Tax relief for bad debts

Most businesses suffer from bad debt once in a while. There are various reasons for it to happen. For example, you might deliver goods or services to your client which since then closed its business or ran into financial difficulty. Often, customers do pay back their debt. However, some of them may refuse to pay and avoid all attempts to help you recover it.

Several ways to recover those debts are available such as making a claim using the Money Claim Online services. Unfortunately, there are no guarantees that these actions will help to solve the problem, and some businesses may eventually have to accept that they incurred bad debt.

The good news is that the tax offers relief after incurring bad debt. The way this relief is given depends on whether your accounts are prepared on the cash basis or the accrual basis. However, business owners can only use the accruals basis method.

Cash basis

The cash basis method provides automatic relief for bad debts. Under the cash basis, income is not recognised until it is received. That means that if an invoice hasn’t been paid, then it’s not considered when calculating taxable profits. Unfortunately, companies can’t use the cash basis to prepare their accounts.

Accrual basis

Under the accrual basis, income must be recognised when earned. This means that the associated income is taken into account when the work is done, not when the invoice is paid. 

Consequently, the invoiced amount will be reflected in the calculation of taxable profit, regardless of whether it has been paid or not. The amount owing will appear in the balance sheet as a debtor of the business.

Usually, a deduction isn’t allowed for a debt owed to a business in computing the taxable profit. But an exception is made for bad debt and for doubtful debts. Once this is the case, a deduction can be made in the period in which the debt became bad or doubtful. This may not be the same period as when the income is taxed if at that time the debt was expected to be paid.

Example

ABC Ltd prepares accounts to 31 March each year using the accruals basis. 

On 21 March 2022, it invoices a customer for £6,000.

The invoice is taken into account in calculating the taxable profit for the year 31 March 2022.

In July 2022, the customer closed down without paying the debt. The debt recovery looks very unlikely.

Tax relief is given as a £6,000 deduction when calculating the profit for the year to 31 March 2023 as this is the period in which the debt went bad.

To find out more information on bad debts please visit the official government website.