In this post we are going to show you how to deal with pass through costs in Xero. But as a matter of fact, the very same principles can be used with any other accounting software. Read on and learn how to deal with pass through costs in Xero and the VAT implications thereof. Hopefully, after this read, you will avoid overstating expenses (duplication of expenses), payables and tax mistakes.

What are pass-through costs?

It is not uncommon that a supplier pays a third’s party bill on behalf of their clients. For instance, professional firms often pay their client’s bills for services like notaries, Registrar of Companies, certifications, Government fees and the like. As these expenses are client’s costs, and they must be passed through to the client.

We are not talking here about the supplier’s own expenses that are charged to the client, like travel expenses, meals, hotels, or even subcontractors…These are expenses incurred by the supplier, where the bills are issued to the professional firm not to the end client. On the contrary, in pass through cost (“suplidos” in Spanish) the invoice issued, for instance, by a notary has the final client as recipient, not to the professional firm.

The rationale behind this is that the beneficiary of the notary’s services is the final client, not the professional firm. The latter just acts as a mere intermediary and pays for the invoice, for practical reasons. Subsequently, the accounting or legal firm will include in its invoice, together with its own fees, the expenses that it has paid to third parties on behalf of its clients, so that they duly reimbursed.

VAT treatment of pass-through cost

Clearly, these pass-through costs re-charged to the clients are not services that an accounting or legal firm have provided to the customer, but a reimbursement of expenses incurred on his behalf (with the corresponding invoice in the name of the end customer).

Therefore, from the professional firm’s perspective these items are not subject to VAT and they do not carry VAT. Technically, these items are not included in the VAT taxable base. In a simplified approach, we could say that these lines of the invoice are tax exempt. Of course, the underlaying service (provided by the notary, for instance) would normally be subject to VAT, and this fact will appear on the invoice issued by the notary for the end client.

This treatment is in stark contrast to the VAT treatment of the own legal firm’s expenses re-charged to the end client (travel expenses, telephone…). At the end, all companies must recover all their costs from their customers if they want to remain in business, either in-house costs (like salaries, mileage, depreciation…) or third-party costs required to provide their services. All these are subject to VAT.

It is not always evident to distinguish between these two types of transactions. The main tip not to make costly mistakes is to focus on who appears as recipient of the underlaying service in the bill issued by the ultimate supplier (notary…). If it is the end client, then it is a true pass-through cost exempt from VAT.

Customer accounting of pass-through cost in Xero

At this point, it should be clear that the end client shall receive two invoices, the one from the notary – which has been paid by the legal / accounting firm – and the invoice from the latter where the amount of the notary invoice without VAT is charged in one line.

The main accounting issue here is to avoid a duplication of expenses. We have seen once and again that both bills are fully expensed. An additional problem is that the notary bill will appear as unpaid, even though it is not (it was paid by the accounting / legal firm on behalf of the end client)

For Xero accounting users, our suggestion to deal with this issue is as follows:

a) The invoice from the accounting/ legal firm is expensed only for the for their own fees (“accounting services”). Third parties’ recharged costs should be allocated to the account 4009 “suppliers invoices pending receipt”; this is a balance sheet`s account (“control account”); so that this transaction is not expensed. The tax rate to be applied is tax exempt, as explained before.

b) The notary’s invoice is posted as usual, to the corresponding expense account: in this case to legal services, with its VAT at 21%.

c) Since the notary’s bill is already paid, it must appear in Xero as such. To achieve this, we will use the account 4009 “suppliers invoices pending receipt” as the payment account. By using the account 4009 “suppliers invoices pending receipt” as the payment account, what we actually do is to post a credit entry to that account, which cancels the debit made in point a) above. Remember that in Xero you can enable payments into any account, not only in bank accounts. However, for non-bank accounts, you must check the box “enable payments into this account” when configuring the relevant account. Otherwise, they could not be used as bank like accounts to register payments on them.

In this way, the notary’s invoice appears as paid and the duplication of the expense is avoided – which is what would happen if the two bills were fully posted as expenses.

Tax Partners is one of the leading Spanish firms specialised in customizing and using Xero in Spain. Please feel free to contact us if you need more information about the use of Xero in Spain