Income tax considerations relating to bad and doubtful debts

By Doria Cucciolillo, Assistant Manager and Associate Professor David Warneke, Director

In the current economic climate, especially given the high interest rates, businesses often experience financial difficulties. This often results in an inability to settle outstanding debts owed and conversely, to recover debts due by customers. Irrecoverable or doubtful debts owed by or to a taxpayer may respectively result in an additional or reduced income tax liability. It is important to bear income tax principles in mind when dealing with these situations. This article focusses on the key income tax considerations for taxpayers relating to irrecoverable and doubtful debts. Banks and other types of moneylenders will generally be subject to other forms of tax treatment that are not covered here.

A taxpayer may become entitled to a section 11(i) deduction for bad debts when a debt owed to that taxpayer becomes irrecoverable. Such a deduction can only be claimed in the year of assessment that the debt first becomes irrecoverable. This would be the year in which there is no reasonable prospect of recovering such debt, irrespective of the accounting classification thereof. The taxpayer should be able to substantiate the basis for writing off the debt, for example the insolvency of the debtor, and any steps taken to recover the debt. To qualify for this deduction, the underlying amount must have been included in the taxpayer’s income in the current or a prior year of assessment. To illustrate, while a bad debt resulting from the sale of goods or the rendering of services would qualify for this deduction, a deduction would not be permitted in respect of a loan of money, which would result in a capital loss upon disposal of the debt, including by way of abandonment by the creditor of its claim. The capital loss may however have to be disregarded altogether if it is a loan to a ‘connected person’, depending on the circumstances. Furthermore, a taxpayer is only entitled to this deduction if the debt is due to that taxpayer when it becomes bad. A deduction is thus unavailable for debts ceded to another person, unless ceded ‘with recourse’. If a debt in relation to which this deduction was claimed is subsequently recovered, it will trigger a recoupment in the hands of the creditor. 

If a debt has not become irrecoverable, the creditor may become entitled to a section 11(j) allowance for the debt as a doubtful debt. Like the section 11(i) deduction for bad debts, this allowance can only be claimed in respect of debts due to the taxpayer at the end of the year of assessment where the underlying amount had previously been included in the taxpayer’s income. The qualification for and calculation of the allowance depends on whether IFRS 9 is applied in relation to the debt for financial reporting purposes. An important point to note is that VAT levied by the taxpayer that is included in the debt must be excluded from the deductions claimed in terms of sections 11(i) and 11(j).

Where IFRS 9 is applied, the allowance is calculated as 40% of the sum of the lifetime expected credit loss and any bad debt written off for financial accounting purposes that was not allowed as a bad debt deduction in the current or previous years of assessment. For other impaired debts to which IFRS 9 is applied, a 25% allowance is permitted. 

Where IFRS 9 is not applied, the allowance is calculated as the sum of the following amounts: 40% of debt that is 120 days or more in arrears plus 25% of debt that is 60 days or more in arrears. The value of security provided in respect of the debt must be considered in calculating the allowance.

A taxpayer may apply to the Commissioner for a directive to increase the 40% allowance to an allowance of up to 85%, based on various factors prescribed in section 11(j). The doubtful debt allowance claimed in a given year of assessment must be reversed i.e. included in the taxpayer’s income, in the subsequent year of assessment. 

From a capital gains tax perspective, a disposal event will be triggered, among other things, by the waiver, discharge, cancellation or abandonment of a debt that a taxpayer holds as an asset. This may give rise to a capital loss for the creditor which, as noted above, may have to be disregarded or may be available for set-off against the creditor’s other capital gains. It is important to note that an allowable bad debt deduction in respect of the debt must be subtracted in determining the base cost of the debt and would thus effectively reduce the amount of the capital loss.

A capital loss arising on the disposal of a debt owed to the taxpayer by a ‘connected person’ must be disregarded, unless (and to the extent) that the debt represents:
  • Gross income or a reduction in a balance of assessed loss of the debtor;
  • A capital gain in the hands of the debtor;
  • The reduction of expenditure or base cost of an asset of the debtor that was funded by the debt; or
  • Gross income or a capital gain in the hands of an acquirer of the debt (subject to the creditor proving this). 

From the debtor’s perspective, income tax consequences would apply if the debt was rendered void with no legal force or validity through insolvency or prescription or if there was an ‘arrangement’ in terms of which the debt was cancelled or waived. The fact that the creditor may have claimed a section 11(j) allowance or 11(i) deduction for the debt does not of itself affect the debtor’s position.

In the case of the debt being rendered void through insolvency or prescription, the debt reduction provisions (section 19 and paragraph 12A of the Eighth Schedule) would not usually apply because even though there would have been a ‘cancellation’ of the debt, such ‘cancellation’ would usually not have occurred because of an ‘arrangement’. The term ‘arrangement’ is not defined for purposes of the debt reduction provisions and it is considered that in context, it must take its ordinary meaning as given in the Cambridge online English dictionary as ‘an agreement between two people or groups about how something happens or will happen’. However, if the debt was used to fund income tax deductions, a recoupment may result in terms of section 8(4)(a) and if it represents the amount outstanding for the purchase of a capital asset from the creditor, the base cost of the asset may have to be reduced in terms of paragraph 20(3)(b) of the Eighth Schedule.

This article has considered the general income tax consequences that may arise from irrecoverable or doubtful debts. However, it should be borne in mind that exceptions may apply to the general rules, depending on the nature of the taxpayer or the structure of the transaction. Further implications may also arise from a value-added tax perspective. It is therefore advised to consult with a professional tax advisor when encountering these types of transactions.