In this guide, we’ll shed light on income that can’t be recovered and ways to write off a debt as bad debt.
What is a bad debt?
As a business owner, you may be allowed to apply for a claim for a deduction for income that cannot be recovered from a debtor or customer. This unrecoverable income is referred to as bad debt. Reaching out to accountants Melbourne will be a good idea to let them manage circumstances when a bad debt occurs.
Income tax and bad debt
The accounting method for calculating your assessable income can affect whether you may be eligible to claim a bad debt deduction:
- Accruals basis
- Cash basis
Accruals basis
If you use accruals basis to account for your assessable income, you may have to include an amount you earn as assessable income in your tax return before you get payment of that amount. If you determine that an amount included in your assessable income is unlikely to be recovered from the debtor, you may be eligible to claim a tax deduction for that amount. To qualify for the deduction, you may need to formally write off the unrecoverable amount as a bad debt.
If you subsequently recover an amount that you earlier wrote off as a bad debt and claimed as a tax deduction, the recovered amount must be included in your assessable income when you receive it. Writing off a debt as bad is not similar to waiving a debt. There are various tax consequences for debt forgiveness or waiver, and there may also be tax consequences for the debtor.
Cash basis
When accounting for your assessable income on a cash basis, you will not need to include an amount in your assessable income until it is received. So, writing off, waiving, or forgiving a debt for an amount of unpaid income will have no income tax consequences for you.
How to write off a debt as bad?
You may be able to claim a bad debt deduction 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 are required to do all of the following:
- Include the income in your tax return
- Determine the debt is bad
- Write off the debt
Include the income in your tax return
You are only allowed to claim a bad debt deduction for amounts that are 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 are required to determine whether the debt is bad when you propose to write it off. There needs to be a debt owing to you, and it is genuinely bad. This means it needs to be an amount that you’ve determined is not likely to be recovered through any reasonable and commercial attempts.
Depending on your situation, this doesn’t always mean that you must have started formal proceedings to recover the debt. There are several ways to show an amount is no longer recoverable, and what comprises a reasonable attempt will depend on the circumstances. For instance, you may give evidence of communications seeking to get payment of the debt, including attempts to contact the debtor by phone/mail and reminder notices issued.
Write off the debt
Before you claim it as a bad debt deduction, you must write off the debt as bad. This means you need to have decided to write off the debt and must have recorded that decision in writing before the end of the income year in which you claim a deduction. For instance, you may have removed the debt from the client’s account and identified a bad debt expense.
If you are a company, before a bad debt deduction, you need to meet the continuity of ownership test. If you don’t meet the continuity of ownership test, you are still allowed to deduct the bad debt if:
- For debts incurred before 1 July 2015 and written off as bad debts, you meet the same business test outlined in Taxation Ruling TR 1999/9.
- For debts incurred on or after 1 July 2015 and written off as bad debts, you need to satisfy either of the following business continuity tests:
- The same business test, as mentioned in Taxation Ruling TR 1999/9; or
- The same business test, as mentioned in Law Companion Ruling LCR 2019/1.
Special rules for bad debt deductions may also apply to:
- Tax-consolidated groups and more than one entry consolidated groups.
- Trusts, liable to certain exclusions, including trusts that have made a family trust election.
- Taxpayers liable for the Taxation of Financial Arrangements rules.