No business wants to be in a position where they can’t recover outstanding debts but we have to be realistic and acknowledge that it does happen sometimes. The good news is that if your business has to write off a debt, a tax deduction is available for the amount of the debt written-off.
A debt that is unpaid and deemed to be a bad debt is an allowable deduction provided it was included as assessable income in the current or a previous income year and is written off as “uncollectable” in the same year that a deduction is claimed.
At this time of the year, it makes sense to go through your debtors list and if there are any debtors on it who you believe can’t or won’t pay, write off those debts by 30 June to claim the deduction this year. The business must keep a written record to document that the debt has been written off, such as a board minute authorising the writing off of the debt and a physical record of the debt and of the decision to write it off.
The debt must actually be written-off before the income year ends. To qualify as a deduction, the debt has to be more than merely “doubtful”, and certain conditions must be satisfied. The ATO says there is no allowable claim for the mere provision of doubtful debts, and a debt is not necessarily bad merely because time has passed without payment being made.
The conditions that must be satisfied for a deduction to be claimed in respect of a bad debt are:
- it was included in the taxpayer’s assessable income in the current or former income years, or
- it is in respect of money lent in the ordinary course of a business of lending money by a taxpayer who carries on that business.
To claim a tax deduction, the debt must:
- be in existence (for example, no deed of release has been executed)
- be genuinely “bad”, and
- be written-off as a bad debt in the year of income the deduction is claimed.
It is not essential that a creditor take all legally available steps to recover the debt – if a debt is “bad” based on commercial judgement, it is also bad for tax legislation purposes.
A debt is considered to be “bad” if:
- the debtor has died leaving no, or insufficient, assets to meet the debt
- the debtor cannot be traced and the creditor cannot find the existence of (or location of) assets against which action could be taken
- the debt has become statute barred
- the debtor is a company in liquidation or receivership and there are insufficient funds to pay the whole debt, or the part claimed as a bad debt, or
- there is little or no chance of the debt (or part of it) being recovered.
A debt will generally be accepted as “bad” (depending on the particular facts of the case) if the taxpayer has taken all reasonable steps to try to recover the debt and not simply written it off as bad out of hand.
Amongst the steps that a creditor may wish to prove to the ATO that appropriate steps have been taken to recover the debt include sending reminder notices, taking action to find out the debtor’s asset position (and therefore assessing the debtor’s capacity to pay the debt) and commencing formal recovery proceedings.
In the current COVID-19 environment, more businesses are being vigilant about their debtor management practices, especially where debts are ageing or there are clear signs that a debtor is in financial distress.
Note that if all or part of a debt that was written-off earlier is recovered, the amount recovered must be shown as income in the year it is received.
Special rules apply which can impact your ability to claim a deduction for bad debts in the following circumstances:
- The entity must satisfy the continuity of ownership or same business test.
- No deduction is available in cases involving the trafficking of bad debts.
- Where a debt is forgiven between companies under common ownership, the creditor may agree to forego or reduce their deduction.
- Certain trusts cannot deduct a bad debt if there has been a change in ownership or control or an abnormal trading in their units.
And finally
Speak to a tax agent like H&R Block. They can identify exactly what you need to do to get into shape for the 2022 tax season and maximise your deductions.
Mark Chapman is director of tax communications at H&R Block.