VAT and Bad Debts
Bad debts are bad news! As much as traders may attempt to avoid bad debt situations, unfortunately they tend to be common to all traders at one point or another. For many businesses, especially those where cash flow is tight, any help to ease the bad debt burden is welcome.
Insofar as VAT and bad debts are concerned, item 4(c) of the Seventh Schedule to the Maltese VAT Act provides that when, after a supply takes place, the amount due as consideration for that supply becomes a bad debt, and “the taxable value of that supply shall be reduced accordingly”.
Item 10(2) of the Tenth Schedule to the VAT Act goes on to state that “a claim for a deduction by way of a bad debt relief shall be subject to such directives as the Commissioner may give as to the circumstances in which it may be made and the documents or other evidence that should be produced.”
In light of the above, on 30th November 2014, the VAT Department issued guidelines outlining the administrative procedures that must apply in order to affect a claim for bad debt relief. The following salient conditions have been highlighted:
A claim for bad debt relief may be made following a final Court judgement showing beyond doubt and to the satisfaction of the Commissioner that the debt can never be recouped.
The claim must reach the Commissioner by not later than twelve months from the date of delivery of the final judgement.
VAT in connection with the claim must have already been accounted for and paid to the Department.
All VAT returns and payments due as at the date of the claim must have been submitted by that date.
The debt must have been written off in the claimant’s day-to-day VAT accounts and transferred to a separate bad debt account.
The supply must have been made to the customer, or to a third party through the customer.
The value of the supply must not be more than the customary selling price.
The debt must not have been paid, sold or factored under a valid legal assignment.
Given that claiming bad debt relief tends to be a topical issue which is of interest to many, guidance in this respect was definitely required and welcomed as it has provided a degree of clarity in assessing whether to affect such claims, or otherwise. Notwithstanding the above the conditions appear to be somewhat onerous.
Comparing the VAT and IRD Guideline for Bad Debt Relief Claims
Reference is being made to the guidelines issued by the Maltese Inland Revenue Department, outlining when a deduction for bad debts is allowable for income tax purposes.
According to article 14(1)(d) of the Income Tax Act, the Commissioner has to be satisfied that the debt has become “bad”. These guidelines provide that whether a debt is bad is dependent on objective consideration of the facts surrounding the case and, in accordance with Revenue practice, a debt should not be considered “bad” until:
The debtor has died leaving no, or insufficient assets out of which the debt may be satisfied; or
The debtor has become insolvent; or
The debtor cannot be traced and the creditor has been unable to ascertain the existence or whereabouts of any assets against which action could be taken; or
The debt has become statute-barred; or
If dealing with a corporate debtor, the debtor is liquidated or in liquidation and there are insufficient funds to pay the debt being claimed; or
The creditor has taken all the legally available steps to recover the debt, where appropriate, or
The debtor has absconded and his whereabouts are unknown.
The guidelines issued by the IRD further provide that the debt need not be “bad” in its strict sense (that is the debt is not required to be irrecoverable in the future) however relief should be still allowed insofar as the commercial judgement pointing to the relevant facts indicates that a debt is bad for the time being. This is a marked difference from the position taken by the VAT Department which provides that court judgement must indicate that the debt “can never be recouped”.
The IRD guidelines add that it is NOT essential that a creditor takes all legally available steps to recover bad debts but that a creditor makes a bona fide assessment, based on commercial consideration, of the extent to which the debt is bad. Again this approach appears to be in stark contrast to the VAT guidelines which require that full legal action be taken.
The Commissioner has also ruled that a debt may be considered to have become bad where “on an objective view of all the facts or on the probabilities existing at the time the debt, or part of the debt, is alleged to have become bad, there is little or no likelihood of the debt, or part of the debt, being recovered. The guidelines set-out a list of some or all steps which one could take to make a claim in this respect, one of which being that a “judgement has been entered against the delinquent debtor”. This item is similar to the aforementioned judgement requirement imposed in terms of the VAT guidelines; however, this is merely an option available to the claimant of bad debt relief rather than a requirement, as it has been made for VAT purposes.
Another point of note in this respect is that, from a VAT perspective, all VAT returns and payments due as at the date of the claim must have been submitted by that date however this condition has not been instilled from an income tax perspective.
Following the merger of the Revenue Departments, one would expect that a single set of principles defining what constitutes a “bad debt” would have been drawn up, for both Income Tax and VAT purposes. As a result of the current inconsistencies, a company’s debt may be classified as “bad” for income tax purposes and as a debt due and payable from a VAT perspective.
