What is a bad debt?
Just what is a bad debt? That’s a question that Inland Revenue has set out to define in a recent exposure draft for public consultation.
The department proposes defining a bad debt as:
- an existing debt owed to a taxpayer
- that has been judged to be “bad’ by a “reasonably prudent commercial person”
- and has been written off in accordance with the record keeping system maintained by the taxpayer.
It follows under the “reasonably prudent commercial person” test that there is no reasonable likelihood that the debt will be paid either in full or in part, either by the debtor themselves, or someone else. This means that any decision must be objective and based on factual circumstances in each case. The onus of proof is on the taxpayer and the taxpayer would be expected to justify the write off in the event of a tax audit or review.
It follows then that a debt is not bad if there is an ongoing dispute between the parties. Nor is it bad if an arbitrary period of time has elapsed, for instance, 90 days. There is, however, no need for a debtor to be insolvent in order to write off a debt.
Some of the considerations that might help in deciding whether a debt is bad include:
- The length of time a debt is outstanding. A “reasonably prudent commercial person” might conclude that the longer a debt is outstanding, the less chance there will be of it being collected. However, the department also concedes that even debts that are recent may be bad.
- The effort made to collect the debt. What steps have been taken to get the debtor to pay?
- Useful information about the creditor such as knowledge of financial difficulties.
- The debtor is deceased and there are little or no assets left to repay the debt.
- The debtor cannot be traced and so no action can be taken.
- The debtor is bankrupt, or a company is in liquidation or receivership.
So the debt must first be bad before it is written off. The taxpayer can then write off the debt in order to claim the income tax deduction and the GST deduction from output tax. The time a debt is written off is important as it will determine which income year the deduction is claimed, based on their accounting methods.
It is useful to note that whilst some companies may make a provision for doubtful debts, those debts that might become uncollectible in the future, there is no provision in New Zealand legislation that allows doubtful debts as a deduction.
Submissions on the exposure draft close on 4 July 2018.
This article is general in it’s application and should not be relied on as an opinion. If you want advice specific to your circumstances, please don’t hesitate to contact us directly.