Bad debts deductions – what you need to know

COVID-19 has had a debilitating effect on many sectors of the economy and unfortunately, the coming 12 months will see more businesses in financial distress and an uptick in business insolvency.

In such an environment, the commercial reality is that many businesses will be owed debts that will not be paid in full or at all.  For many businesses, this could spell disaster.  For this reason, debtor management is crucial in the present environment.

When a debt does go bad, while the cash-flow implications can be gruesome, the tax effect can be neutralised by claiming a deduction for the bad debt.  As such, possibly for the first time in a while, businesses will need to consider and apply the bad debt deduction provisions of the Income Tax Assessment Act 1997 (Cth) (1997 Act).

This article outlines some of the key elements of the bad debt deduction provisions of the 1997 Act and the issues that businesses must be attuned to when applying them.  The key point to note is that not all debt write-offs will give rise to a tax deduction.

Preconditions to claiming a deduction

The deductibility of debts that are written off as bad is dealt with by section 25-35 of the 1997 Act and Taxation Ruling TR 92/18 (Ruling).  Although the Ruling refers to the predecessor of section 25-35 (section 63 of the 1936 Act) the Ruling reflects the ATO’s current views.

Subsection 25-35(1) provides that a deduction can be claimed for a debt (or part of a debt) that is written off as bad in an income year if ‘it was included in your assessable income’ in the current income year or a previous year.  For example, this will be difficult to show in a partnership context where the debt was included in assessable income in Year 1 and a new partner was admitted in Year 2.

This general rule is affected by a number of specific rules in subsection 25-35(5), which are discussed further below.  There are also particular provisions that apply to bad debts in the context of money lending businesses and luxury car leases – these will not be addressed here.

There are four key conditions that must be satisfied in order to qualify for a bad debt deduction:

The debt must exist

A debt is defined as ‘a sum of money due from one person to another.’ The general rule is that this includes circumstances where the entitlement is in equity as well as at law.  An equitable entitlement to a debt will also qualify.

The debt must be bad

A debt does not have to be completely unrecoverable to qualify as bad, although it must be more than merely doubtful.  A debt will be ‘bad’ if an objective assessment of the facts would allow a sound commercial judgement to be made that the debt (or part of it) is currently unrecoverable.  This will not be satisfied merely because the debt has remained unpaid for a significant amount of time.  Also, the creditor must be able to show they have actively pursued recovery of the debt.

Paragraph 31 of the Ruling provides examples of circumstances where a debt may be bad, including where the debt has become statute barred, a corporate debtor is in liquidation or receivership or an individual debtor has disappeared and they have no assets.

Paragraph 32 then provides a list of actions that a creditor may take to show that appropriate steps have been taken to recover the debt, including by sending reminder notices, taking action to ascertain 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.  Aside from being good business practice, the steps that are taken to actively manage debtors will also be evidence that will support a claim for a deduction should the debt prove unrecoverable.

In our practical experience, the ATO will not necessarily ‘lower the bar’ when it comes to proving that active steps have been taken to seek recovery of a debt prior to claiming a tax deduction because the debt has been judged to be unrecoverable.

The debt must be written off as bad during the year of income in which the deduction is claimed

There must be written documentation which records the debt as written off in the year that a deduction is claimed ie before the end of the financial year.  Practically, this means that for any bad debt deduction claims sought to be made for the 2020 financial year, that documentation should be prepared now.  

‘Writing-off’ a debt does not simply mean that the debt is written off in the accounts.  As stated above, to be a bad debt, there must be ‘commercial judgement’ based on the objective facts that the debt is currently unrecoverable.  To support this decision making, the considerations which have led to a debt being written-off as bad should be recorded, for example, in the minutes of a board meeting or in a written recommendation prepared by the entity’s financial controller.

The debt must be for an amount which was brought to account as assessable income

The debt must represent an amount which was brought to account as assessable income in either the income year in which the debt is written-off as bad or in an earlier income year.  However, the bad debt deduction can only be claimed in the financial year that debt was written-off as bad, meaning there may be a mismatch between the income year in which tax was paid on the assessable income represented by the debt and the income year the deduction is claimed.

Also, this requirement presupposes that the entity accounts for income on a non-cash (accruals) basis, whereby revenue is recorded when it is earned rather than when cash is received.  If the entity records income on a cash basis, it will be impossible to claim a deduction for a bad debt as the amount would never have been recorded as income in the first place.

The question of whether the debt represents the amount which has been previously included in assessable income is not always straightforward.  For example, the ATO takes the view in Taxation Determination TD 2016/19 that a beneficiary is not entitled to a deduction under section 25-35 for an unpaid present entitlement (UPE) that they purport to write off as a bad debt, because the amount of the unpaid entitlement is not itself an amount which is included in the beneficiary’s assessable income.  Rather, under Division 6 and the application of the ‘proportionate’ approach to trust taxation, the trust distribution represented by the UPE is merely used to determine the amount of the net income of the trust which is attributable to the beneficiary and included in its assessable income.

For a partner in a partnership, if it was not a partner in the year the amount was included in the partnership’s assessable income, the partner would not be entitled to its share of any bad debt deduction.

Further considerations

Circumstances where special rules may affect your ability to claim a deduction for bad debts include:

• 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.
• If you recoup an amount in relation to a bad debt that has been deducted, the recoupment may need to be included in your assessable income.
• Certain trusts cannot deduct a bad debt if there has been a change in ownership or control or an abnormal trading in their units.
• An entity that used to be a member of a consolidated group or multiple entity consolidated group can deduct a bad debt that used to be owed to a member of the group only if certain conditions are met.

Key takeaways

If you are considering writing-off debts:  read the Ruling, take positive action to recover the debt and ensure you have written evidence that the debt was written off before year end.

This article was written with the assistance of Bradley White, Law Graduate.