In this blog, we’ll discuss income that you can’t recover and how to write off bad debt.
What is bad debt?
As a business owner, you may claim a deduction for income that cannot be recovered from a debtor or customer. This unrecoverable income is called bad debt.
Income tax and bad debts
The accounting method that is used to check your assessable income can impact whether you can claim a bad debt deduction. Here are accounting methods:
- Accruals basis
- Cash basis
Accruals basis
If you account for your assessable income on an accruals basis, you need to include an amount you earn as assessable income in your tax return prior to receiving payment of that amount. If you determine there is no or little chance that an amount included in your assessable income will be recovered from the debtor, you can claim that amount as a tax deduction. To claim a deduction for the assessable income that is unrecoverable, you need to write off bad debt.
If you subsequently recover an amount that you 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 bad debts as bad is not the same as forgiving or waiving a debt. There are different tax circumstances for debt forgiveness or waiver, and there may also be tax consequences for the debtor.
Cash basis
If you use the cash basis method to account for your assessable income, you are not required to include an amount in your assessable income until it is received. Therefore, forgiving, writing off, or waiving a debt for an amount of unrecoverable income will have no income tax consequences for you.
How to write off a bad debt
A bad debt deduction can be claimed where you take into account 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 need to do all of the following:
- Include the income in your tax return
You can only claim a bad debt deduction for amounts you’ve added to your assessable income, either in your tax return for the year you claim the deduction or in an earlier income year.
- Determine that the debt is bad
You must determine that the debt is bad when you propose to write it off. There should be debt owing to you, and it is bad. This means it should be an amount that you have determined is not likely to be recovered through any reasonable and commercial attempts. Depending on your situation, this doesn’t always mean you must have commenced formal proceedings to recover the debt.
There are various ways to show the amount is no longer recoverable, and what comprises a reasonable attempt will depend on the circumstances. For instance, you may need to give proof of communications to get payment of the debt, including attempts to contact the debtor by mail/phone, and reminder notices issued.
- Write off the debt
You must write off the debt as bad prior to claiming it as a bad debt deduction. This means you need to decide to write off bad debt and record 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. The debt should still be in existence, and not otherwise dealt with, when you write it off and claim a deduction.
If you are a company, you need to meet the continuity of ownership test before you deduct bad debt. If you don’t meet the continuity of ownership test, you can still deduct the bad debt if:
- For debts incurred before 1 July 2015 which are written off as bad – you meet 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 meet one of the tests related 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.
If you need help managing bad debts or keeping your accounts up to date, our bookkeeping services in Melbourne can help.