Factoring Debts: The VAT Consequences

Andrew Needham looks at the VAT consequences of debt factoring and how it affects tax points and bad debt relief.

 

The term ‘factoring’ covers a variety of services involving debt assignment in which the factor provides clients with finance in respect of debts owing from their trade debtors. The advantages to the client may include some or all of the following:

• immediate finance (the up-front payment of, typically, 80% of the debt);
• protection against bad debts;
• sales ledger administration;
• a debt collection service, from initial contact with the debtors through to legal enforcement;
• provision of credit information on customers;
• provision of legal advice; and
• provision of management information.

There are two main types of factoring, known as ‘non-recourse’ and ‘recourse’.

 

With non-recourse debt factoring, the factor purchases the debt for a percentage of the invoiced amount and then owns the debt outright. 

 

In the case of recourse debt factoring, the factor makes an advance of money to its client but does not take ownership of the debt and can return it to the client if the debt cannot be collected. This is the most common type of debt factoring. The factor opens a client account to which he credits the face value of the debts he has bought and debits his charges (these may be consideration for a number of standard-rated supplies of administrative, clerical and accounting services). The balance, less an agreed retention, is available for the client to draw upon. The factor debits to the account any payments to the client and also a finance charge.

 

Where a business uses the standard tax point rules, a tax point is created by the issue of the invoice and VAT becomes due at that time. 

 

If a business uses cash accounting, ‘request for payment’ or other methods of deferring the accounting for VAT, the VAT becomes due when the factor collects the debt, not when the factor pays its client, which can provide a cashflow advantage for businesses. This means that the factor will need to keep its customers informed of when the debts are collected by them.

 

In the event that the factor cannot provide this information, HMRC will allow the business to bring forward the tax point to when the debt is assigned to the factor.

 

The initial advance made by the factor to the business is not a payment for the purposes of the cash accounting scheme; it is simply treated as a loan.

 

If a business has issued an invoice that has not been paid six months after the due date for payment, it can normally claim bad debt relief on the VAT element.

 

If debts are factored, bad debt relief is not available where an assignment of the debt is an absolute, non-recourse agreement.

 

Where there is provision for the reassignment of a debt, bad debt relief will be available once the debt is reassigned to the business. No bad debt relief can be available during the period in which the debt remains assigned to the factor.

 

If a business receives a payment from the factor for the unencumbered sale of a debt, this is considered to be for an exempt supply of finance and, therefore, will be disregarded for the purposes of bad debt relief. The business will therefore still be able to claim bad debt relief.

 

If you factor your debts you will need to make sure you are aware of the rules and account for VAT at the correct time, and also when you can claim bad debt relief.