Tax deductions for unrecoverable income (bad debts).

It is the time of year when most business owners are thinking about their tax returns and of course looking at ways to reduce their tax liabilities for the financial year. One way to reduce your liability is to make sure that you claim a deduction for debts.

By referring your debts to a debt collection agency or solicitor for debt recovery you can then write off that debt and you may be able to claim a deduction for income that cannot be recovered from a customer or debtor. This unrecoverable income is also known as a ‘bad debt’.

Income tax and bad debts.

The accounting method you use to account for your assessable income affects whether you can claim a bad debt deduction:

Accruals basis.

If you account for your assessable income on an accruals basis, you may be required to include an amount you earn as assessable income in your tax return before you receive payment of that amount.

If you determine there is no or little likelihood that an amount included in your assessable income will be recovered from the debtor, you may be able to claim that amount as a tax deduction.

To claim a deduction for the assessable income that cannot be recovered, you need to write off the unpaid amount as a bad debt.

If you subsequently recover an amount that you wrote off as a bad debt and claimed as a tax deduction, the amount you recover must be included in your assessable income during the financial year when you receive it.

Writing off a debt as bad is not the same as waiving or forgiving a debt. There are different tax consequences for debt forgiveness or waiver and there may also be tax consequences for the debtor.

Cash basis.

If you account for your assessable income on a cash basis, you will not include an amount in your assessable income until it is received. Therefore, writing off, forgiving, or waiving a debt for an amount of unpaid income will have no income tax consequences for you.

How to write off a debt as bad.

A bad debt deduction may be claimed where you account for your assessable income on an accruals basis.

To claim a bad debt deduction in an income year for an amount included in your assessable income that has not been recovered, you must do all of the following:

Include the income in your tax return.

You can only claim a bad debt deduction for amounts you have included in your assessable income, either in your tax return for the year you claim the deduction or in an earlier income year.

Determine the debt is bad.

You need to determine that the debt is bad at the time you propose to write it off. The debt must not be merely doubtful. There must be a debt owing to you and it is genuinely bad. This means it must be an amount that you have determined is unlikely to be recovered through any reasonable and commercial attempts.

Depending on your circumstances, this does not always mean you need to have commenced formal proceedings to recover the debt. There are many ways to demonstrate an amount is no longer recoverable, and what constitutes a reasonable attempt will depend on the circumstances. For example, you may provide evidence that you have referred the debt to a debt collection agency or solicitor that has made communications seeking to obtain payment of the debt, including reminder notices issued and attempts to contact the debtor by phone/mail/email/sms.

Write off the debt.

You need to write off the debt as bad before you can claim it as a bad debt deduction. This means you must have made the decision to write off the debt and recorded that decision in writing before the end of the income year in which you claim a deduction. For example, when you refer the debt to a debt collection agency or solicitor you will remove the debt from the customer’s account and recognise it as a bad debt expense.

The debt must still be in existence, and not otherwise dealt with when you write it off and claim a deduction. For example, you must not have waived or forgiven the debt, extinguished the liability in another way, or sold the debt.

If you are a company, before you deduct a bad debt, you must satisfy the continuity of ownership test. If you do not satisfy the continuity of ownership test, you can still deduct the bad debt if:

For debts incurred prior to 1 July 2015 which are written off as bad – you satisfy the same business test, as set out in Taxation Ruling TR 1999/9.
For debts incurred on or after 1 July 2015 which are written off as bad – you satisfy one of the tests relating to the continuity of business.
- the same business test as set out in Taxation Ruling TR 1999/9, or
- the similar business test as set out in Law Companion Ruling LCR 2019/1.

There are also special bad debt deduction rules for:

tax consolidated groups and multiple entry consolidated groups
trusts (subject to certain exclusions, including for trusts that have made a family trust election)
where the taxation of financial arrangement (TOFA) rules apply to you.

GST and bad debts.

If you account for goods and services tax (GST) on a non-cash (accruals) basis, you can claim a decreasing adjustment for a bad debt if:

you made a taxable sale and have paid GST to the ATO for that sale, and
you have not received the consideration, either in whole or in part, for the taxable sale, and
you write the debt off as bad or the debt has been overdue for 12 months or more.

The ways to demonstrate that a debt is bad for income tax purposes also apply to when a debt is considered bad for GST purposes. For instance, you may provide evidence that you have referred the debt to a debt collection agency or solicitor that has made communications seeking to obtain payment of the debt, including reminder notices issued and attempts to contact the debtor by phone/mail/email/sms. Similar to income tax, you cannot write off a debt as bad if you have forgiven the debt or set it off against other liabilities.

You can make the decreasing adjustment for the tax period in which you:

write off the debt, or
become aware that the debt was overdue for 12 months or more.

If you claim a decreasing adjustment after writing off a debt as bad or where a debt was overdue for 12 months or more, and subsequently recover some or all of that debt, you will have an increasing adjustment in the tax period in which you recover the debt.

If you have any queries with regards to writing off bad debts and claiming bad debts as expense deductions on your tax returns, please call Paul Thorndike on 0429 008 247 or email us at enquiries@nswcreditlaw.com.au

REFERENCE – The above information is referenced from the ATO website. Please visit the ATO website for other tax considerations at www.ato.gov.au