, hence a "tax point" is created as soon as you pay). As such, this should not form part of your TOMS turnover.
Cancellation costs however can still usually form part of your cost of sales for TOMS purposes. This is because the services are still costs of direct travel (plus, now that HMRC have revised their view on non-TOMS cancellations, there is still a "tax point" for these purchases). So, this at least may be a small help in reducing the TOMS VAT liability for the full financial year and may possibly mean that many businesses have a repayment position for their annual adjustment.
Please note that, although the annual adjustment may mean that a repayment is due at year end, total VAT paid under TOMS for the full year (i.e. provisional in-year VAT paid plus the annual adjustment) cannot be a negative. If an overall loss is made for TOMS services in the financial year, the lowest amount of VAT payable is nil.
Refunds given
Where you issue a refund to a customer, any VAT already accounted for should be reversed. There are a few possibilities here:
- If an invoice has already been issued, a credit note should be raised to reflect the reduction or cancellation. Assuming you have already accounted for the output VAT to HMRC, this output VAT should be adjusted (i.e. a negative VAT amount in Box 1 and Box 6 of the return in which the credit note is issued). If the original invoice and credit note are in the same VAT return, there will be no "refund" per se, but the amounts should still be reflected in the sales ledger for that return (i.e. the sales ledger should show a positive entry for, say, £100 plus £20 VAT for the invoice, and a corresponding negative £100 plus £20 VAT for the credit note).
- If an invoice has yet to be issued, then the correct action point will depend on why an invoice has not been issued. Where a customer pays for a service, an invoice should strictly speaking be issued at that point. If the customer is a business which can recover the VAT, then they will be expecting a VAT invoice once payment is made.In most cases, an invoice and credit note should be issued to ensure accounts are reflected properly. If invoices are not issued because customers are individuals (or other non-taxable persons) then you may not issue a credit note, but the credit should still be reflected in accounts and ledgers.
Refunds received
Where you receive a refund, if VAT was originally recovered then the appropriate amount should be paid back to HMRC based on the date the refund was received (or the date of the credit note received, if earlier).
Input VAT recovery when a purchase is likely to be cancelled
Some businesses I have spoken with have said that they have purchased services which would usually be included on the quarterly return, but that they are almost certain will be cancelled in due course, and credit notes issues.
For example, a purchase of £1,000 plus £200 VAT is made on 1 March and the business completes a May VAT return. The purchase is cancelled on 15 June.
By the end of May, the purchase has not been cancelled and no refund has been given. As such, the business would be within its rights to recover the VAT from HMRC on its May VAT return (even though the purchase has been cancelled before the May return has been submitted). If and when a cancellation is made and a refund given, this would need to be reversed and the input VAT paid back to HMRC (the August return in the example above). However, the originally input VAT recovery is still valid and acceptable.
Remember that it is never compulsory to recover input VAT, and many businesses would choose not to recover the VAT if they are certain or close to certain that they will have to pay it back to HMRC later. However, for some, this may give a welcome cash flow advantage and is perfectly acceptable to recover if so.
Bad debts
It may be a few months until we see the full effect of bad debts but, for many, payments have been slower than usual. Outside of TOMS, suppliers should account for VAT on sales based on the "tax point" - the earlier of the date of the invoice, date of payment and date the service is performed or completed. This means, in many cases, VAT is accounted for before any payment has been received. Normally, although sometimes inconvenient cashflow-wise, it all works out once payment is received. However, what happens if payments are never received, or delayed for a long time?
VAT can be reclaimed from HMRC subject to the following:
- You have already paid the VAT to HMRC;
- You have transferred the amount from your day-to-day accounts to a separate bad debt account;
- The debt cannot have been sold, factored, etc; and
- 6 months has passed since the "tax point" or the date payment was due (whichever is later).
Bad debt relief should be claimed in Box 4 of your VAT return.
I hope this article is useful to those of you who have not had to deal with these types of adjustments before. Hopefully, we will not be dealing with them for too much longer and I can't wait for the industry to be up and running again :-)