Tax – New Allowance For Doubtful Debts

As much as we all hope that bad debts will never affect our business, the reality is that we do not live in a perfect world and that bad debts will come knocking on our door at some point in time.

While bad debts cannot be avoided altogether, taxpayers should ensure that they at least attain the benefits of tax relief that are available.

In this article we shall deal with bad debt relief available for income tax purposes. In a follow-up article we shall deal with the VAT treatment of irrecoverable debts.

Introduction

The process of recovering trade debts normally commences with an expectation of full recovery, after which certain red flags may indicate that full recovery may be a little optimistic and finally peace has made with the fact that the debt cannot be covered at all.

The income tax act recognises the above business realities in that it makes provision for an initial allowance for the red flagged items (doubtful debts) and the ultimate deduction of the bad debt written off.

The red-flagged items 

For debts falling into this category, SARS allows a taxpayer an allowance in anticipation of the debt ultimately becoming bad. 

Different rules apply to years of assessment commencing on or after 1 January 2019 and years of assessment that commenced before that date. 

Year of assessments that commenced before 1 January 2019

For years of assessment that commenced before 1 January 2019, the allowance for doubtful  debt was essentially 25% of the amount of debts considered to be doubtful based on either a detailed list of potential doubtful debts or a general formula essentially based on historic data with regards to irrecoverable debts for the specific taxpayer. 

The 25% allowance was allowed on the value of debtors excluding VAT (the VAT element always being recoverable from SARS through the VAT system).  

Any allowance claimed in a year of assessment had to be added back in the subsequent year of assessment and be replaced with a new computed allowance. 

For year of assessments commencing on or after 1 January 2019

The doubtful debt dispensation for years of assessment commencing on or after 1 January 2019 differentiates between taxpayers accounting for debtors in terms of IFRS 9 and those that do not.

In the case of taxpayers that apply IFRS 9 to debts, the allowance is computed as 40% of the amount by which the debt has been impaired in terms of IFRS 9 as well as 40% of actual bad debts written off for accounting purposes but not yet deducted for income tax purposes as bad debts. To this is added a 25% allowance for debt impaired relating to debt other that the debt qualifying for the 40% allowance. 

In the case of taxpayers that do not apply IFRS 9 to debts, the allowance is essentially computed as 40% of debts in arrears longer than 120 days and 25% of debts in arrears longer than 60 days.

In both instances, where a taxpayer utilises IFRS 9 and otherwise, the taxpayer may apply to increase the allowance percentage from 40% to a maximum of 85%. The onus is on the taxpayer to prove that the higher allowance is warranted based on the specific facts of each case. 

Actual write-offs 

In the case of debts that have become bad in a financial year of assessment the taxpayer must make a deduction of the bad debt in that year of assessment. The deduction cannot be claimed in any other year of assessment.

Further criteria that must be considered before a deduction for bad debts can be made, is whether the income relating to the debt has been included in the gross income of the taxpayer previously. The debt must furthermore have been owing to the debtor at the end of the year of assessment in which the deduction is made. If either of these criteria is not met, no deduction may be made for bad debt in terms of section 11(i) of the income tax act.

Where a deduction for bad debts cannot be made in terms of section 11(i) of the income tax act, all is not lost. A deduction may still be available as a deductible loss incurred as envisaged in section 11(a) of the income tax act. For example, if a loan is written off by a financial institution, the loan would not have been included in the income of the institution but should qualify for a deduction in terms of section 11(a) of the income tax act, being a loss incurred in the process of conducting a lending business. 

Summary

The above is a high-level summary of the principles governing tax relief in respect of doubtful and irrecoverable debts. Care should be taken to ensure that the onus of proving that the relevant debts qualify for allowances can be disposed of and that deductions are made in the correct years of assessment.

In the next article we shall deal with the VAT implications of irrecoverable debts.