Comparing the Maltese situation to that in the UK and Ireland
The Maltese guidelines are similar to those issued by the UK however, one significant difference is that that the UK requires the debt to have remained unpaid for a period of 6 months after the later of the time the payment was due and payable (determined by the supplier’s normal credit terms or in accordance with an agreement reached with a customer) and the date of the supply in order to be eligible for claim. Also, the UK allows for the claim to be made within 4 years and 6 months. Conversely, apart from linking the possibility of making such claim to being in possession of a final Court judgement evidencing that the debt can never be recouped (rather than the expiration of a 6 month period as imposed by the UK), the Maltese VAT guidelines require that the claim is made by not later than 12 months from delivery of final judgement.
With reference to the Irish guidelines, in order for relief to be claimed, a trader must have taken all reasonable steps to recover bad debt. The acts that constitute ‘reasonable steps’ would need to be determined on a case by case basis and may comprise a number of actions undertaken to recover the debt such as correspondence with the debtor, referral of issue to a solicitor or debt collectors or other action which can provide objective evidence that the trader can reasonably consider a debt to be bad and to classify the debt as such in his/her accounting records. The guidelines provide that correspondence from the liquidator of the debtor confirming that the debtor does not have sufficient funds to pay non-preferential creditors could provide evidence to justify such a claim. Again, this differs significantly from the requirements imposed in terms of the Maltese guidelines which require “a final Court judgement showing beyond doubt and to the satisfaction of the Commissioner that the debt can never be recouped”. This criterion creates an automatic barrier to smaller traders who would most likely:
Limit claims of bad debts relief to dealings with clients which end up in court;
Evaluate the cost/benefit analysis before proceeding – i.e. the cost of initiating proceedings – court fees, legal fees, time spent etc. against the benefit of recouping VAT which they have essentially advanced to the VAT Department in anticipation of the receipt of such amount from their clients, the latter which was never received.
Consequently, it is more likely that larger traders would be in a position to apply for such relief, which would result in them being better off in comparison with smaller traders carrying out the same activity however who do not have sufficient resources at their disposal (human and financial) to initiate the process to affect such a claim. Additionally, in terms of the Maltese guidelines, the Commissioner must also be satisfied that the debt can never be recouped. This has introduced a subjective element to the test.
Interestingly, another requirement for claiming bad debt relief as per the Irish guidelines is that the debt is allowable as a deduction in arriving at the tax-adjusted profits for income tax purposes. This effectively links the trader’s VAT position to its income tax situation. As evident from the above, the Maltese guidelines effectively do not make such a link.
UK rules also provide that if a taxable person pays a premium for insurance against bad debts, payment by the insurer does not affect the person’s right to claim relief. The Maltese guidelines on the other hand provide that the Commissioner reserves the right to refuse or reverse a bad debt relief claim where the person was insured against the bad debt. Similarly to the UK, the Irish guidelines also provides that entitlement to receive compensation payment under a policy of insurance against a bad debt does not affect entitlement to bad debt relief.
A requirement that Malta has introduced, which UK and Ireland have not is the requirement that all VAT returns filed and VAT payments due paid by the date of the request. Also, in order to claim relief in Malta, an application to the Commissioner would need to be made by means of a registered letter, enclosing the relevant documentation requested in the guidelines and relief may only be accounted for once authorised by the Commissioner. On the other hand, from their giudelines it seems that both Ireland and UK allow a claim to be made directly through a tax payer’s VAT return without obtaining the prior green light from the authorities. UK and Ireland also outline the method of calculation of such relief in cases where partial payment has been received and substantiate this by using examples. On the other hand, the Maltese guidelines simply provide that pro-rata calculation shall be made in the case of invoice/s subject to varying VAT rates. The Maltese VAT Department may not have felt the need to go into depth in this respect, possibly since the method may be communicated once the go-ahead to claim VAT has been granted by the Commissioner.
In accordance with the Maltese guidelines, the debt must not have been paid, sold or factored under a valid legal assignment. The UK seem to take the same position insofar as the assignment of the debt is absolute, i.e. there is no provision for the reassignment of the debt in the contract. On the other hand, where there is provision for the reassignment of debt, bad debt relief can be availed of once the debt is reassigned to the trader. Similarly to the UK, the Irish guidelines provide that in a factoring or invoice-discounting arrangement with recourse, the originator may be entitled to bad debt relief where all the other conditions imposed in terms of the Irish guidelines are satisfied.
