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The requirements to claim bad debts as tax deductions

19 April 2013   (0 Comments)
Posted by: Author: Doria Cucciolillo
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Source: Doria Cucciolillo

At some point in time a business may experience a situation where its customers are unable (or unwilling) to settle their outstanding debts. Despite all efforts, the entity may achieve little or no success in recovering these amounts. Although a situation like this can cause severe financial distress for the creditor, such entity may find comfort in the fact that, subject to certain conditions, an additional tax deduction may be available. The South African Revenue Service (SARS) will only grant a deduction for irrecoverable debts (also referred to as "bad debts”) if certain requirements are met. 

First off, the debt must relate to an amount that was included in the taxpayer’s income in the current or a preceding year of assessment. For tax purposes, the term "income” refers to all amounts included in the taxpayer’s gross income excluding amounts that qualified for an exemption. Therefore, it is important to consider the composition of outstanding balances to ensure that the full value of the irrecoverable debt was initially included in gross income and that it was not exempt for normal income tax purposes. Amounts owed by trade debtors will normally constitute "income” since it accrued to the entity from its trading activities. These amounts are not of a capital nature since it is derived from the entity’s income-earning structure and therefore it complies with all the requirements to be classified as gross income. However, if an entity sells a capital asset (like a motor vehicle) on credit, the subsequent failure to recover such debt will not result into a tax deduction. Since the proceeds from this transaction are capital of nature, it does not constitute gross income but it will rather attract capital gains tax implications. 

Furthermore, a deduction for irrecoverable debts is only allowed to the extent that such amounts became irrecoverable during the current year of assessment. Therefore, no future deduction will be available if the taxpayer fails to submit the claim within the appropriate assessment period. The taxpayer must prove to SARS that the debts are irrecoverable before a deduction will be granted. Its actions must show that all possible procedures were followed to encourage payment. Normally these methods will include settlement discounts, letters of demand, levying of interest, etc. If all these efforts fail, the debtor’s account must be handed over for legal prosecution.

The final requirement that needs to be considered is whether or not the debt belongs to the taxpayer at the end of its year of assessment. If, for instance, the taxpayer waived his right to receive payment or sold his business (together with all its assets) to another person, he forfeits his ownership of the debt and therefore he will no longer be entitled to claim a deduction when such debts become irrecoverable. 

If a taxpayer qualifies for a deduction of irrecoverable debts, the associated administrative responsibilities must be considered. When the deduction is claimed, the taxpayer’s tax return must be accompanied with a document that sets out the following information: a list with the names of all debtors involved, the dates on which these debts were permitted as well as a description of the transaction that initiated the debt, the amount that is written off, and motivations or reasons for writing off these debts. The taxpayer’s accounting records must also reflect this transaction in order to justify the validity thereof. 

It must be noted that these amounts will be taxable if it is recovered by the taxpayer in the future. In such instances the debtor is already removed from the accounting records. Therefore the recovered debt still retains its initial nature (for example, trade income) and it does not change to a capital receipt. The amount will therefore constitute gross income and will be subject to normal income tax. Effectively, the taxation of these amounts is deferred until actual receipt takes place since there is no certainty that settlement will occur.

From the above it is evident that taxpayers need to familiarise themselves with the special deduction that is available for irrecoverable debts. In doing this, taxpayers can ensure that they comply with the necessary requirements to qualify for this deduction when necessary. Since amounts are included in gross income on the earliest of receipt or accrual, failure to utilise this deduction may result into the unfair situation where the taxpayer is taxed on an amount that will never be received. The only adjustment that can be made to reverse this inclusion is the deduction for irrecoverable debts. 

List of References

Stiglingh M, Koekemoer AD, van Schalkwyk L, Wilcocks JS & de Swardt RD. 2012. SILKE: South African Income Tax 2013. Durban: LexisNexis Butterworhts - P174


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