According to the ATO, what is a bad debt?

The ATO released the Taxation Ruling 92/18 “Income Tax: Bad Debts” which provides a comprehensive outline as to what constitutes a bad debt and the circumstances in which a deduction for bad debts will be allowable.

Four conditions must be satisfied in order to qualify for a bad debt deduction:

1. A debt must exist;
2. The debt must be bad;
3. The debt must be written off as a bad debt during the year of income in which the deduction is claimed;
   1. The writing off of a bad debt must be evidenced in some form of writing which indicates the creditor has treated the debt as bad.
4. The debt must have been brought to account as assessable income in any year or, in the case of a money lender, the debt must be in respect of money lent in the ordinary course of business of lending money by a taxpayer who carries on that business.

The question therefore becomes: What is a bad debt? Whether a debt will be considered bad for the purposes of obtaining a bad debt deduction under section 63 of the Income Tax Assessment Act 1936, is matter of judgment which must be considered with regard to all of the relevant circumstances of each case.

Strictly speaking, for an individual debtor, a debt is not ‘bad’ until the debtor has died without assets, or the debt has become statute barred. In the case of a corporate debtor, this would arise on receipt of the liquidator’s final distribution or when the company is completely wound up.

This being said, a debt does not have to comply with the concept of a bad debt in the strict sense in order to be considered a bad debt. This is because section 63(3) of the Act contemplates that an amount may be subsequently received in respect of a debt previously written off as bad, which would not be possible under the strict definition of a bad debt.

A debt may be considered to have become bad in any of the following circumstances:

1. The debtor has died leaving no, or insufficient, assets out of which the debt may be satisfied;
2. The debtor cannot be traced and the creditor has been unable to ascertain the existence of, or whereabouts of, any assets against which actions could be taken;
3. Where the debt has become statute barred and the debtor is relying on this defence (or it is reasonable to assume that the debtor will do so) for non-payment;
4. If the debtor is a company, it is in liquidation or receivership and there are insufficient funds to pay the whole debt, or the part claimed as a bad debt;
5. Where, on an objective view of all the facts or on the probabilities existing at the time the debt, or a part of the debt, is alleged to have become bad, there is little or no likelihood of the debt, or part of the debt being recovered.

As a practical guide, the circumstances where a debt will be considered bad under (e) of the above list will depend on the particular facts of the case, where the taxpayer has taken the appropriate steps in an attempt to recover the debt and not simply written it off as bad.  Such steps may include the following:

1. Reminder notices issued and telephone/ mail contact is attempted;
2. A reasonable period of time has elapsed since the original due date for payment of the debt;
3. Formal demand notice is served;
4. Issue of, and service of, a summons;
5. Judgement entered against the delinquent debtor;
6. Execution proceedings to enforce judgement;
7. The calculation and charging of interest is ceased and the account is closed (a tracing file may be kept open; also, in the case of a partial debt write off, the account may remain open);  
8. Valuation of any security held against the debt;
9. Sale of any seized or repossessed assets.

Generally, provided a bona fide commercial decision is taken by a tax payer as to the likelihood of non-recovery of a debt, it will be accepted to be a ‘bad debt’. It is not essential that a creditor has taken all the necessary legal steps to recover the debt. What is required is that the creditor has made a bona fide assessment, based on proper commercial considerations, of the extent to which the debt is bad. The debt however, must not be ‘merely doubtful.’ For example, a debt will not be considered bad only because the set period of time for payment has elapsed with no payment or contact having been made by the debtor.

Section 63(2) of the Act provides for a debt being bad where the debtor has become bankrupt or has executed a deed of assignment or scheme of arrangement. The debt will be bad to the extent to which the amount of the debt owed to a tax payer exceeds the amount, if any, which will be received by the tax payer. Where a trustee in bankruptcy, receiver or liquidator advises the creditor of the amount expected to be paid in respect of the debt, the remainder of the debt can be written off as when the advice is given.

Evidence including the value of collateral securing the debt and the financial condition of the debtor should be considered. Ultimately, the taxpayer is the one who must prove the debt is bad.

Certain taxpayers who fail to satisfy the requirements under section 63 may be entitled to a bad debt reduction under subsection 51(1) of the Act. This may include any business losses or outgoings of a revenue nature which are an allowable deduction under subsection 51(1) when incurred. For a loss to be an allowable deduction under section 51(1) it must have been incurred in gaining or producing assessable income or in carrying on a business for the purpose of gaining or producing assessable income. In addition, the loss must not be of a capital, private or domestic nature. A loss occasioned by a debt is incurred when the loan is disposed of, settled, compromised or otherwise extinguished.

Where a tax payer recoups an amount which has previously been allowed as a bad debt deduction under either sections 63(1) or 51(1), the taxpayer will have to include this amount in assessable income pursuant to subsection 63(3). A tax payer may write off a portion of a bad debt (partial debt) and be entitled to a deduction for that part only.

What’s the best way to recover your debts?

The first step in recovering your debt is to establish that you debtor has the capacity to repay the debt. If you can discuss the issues they may be facing you may be able to work out an alternative payment strategies that could benefit both parties involved. In any event, you should contact the debtor and inform them of their late payment. It is possible that their overdue payments are because of an oversight or administration error such as a failure to receive their invoice. If you don’t receive payment following the initial contact, you should send a formal reminder letter.

It is important during this process to maintain customer relationship and act in a professional manner. For professional debt collectors, the ACCC and ASIC have imposed standards of conduct that prohibit harassment and unconscionable conduct in order to obtain payment.

My attempts have proven unsuccessful… what next?

If all your reminders have come to no avail, the next step is to pursue legal action, by issuing and serving a summons. Read on to find out the benefits of doing so and how Law Central can make this process as pain-free as possible.
Issuing a summons can compel a debtor to repay their debt for a number of reasons. In addition to avoiding the cost and stress of court proceedings, debtors may also not wish to damage their credit ratings. It is unfavourable to have to have debt claims against your name and it will be more unlikely to obtain future finances from creditors.

It is very important to ensure that you commence proceedings correctly, as summons can be set aside if they are defective.

When debts go stale…

If an outstanding debt is left long enough, it will become statute barred and will unable to be recovered. To prevent this from occurring, you must issue court proceedings within the limitation period (usually 6 years) of the debt being due for payment.

If you end up in Court:

Gold and Platinum members read on to find out what court you’ll need to make a claim in to recover your debt. The following guidelines relate to debt recovery matters only and may not apply to other claims.

 Build these documents now:

• Demand and Statement of Claim for Debt - NSW
• Demand and Summons for Debt - NT
• Demand and Summons for Debt - TAS
• Demand and Summons for Debt - VIC
• Demand and Summons for Debt - WA
• Loan Agreement (also for Debt/Equity rules)