VAT and Bad Debts: VAT Directive and EU Case Law
The provisions available in the VAT Act in relation to bad debt relief effectively transpose article 90 of Council Directive 2006/112/EC (the Principal VAT Directive), which provides that:
In the case of cancellation, refusal or total or partial non-payment, or where the price is reduced after the supply takes place, the taxable amount shall be reduced accordingly under conditions which shall be determined by the Member States.
In the case of total or partial non-payment, Member States may derogate from paragraph 1.
According to case-law of the Court of Justice of the European Union (CJEU), the transposition of a directive into domestic law does not necessarily require the provisions of the directive to be enacted in precisely the same words in a specific, express provision of national law and a general legal context may be sufficient if it actually ensures the full application of the directive in a sufficiently clear and precise manner, so that, in the case of a directive intended to confer rights on individuals, the persons concerned are enabled to ascertain the full extent of their rights and, where appropriate, rely on them before the national courts.
The core of article 90(1) of the VAT Directive is that a Member State is required to reduce the taxable amount and consequently the amount of VAT payable when, after a transaction has been concluded, part or all consideration has not been received by a taxable person. This embodies one of the fundamental principles of this Directive which provides that the taxable amount is the consideration actually received and, as a consequence of this, the tax authorities may not charge an amount of VAT exceeding the tax paid by the taxable person.
Nevertheless, article 90(2) permits Member States to derogate from the rule outlined in 90(1) and hence a taxable person is not in a position to rely on the right of reduction in their taxable amount in the case of non-payment of the purchase price if the relevant Member State intended to apply the derogation provided for in Article 90(2). The intention of the EU legislature here is to allow discretion to each Member State to determine whether non-payment entitles a taxable person to reduce the taxable amount accordingly or whether such a reduction is not allowed in that situation.
Despite allowing a certain degree of discretion to determine the reduction, the CJEU held that it does not alter the precise and unconditional nature of the obligation to allow the reduction in cases referred to in article 90. Therefore, a taxable person may reply on the provisions of article 90(1) of the VAT Directive before national courts against the State to obtain a reduction in their taxable amount for VAT.
It however must be noted that, in terms of article 273 of the VAT Directive, Member States may impose the necessary obligations to ensure the correct collection of VAT and to prevent VAT evasion. Since both 90(1) and 273 do not specify either the conditions or obligations which the Member States may impose, the ECJ held that the provisions give Member States a margin of discretion as to the formalities to be complied with to ensure that the taxable amount has been indeed reduced.
From CJEU case law, it is evident that measures to prevent tax evasion or avoidance may not, in principle, derogate from the rules relating to the taxable amount except within the limits strictly necessary for achieving that specific aim. According to the CJEU, they must have as little effect as possible on the objectives and principles of the VAT Directive and may not therefore be used in such a way that they would have the effect of undermining the neutrality of VAT.
In light of the above, one may question whether the fact that a final Court judgement showing beyond doubt and to the satisfaction of the Commissioner that the debt can never be recouped is too onerous and may undermines the neutrality of VAT. Another question that comes to mind is – what if the VAT which is rightly recoverable is not substantial, would a taxable person bother going through the hassle of initiating court proceedings to make a claim?
Additionally, in a case involving substantial VAT which a taxable person is attempting to recover, obtaining a court judgment may take a significant amount of time, which for a business means money, especially more so if that business utilized a form of financing to cover VAT costs which it has not recouped.
Moreover, are Maltese courts not over clustered with pending cases to now have the added burden of decisions to contend?
In the light of our analysis, we believe that the following could be considered to increase the efficiency of VAT system on bad debts.
First of all, given the merger of the local tax administrations, one set of principles which would streamline the classification of a “bad debt” from both an income tax and a VAT perspective could be established. This should simplify the relief situation for traders. Secondly, specific conditions should be introduced to deal with relief from a VAT perspective involving claims of a low amount. We believe that reference to the guidelines issued by the Inland Revenue Department should be made. Thirdly, prior to the issuance of future guidance notes, more communication between all stakeholders could be suggested.
Finally, we question whether it is more practical to create a Council that would be tasked with fiscal assessment. Upon evaluating the evidence, which would be presented by the unpaid debtor this Council could very well confirm whether the balance should be allowable under the bad debt relief systems in accordance with both the Income Tax Act and VAT Act.