Effective cash flow management is critical to running a successful business. However, many companies overlook this fundamental principle, focusing primarily on revenue under the assumption that increased sales will automatically lead to better financial performance. This often results in businesses with rising sales volumes facing liquidity challenges, struggling to meet their financial obligations, and in some cases, even defaulting and ceasing operations.

Maintaining healthy cash flow is always essential but becomes particularly crucial during periods of economic uncertainty, when access to capital is constrained. More than a quarter of small and medium-sized enterprises (SMEs) in the UK report difficulties in securing financing from banks. As the cost-of-living crisis intensifies, these challenges are likely to worsen as lenders become more cautious. Insufficient liquidity is frequently cited as the leading cause of failure among startups.

To improve cash flow, businesses should consider reviewing their indirect tax strategies, particularly with respect to VAT. While VAT is often perceived by SMEs as a burden, it can, in fact, present opportunities to enhance liquidity. There are several VAT mechanisms available that can deliver cash flow benefits. This article explores some of these VAT-related measures, focusing on those applicable in the UK and certain EU countries.

Two of the most common VAT accounting methods are accrual accounting and cash accounting. Under the accrual method, VAT is remitted based on the amounts shown on invoices, regardless of whether the invoices have been paid. In contrast, the cash accounting system requires businesses to remit VAT when payment is received, while VAT on purchases can only be reclaimed once the supplier has been paid.

Eligibility criteria for using cash accounting vary by country. In the UK, businesses can opt into this scheme if their expected taxable revenue does not exceed £1.35 million in the next 12 months and they have no outstanding VAT returns or penalties. Unlike in some other countries, UK businesses do not need to apply for permission from the tax authorities; they can begin using cash accounting at the start of any VAT period, provided they meet the criteria. In Germany, businesses are eligible for cash accounting if their revenue in the previous calendar year was no more than €600,000. Start-ups can also qualify if their projected revenue for the first year is below this threshold. However, businesses must apply to their local tax office to gain approval to use this method. It is important to note that most countries exclude certain transactions from the cash accounting scheme. For instance, sales subject to the reverse charge mechanism or long-term contracts typically require the use of accrual accounting, even for businesses that primarily use the cash accounting method.

Given current market conditions, cash accounting may be particularly beneficial for businesses experiencing delayed payments or a high incidence of bad debts. This method can improve short-term liquidity by aligning VAT payments with actual cash inflows. Additionally, businesses utilizing cash accounting can delay VAT remittance by scheduling customer payments at the beginning of the next tax period rather than at the end of the current period. This approach allows them to legally retain and utilize the received funds for an extended period before remitting the VAT to the tax authorities. Another advantage is the transparency cash accounting offers in terms of available cash flow at any given time.

However, cash accounting schemes are not without their drawbacks. Businesses that are typically paid upon sale, frequently reclaim more VAT than they pay, or make continuous supplies of services may see limited benefits. Under cash accounting, input VAT can only be reclaimed once payments are made to suppliers, which may delay VAT recovery for businesses with extended supplier payment terms. Furthermore, businesses handling transactions outside the scope of the cash accounting scheme may face added complexity and administrative burden by managing two different accounting systems. As revenue thresholds apply to cash accounting schemes, growing businesses may eventually need to transition to accrual accounting, potentially disrupting established processes.

Cash flow can be optimized by carefully managing the timing of sales invoice issuance. Under accrual accounting, businesses are generally required to remit VAT to the tax authorities in the same tax period in which an invoice is issued, regardless of when payment is received from the customer. If the customer delays payment, the seller is forced to use their own funds to meet the VAT liability.

To avoid pre-financing VAT, businesses could consider issuing invoices in a subsequent tax period, allowing VAT to be remitted later. For example, if taxes are remitted monthly and an invoice is set to be issued at the end of October, postponing it to early November could delay the VAT payment obligation.

However, it is essential for businesses to comply with the regulatory deadlines for issuing invoices and these requirements vary across countries. For example, Italy mandates that invoices be submitted via the Sistema di Interscambio within 12 days of the transaction date. The United Kingdom allows a 30-day window for invoice issuance post-supply. Both the Netherlands and Ireland require businesses to issue invoices by the 15th day of the month following the supply of goods or services. Germany offers a comparatively generous timeframe, permitting invoice issuance within six months after the transaction. However, for specific transactions such as cross-border sales to VAT-registered businesses in other EU countries, invoices must be issued by the 15th day of the month following the sale.

Businesses typically remit VAT to the tax authorities in the tax period when an invoice is issued to a customer. If the invoice remains unpaid and a bad debt arises in a subsequent tax period, the business faces either absorbing the VAT as a cost or reclaiming it through bad debt relief. Notably, under the cash accounting system, there is no need to claim bad debt relief as VAT on bad debts is not pre-financed.

All EU countries and the UK provide some mechanism for bad debt relief. The Court of Justice of the European Union (CJEU) has affirmed that the reduction of the taxable amount in cases of total or partial non-payment constitutes a fundamental right for taxpayers and cannot be entirely abolished. However, the specific conditions, timeframes, and procedures for claiming this relief vary across countries. Some impose stringent requirements or extended waiting periods before bad debt relief can be claimed, potentially making it challenging to obtain in practice.

