Bad Debts Written Off - Tax Deductible?
Malaysian Income Tax Act, 1967 allows a deduction for bad debts / irrecoverable debts under Section 34 (2).
During tax audits, some of the taxpayers were told that they could not claim tax deduction on the bad debts written off or the specific provision for doubtful debts in their tax returns.
However, Section 34 (2) of the Income Tax Act, 1967 (ITA) allows a trade debt which is reasonably estimated as irrecoverable debt or bad debt to be deducted from gross income in computing the adjusted income of the business.
What is a trade debt?
Trade debt is a debt that arises from the sales of goods or services and has been included in the gross income of a business.
Conditions to be fulfilled for a trade debt to be written off as a bad debt
The debt shall be an amount that has been included in the gross income; and
The debt is irrecoverable.
When can a debt be considered as irrecoverable?
After taking reasonable steps to recover the debt as mentioned below, a debt can be considered irrecoverable or bad debt on the occurrence of any ONE of the followings;
the debtor has died without leaving any assets from which the debt can be recovered;
the debtor is a bankrupt or under liquidation and there are no assets from which the debt can be recovered;
the debt is statute-barred
the debtor cannot be traced despite various attempts and there are no known assets from which the debt can be recovered;
attempts at negotiation or arbitration of a dispute debt have failed and the anticipated cost of litigation is prohibitive; or
any other circumstances where there is no likelihood of cost effective recovery.
What is reasonably estimated?
Reasonably estimated means reasonable steps has been taken to recover the debts before writing-off the debts such as the following steps. To support a claim for deduction of a bad debt written off for tax purposes, there should be sufficient evidence of such steps taken, including one or more of the following:
issuing reminders; - the Public Ruling 4/2019 (PR) did not mention on the number of reminders, nevertheless, based on our tax audit and subsequent appeal experience, at least 3 reminders were required as documentary evidence.
debt restructuring scheme;
rescheduling of debts settlement;
negotiating or arbitration of a disputed debt; or
legal action (filing of civil suit, obtaining of judgement from the court and execution of the judgement).
As mentioned in the PR, the above steps that should be taken are depends on the amount of the irrecoverable debts or bad debts to be written off, where there should be cost effectiveness on each action taken. The reasons must be documented.
The steps taken should be considered a reasonable basis, if no legal action taken, it should be shown that the anticipated cost of legal action is prohibitive in relation to the amount of debt.
Provision for doubtful debts
A general provision is not tax deductible because it is an amount based on a certain percentage of the total outstanding debts. Even though a general provision is a requirement under MFRS / IFRS 9, still it is not tax deductible.
Specific provision for doubtful debts is tax deductible whereby each debt is evaluated separately.
SASTEP Sdn Bhd v Ketua Pengarah Hasil Dalam Negeri (2017).
The High Court of Sabah and Sarawak at Kuching, decided against the appellant on the grounds that the reason to write off the debt was not bona fide because the appellant was able to recover the debt which was owed by a related party but did not do so. The decision to write off the debt was NOT done based on commercial consideration. As for the legal action taken against the debtor, it was done only after the debt was statute-barred and only for the purpose of the tax appeal. Prior to that, the only action taken to recover the debt was sending a series of notices of demand to the debtor and there were prolonged periods between the demands.
Why normally tax payers not allowed for a deduction of bad debts and specific provision for doubtful debts?
In practice, some taxpayers failed to get tax deduction on bad debts written off due to the reason that they did not take sufficient steps to recover the debts and there is insufficient documentary evidence to support a claim for tax deduction as below;
no reminders sent or no documentary evidence on reminders sent
no documentary evidence to prove that each debt has been evaluated separately - for specific provision for doubtful debts
no documentary evidence on when and by whom the evaluation was done.
no documentary evidence on what specific information used in arriving at the evaluation.
no documentary evidence on the period over which the debt has been outstanding.
Ways to go forward
Business entities should have a debt monitoring system to ensure that reasonable steps are taken to recover the debts.
Always keep documentary evidence.
Review each debt annually and determine if the debt has become doubtful or irrecoverable.
Always remember that you have already paid tax on your gross income, if the debt becomes a bad debt, it is your right to get a tax deduction.
This article largely based on the Public Ruling No.4/2019, published on 24 September 2019 by LHDN. The article is intended to provide a general guide to the subject matter and should not be regarded as a basis for ascertaining the liability to tax in specific circumstances. No responsibility for loss to any person acting or refraining from acting as a result of any material in this publication can be accepted by Gunalan & Associates. Readers should not act on the basis of this publication without seeking professional advice.
Should you require further clarification, please do not hesitate to contact us at firstname.lastname@example.org. Thank you.