Debt factoring and VAT

Newsletter issue - May 2021

Due to the coronavirus, many businesses are experiencing cash flow issues as their customers struggle to make payments in good time. A range of banks offer debt factoring as a way of improving the cash flow position. However, there are VAT considerations that should not be overlooked.

Debt factoring is the term used for any one of a number of arrangements that involve transferring the right to payment of invoices to a third party, e.g. a bank. The business invoices its customer in the usual way, the bank then purchases the right to collect the money from the business for an agreed amount and collects the debt directly. Naturally, the bank will pay less than the face value of the invoice, but this may be acceptable to a business that is having cash flow difficulties as the bank will issue an advance upfront. Any outstanding amount owed to the business is then transferred upon payment by the customer.

Using debt factoring has consequences for VAT. Exactly how the VAT reporting will be affected depends on the type factoring arrangement used.

Recourse agreements. Under a recourse agreement, the bank will reassign the debt to the business in the event that the customer doesn't pay.

Non-recourse agreements. With a non-recourse agreement, the bank actually purchases the debt from the business for a percentage of the amount owing. The risk of non-payment then falls upon the bank, and for this reason non-recourse agreements are less common and more expensive.

Under either type of arrangement, the normal VAT tax point rules apply, so generally VAT must be accounted for based on the earlier of the date the business makes the supply, issues the invoice (unless this is more than 15 days after the supply date), and the date the customer pays the invoice. However, if the business is using the cash accounting scheme the VAT point is the date that the customer pays the bank, not the date the bank transfers money. The initial amount advanced by the bank is not a payment, merely a loan.

Debt factoring also has an effect on bad debt relief. Ordinarily, a business can claim bad debt relief for VAT purposes where an invoice has not been paid within 6 months, reclaiming VAT accounted for to HMRC. Where debt factoring using a recourse agreement is used, the bank can transfer the debt back to the business in the event of non-payment. It is still possible for the business to claim bad debt relief in these circumstances, but not until the debt has been reassigned. Bad debt relief cannot be claimed if a non-recourse agreement is used.