ANY enterprise carrying on a genuine business does not deliberately create bad debts to obtain a tax advantage.
In commercial reality, businesses expect their debts to be settled in full. It is only when a debtor defaults or is unable to meet its obligations that a business may consider making a provision or, as a last resort, writing off the debt.
Recently, it has become common for the Inland Revenue Board (IRB) to challenge the deductibility of bad debts, often due to lack of appreciation of commercial realities faced by taxpayers. A typical basis for disallowance is that no legal action was taken, notwithstanding that the taxpayer may have undertaken follow-ups, issued reminders, and actively engaged the debtor to recover the outstanding amount.
From a commercial perspective, businesses are cost-conscious. Where the debtor’s financial position clearly indicates that recovery is minimal, pursuing legal action may not be practical. Engaging legal counsel and commencing proceedings can result in additional costs without meaningful prospect of recovery.
The legal framework
Under Section 34(2) of the Income Tax Act 1967, a bad debt deduction is allowed where the debt can be reasonably estimated to be partly or wholly irrecoverable, provided it has been recognised as income in the prior year of assessment.
Public Ruling No. 4/2019 provides guidance on reasonable recovery steps, when a debt may be considered irrecoverable, and circumstances where deductions are not allowed, such as waived debts and non-trade debts.
Understanding “irrecoverable”
Irrecoverable means the debt is incapable of being recovered and that recovery is unlikely. When claiming a bad debt, the claimant must be satisfied that reasonable avenues for recovery have been exhausted.
This assessment is factual and may depend on indicators such as the debtor’s financial position or insolvency, prolonged default despite follow-ups, failed negotiations, or absence of assets or enforceable means of recovery. It includes situations where the debtor is deceased with no estate, bankrupt or under liquidation with insufficient assets, cannot be traced despite reasonable efforts, or where the debt is statute-barred.
The deduction should be claimed at the time the “irrecoverability” is established.
What are “reasonable steps” in recovering a debt?
The law does not prescribe a fixed checklist, though guidance is available in the Public Ruling. Reasonable steps may include issuing reminders, restructuring or rescheduling debts, negotiation or arbitration and legal action. The extent of these efforts will vary depending on the circumstances. What is reasonable for a large, secured debt may differ from a small, unsecured balance.
The role of legal action
There is a misconception by IRB officials in placing undue emphasis on legal action when determining deductibility, rather than focusing on a qualitative and quantitative assessment of whether the debt is irrecoverable. Instituting legal action is not, in itself, proof that a debt has become irrecoverable. What is more important is a holistic evaluation of the facts.
Bad debts involving related parties
Where the debt involves a related or connected party, scrutiny is higher. The decision to write off or make a specific provision must be supported by rigorous and well-documented assessment. Taxpayers must demonstrate that the write-off is made on an arm’s length basis, supported by genuine commercial considerations, reflecting what independent parties would agree under similar circumstances.
A matter of judgment
Ultimately, the deductibility of a bad debt is not determined by any single factor, but by an overall assessment of whether the taxpayer has acted reasonably and in line with commercial reality.
A mere write-off in the accounts is insufficient. There must be evidence that the debt is genuinely irrecoverable and that appropriate recovery steps have been taken. The timing of the claim is also critical, as errors may result in penalties for understatement of tax.
The law does not require taxpayers to pursue recovery at all costs. Rather, it expects that any write-off is properly supported, commercially justifiable, and grounded in the facts.
This article is contributed by Thannees Tax Consulting Services Sdn Bhd managing director SM Thanneermalai (www.thannees.com).
