Can Your Business Claim a Tax Deduction for Bad Debts?

April 2021 has been a closely observed month financially, with many government COVID-19 economic supports coming away. As with the wind-down of any stimulus measures, many economists have predicted inevitable business casualties in the coming months.

There is also no doubt that some businesses will find themselves owed debts that cannot be recovered from customers or other debtors. Businesses facing this type of unrecoverable debt, commonly known as “bad debt”, may be able to claim a tax deduction for the unrecoverable amount, depending on the accounting method used.

If the business accounts for its income on an accruals basis – that is, it includes all income earned for work done during the income year even if the business hasn’t yet received the payment by the end of the income year – a tax deduction for a bad debt may be claimable.

In order to claim a deduction for a bad debt, the business must have included the amount in its assessable income either in the current year tax return or an earlier income year. The business will also need to determine that the debt is genuinely bad, rather than merely doubtful, at the time the business writes it off. Whether or not the debt is genuinely bad depends on the circumstances of each case, with the guiding principle being how unlikely it is that the debt can be recovered through reasonable and/or commercial attempts.

According to the ATO, making such attempts does not always mean you need to have commenced formal proceedings to recover the debt. Evidence of communications seeking to obtain payment of debt, including reminder notices and attempts to contact the debtor by phone, mail and email, may be sufficient in certain circumstances.

The next step in claiming a bad debt deduction is to write off the debt as bad. This usually means that the business has to record (in writing) the decision to write off the debt before the end of the income year in which the business intends to claim a deduction. However, the ATO notes that the removal of debt from a customer’s account along with a note indicating that it was a bad debt expense may be sufficient.

Companies that want to deduct bad debts have the additional hurdle of satisfying the continuity of ownership test (COT). Those that do not satisfy the COT may still deduct a bad debt if they satisfy the same business test or the similar business test. Other special rules also exist for trusts, including trusts that have made a family trust election.

There may also be GST consequences for businesses when writing off bad debts. For example, where the business accounts for GST on a non-cash basis, a decreasing adjustment can be claimed where the business has made the taxable sale and paid the GST to the ATO, but subsequently has not received the payment. However, the debt will need to have been written off as bad and have been overdue for 12 months or more.

Businesses that account for income on cash basis will not be able to claim a deduction for bad debts. This is because these businesses only include an amount in their assessable income when it is received; therefore, bad debts will have no income tax consequences.

Important: Clients should not act solely on the basis of the material contained here. Items herein are general comments only and do not constitute or convey advice per se. Also, changes in legislation may occur quickly. We, therefore, recommend that our formal advice be sought before acting in any of the areas.