A debt to a business that is unpaid and deemed to be a “bad” debt can be an allowable deduction as long as it was included as assessable income in the present or even a previous income year, and that it is written off as “uncollectable” in the same year that a deduction is claimed.
But to qualify as a deduction, the debt has to be more than merely “doubtful”, and certain conditions must be satisfied (see this taxation ruling). 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 deduction is available under the legislation for a debt that is written-off as a bad debt in the income year, if:
- 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 “bad”, and
- be written-off as a bad debt in the year of income the deduction is claimed.
If a debt is “bad” based on commercial judgement, it is also bad for tax legislation purposes — that is, it is not essential that a creditor take all legally available steps to recover the debt.
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 and the debtor is relying on this defence (or it is reasonable to assume so) for non payment
- 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
- if, on an objective view of the facts or probabilities existing at the time, 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.
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.
Partial debt “write-offs”
The entire debt does not have to be written-off to get a deduction under tax laws. A deduction may be obtained for the part that is bad and written-off. A partial debt would be deductible only if and when it is found that the remaining debt could not be recovered from the debtor. The same tests for deductibility apply as for the whole of the debt.
Deduction allowed
A deduction for a bad debt is allowable in the year in which the debt is written-off. The debt must actually be written-off before the income year ends, subject to the arrangements outlined in the taxation ruling mentioned above. Making a general provision is not appropriate. It is not sufficient to decide to write off the debt after the income year ends, such as when the annual accounts are prepared.
According to this ruling, a deduction is allowed if:
- a board meeting authorises the writing-off of the debt and there is a physical recording of the debt and of the board’s decision before the end of the income year, but the writing off in the books of account occurs after year’s end, and
- a written recommendation by the financial controller to write off a debt is agreed to by the managing director in writing before year end, followed by a physical writing off after year end.
Claims under the general deduction provisions
If a deduction for a bad debt is not allowable under the above legislation, a deduction may, in limited circumstances, be available under the general deduction rules. To obtain such a deduction, it would be necessary to demonstrate that the loss was incurred in the course of carrying on business for the purposes of deriving assessable income. Note that the debt would be subject to not being specifically excluded (the negative limbs of the general deductibility rules) in this case.
Companies
Companies wishing to claim bad debts must meet stringent tests laid down to avoid “trafficking” in bad debts (see the legislation in regard to this here, and also here). These tests require that a company satisfy either a more than 50% continuity of ownership test or a same business test, comparing the year in which the deduction is claimed with the one in which the debt was incurred. In addition, a deduction is reduced if a debt is forgiven and the debtor and creditor are companies under common ownership and have agreed that the creditor forgo the deduction to a specified amount (see more details here).
NOTE: A company cannot deduct a debt that it writes off as bad on the last day of the year if the debt was incurred on that day (details here). Any bad debt for which an amount is recouped may be included in assessable income.
Source: Tax & Super Australia