In the United Kingdom, bad debt relief can be claimed if the supplier has written off the debt in their VAT accounts and at least six months have elapsed from the later of either the payment due date or the supply date. Claims are disallowed if the debt has been sold under a valid legal assignment or the supplier charged more than the customary sales price. In Germany, bad debt relief requires that the debt is considered irrecoverable, assessed based on the individual facts of each case. A debt is deemed irrecoverable if the supplier is unable to enforce the payment claim legally or practically for the foreseeable future, such as when the customer persistently refuses to pay or has entered insolvency. Notably, there is no specified minimum period of debt irrecoverability that must be met.

For businesses that consistently reclaim more VAT than they remit to the tax authorities, submitting VAT returns more frequently can help expedite VAT refunds. Although the standard tax period is quarterly in both the Netherlands and the UK, businesses can request to switch to monthly returns. This is particularly beneficial for those often in a refund position, where deductible VAT exceeds payable VAT, as it allows them to receive VAT refunds more quickly, thereby improving cash flow and making funds available for business use sooner. Conversely, businesses that typically remit VAT should consider opting for longer tax periods, which can help defer VAT payments and manage cash flow more effectively.

International traders often encounter excess input VAT because they do not collect VAT on cross-border sales while still paying VAT on domestic purchases. To mitigate this cash flow disadvantage, some countries have implemented specific VAT measures tailored for businesses engaged in international trade.

One such measure in Irish tax law is the "Section 56 Authorization," designed to alleviate cash flow challenges for businesses heavily involved in international trade. Under this authorization, Irish suppliers can zero-rate the goods and services provided to the authorized business. Consequently, no VAT is charged on these supplies, eliminating the need for the business to pay VAT upfront and subsequently reclaim it via the tax return. This provision significantly enhances cash flow by reducing the delay between paying VAT on purchases and reclaiming it through VAT returns.

Another effective strategy for optimizing cash flow is to thoroughly review accounts payable to ensure that all eligible input VAT has been recovered. Research conducted by Vanson Bourne reveals that 54% of eligible input VAT remains unrecovered by businesses, often due to a lack of expertise and understanding of VAT reclaim processes. The rules for input VAT recovery vary significantly by country.

For instance, in Germany, VAT on expenses related to the entertainment of business partners and events primarily for entertainment purposes, such as company holiday parties, is generally non-recoverable. However, exceptions apply if the expenses are strictly business-related and modest in nature. In the United Kingdom, VAT on expenses for entertaining UK-based clients is typically non-recoverable. There is, however, an exception for entertaining overseas customers. When entertainment is provided to clients who are not resident in the UK, and the entertainment is directly related to the business, the input VAT on those expenses may be recoverable.

A potential strategy for UK businesses to mitigate non-deductible expenses is to charge clients a nominal fee for hospitality services. By doing so, these expenses become categorized as a "business supply" rather than free hospitality, potentially allowing businesses to reclaim VAT. For example, if a business event costs £100 per person plus £20 VAT and is attended by 40 clients, the standard non-recoverable VAT would amount to £800. By charging each client £5, the business incurs a £1 VAT charge on each amount but can reclaim the initial £800, resulting in a net VAT saving of £760. By understanding these nuanced regulations and employing strategic measures, businesses can enhance their cash flow and ensure they are not leaving money on the table due to unrecovered VAT.

Businesses importing goods can leverage both import VAT deferral and postponed accounting schemes to mitigate the cash flow burden associated with import VAT payments, which are typically due when goods are released into free circulation.

Import VAT deferral allows businesses to delay the payment of import VAT until a specified future date, rather than paying it immediately upon importation. This mechanism provides temporary cash flow relief by extending the payment period. Conversely, postponed accounting enables businesses to account for import VAT on their periodic VAT returns instead of paying it at the point of importation. This method effectively nullifies any cash payment by offsetting the import VAT payable against the import VAT deductible on the same return. While import VAT deferral requires a separate application and approval process with customs authorities, postponed accounting is more seamless as it integrates with the existing VAT return cycle, thereby eliminating the administrative burden associated with VAT remittance at importation.

Several European countries, including the Netherlands, France, and the UK, have implemented postponed accounting to help businesses retain cash that would otherwise be tied up in import VAT payments. However, Germany has opted for import VAT deferral instead. Companies importing goods into Germany can defer the payment of import VAT until the 26th day of the second month following the month in which the goods were imported.

In both the European Union and the United Kingdom, having a compliant invoice is typically a necessary condition for VAT input deduction. The law mandates that businesses maintain proper documentation to support their claims for input VAT, with a compliant invoice serving as essential evidence that goods or services were supplied and VAT was correctly charged.

However, the absence of a compliant invoice does not automatically exclude the right to input VAT deduction. The CJEU has ruled that the substantive conditions for VAT deductions take precedence over formal invoicing requirements. This means that as long as the substantive conditions are met -- namely, that the goods or services were actually supplied and the VAT was correctly charged -- invoices with minor formal errors or deficiencies should not automatically preclude the right to deduct input VAT if there is alternative evidence enabling tax authorities to verify that the substantive conditions for the right to deduct VAT have been met. Additionally, the CJEU has ruled that VAT input deduction should not be denied due to the absence of a formal invoice. For example, in some cases, written agreements or other documents that contain all necessary information could be accepted, provided they allow tax authorities to verify the right to deduct VAT.

The principles of cash flow management are straightforward: "revenue is vanity, profit is sanity, but cash is king." A business will ultimately face financial difficulties and potentially cease operations if its cash outflows consistently exceed its cash inflows. This article has outlined several VAT strategies that SMEs can implement to achieve a substantial boost in cash flow. The most appropriate cash flow optimization measure will depend on the individual circumstances of each business and the specific regulations of the country in which it operates.