What are the VAT consequences of an out of court settlement?

Out of court

A recent case Decided by the First Tier Tax Tribunal highlighted how HMRC can sometimes misread the facts and thereby seek to apply the law inappropriately. In this instance, they sought to apply the bad debt relief legislation when there was no bad debt to apply it to!

A business provided legal services to a client and issued VAT invoices for the services delivered. When the invoices went unpaid, the solicitors commenced legal proceedings against their client. Shortly after doing so, the solicitors finished trading and deregistered for VAT. The parties subsequently reached an out of court settlement for a greatly reduced amount compared to that originally invoiced. The solicitor issued a credit note to the client for the balance of the amount originally invoiced including VAT, and requested repayment of the VAT shown on the credit note from HMRC. This majority of the claim was refused on the basis that it was a bad debt and the request was made after the appropriate time limit and so was out of time.

The First-tier Tax Tribunal found that the consequence of the out of court settlement was that there was no outstanding debt.  There had been a decrease in consideration for a supply under VAT legislation, meaning that the taxpayer was entitled to issue a credit note for the balance of the invoiced amount.  Importantly, the Tribunal also found that there was no maximum time limit between the original supply and the time at which an adjustment in the consideration can be made. Finally, in the case of a de-registered taxpayer, there was no time limit in respect of when it had to make such a claim.

The case serves as a noteworthy reminder about the treatment of settlement payments. Any VAT registered business that has agreed a reduction in the value of a supply with a client through an out of court settlement but has not made a VAT adjustment, may wish to review their position.

Please contact either Gill Yates or David Pegg if you wish to discuss any of the issues raised by this case.

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