Credit Notes vs VAT Bad Debt Relief: How to Choose the Right Option

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Credit Notes vs VAT Bad Debt Relief: Choosing the Right Option

Bad debts are an unfortunate reality for most businesses. When customers don’t pay, it impacts cash flow, profitability, and overall financial stability. But beyond the cash loss, there’s also the VAT question: should you issue a credit note or claim bad debt relief (BDR)?

While both options adjust VAT, the rules are very different—and choosing the wrong one can cause compliance issues with HMRC.

Credit Note or Bad Debt Relief – What’s the Difference?

When faced with an unpaid invoice, some businesses instinctively issue a credit note, thinking it’s the quickest way to recover VAT. While this can bring immediate VAT relief, credit notes are only valid in certain situations.

A bad debt relief claim, on the other hand, has stricter conditions but is the correct route when the debt is genuinely unpaid and the original invoice was correct.

When to Issue a Credit Note

A credit note is only appropriate when the original invoice needs to be corrected or adjusted due to:

Overcharges or billing errors
Returned goods
Post-invoice discounts or price changes

Issuing a credit note reduces the customer’s balance and adjusts both parties’ VAT returns. However:

A credit note cannot be used simply because a customer hasn’t paid.
It only has legal standing if sent to the customer—especially if they are VAT registered—so they can adjust their own VAT records.

When to Claim VAT Bad Debt Relief

Bad debt relief applies when a customer refuses or fails to pay for goods or services you’ve already supplied.

To claim BDR, all of these conditions must be met for each invoice:

You’ve already accounted for and paid the VAT to HMRC.
The debt is written off in your normal VAT accounts and transferred to a separate bad debt account.
The invoice value does not exceed your usual selling price.
The debt has not been paid, sold, or legally assigned to another party.
At least six months have passed since the payment due date or the supply date (whichever is later).

If the debt is later paid, you must repay the VAT claimed under BDR in your next VAT return.

The ‘Regulation 38’ Price Adjustment

Sometimes, neither a standard credit note nor BDR is the right choice. If there’s a genuine reduction in price after VAT has been accounted for, you can make a Regulation 38 adjustment, provided that:

The price reduction is genuine.
A refund is given to the customer.
A credit note is issued within 14 days of the reduction.
The adjustment is included in the VAT return for the period in which the price change happens.
VAT-registered customers reduce their claimed VAT by the same amount.

Credit notes under Regulation 38 can be issued before refunds are made, but never later than 14 days after payment.

Practical Point to Remember

There’s no time limit for making a Regulation 38 adjustment—you could technically issue a credit note for an invoice that’s five years old. However, by that point, it would be too late to claim BDR.