Independent VAT Consultant
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VAT: Principle of mutual debt upheld

Input tax of £160,837 was correctly disallowed by HMRC because the loan agreement between two related companies was not genuine.

14th Aug 2020
Independent VAT Consultant
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Principle of mutual debt upheld in Stonypath vs HMRC tribunal case
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I am often asked: “Can you delay or avoid paying your suppliers, but still claim input tax?” There are two valid answers to this question.

Answer 1: Cash accounting scheme

Where a business uses the cash accounting scheme, it can only claim input tax when suppliers have been paid. This is fair because output tax is only declared on a VAT return when customers have paid their dues.

Answer 2: Six-month payment window

A trader who does not use cash accounting can claim input tax on an accruals basis, subject to the usual rules. But that input tax must be repaid on a VAT return (credit input tax in Box 4) if the debt remains unpaid more than six months after the date of the invoice or the due payment date, whichever is later.

Loan reduction: Is it a payment?

There is no problem with a reduction in the value of a loan being treated as a “payment” to fall within the six-month window. In terms of double-entry bookkeeping, the credit to “other debtors” by the customer receiving goods or services has exactly the same value as a credit to “cash” or “bank”. But the loan must be genuine and this was the key issue in the recent tribunal case of Stonypath Developments Ltd vs HMRC (TC7735).


The taxpayer was a property developer and was apparently owed £1.25m from a related company LAPM Ltd, which traded as a clothes retailer. The sole shareholder of LAPM was married to the only shareholder of Stonypath.

In order to discharge the debt owed by LAPM, all of LAPM’s stock and other assets were sold to Stonypath in December 2013, charging VAT of £160,837. No money changed hands but the value of the debt owed by LAPM was reduced to £89,453 in its accounts. Stonypath claimed input tax on its December 2013 return, selling all of the stock assets of LAPM to a separate business GBC in January 2014, charging output tax of £171,000.

HMRC approach

HMRC disallowed input tax claimed by Stonypath on the basis that the invoice in question was unpaid after six months (s26A, VATA 1994).

There was no evidence of a loan agreement between LAPM and Stonypath, which would treat the loan reduction as a payment. The taxpayer claimed that the debt reduction in the annual accounts of LAPM was clear evidence of payment.

The situation was complicated by the fact that there was no purchase invoice from LAPM to support the input tax claim, even though the accountant acting for Stonypath said it was issued at the time of the stock transfer. LAPM did not account for output tax on the sale and the company was wound up in 2014. 

HMRC victory

Not surprisingly, HMRC won this case on the loan issue, without the court having to consider the problem about the missing purchase invoice.

Learning points

Bad debt and VAT issues are likely to be important in the post Covid-19 world and its difficult trading climate.

To summarise, the principle of treating a loan reduction as a payment is fine for both customers claiming input tax and also for suppliers working out how much bad debt relief to claim. This is known as the principle of “mutual debt” - see VAT Notice 700/18, para 3.7.

The problem for Stonypath was that the supposed loan with LAPM was not properly documented for either legal or tax purposes. The lack of paperwork also caused problems with its bankers. The debt of £1.26m supposedly related to building work done by Stonypath for LAPM in 2005, but there was no documentary evidence of the debt and how it arose.

A mystery to me was why LAPM, as tenant of its trading premises, would pay for building work to be done on a building owned by someone else?

The message is simple: the paperwork must always be given top priority!    

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