What is bad debt?
Bad Debt refers to a debt or receivable that is unlikely to be collected and recovered by a business or individual. It occurs when a debtor is unable or unwilling to fulfill their financial obligation to repay a debt owed to a creditor. Bad debts typically arise from situations where there is a credit relationship, such as when a business extends goods or services to customers on credit terms or when individuals lend money to others. Bad debts can result from various situations, such as economic downturns, debtor insolvency, disputes over goods or services provided, or other financial difficulties faced by debtors. Recognizing a receivable as bad debt means writing it off the books of accounts – so the provision of the Financial Reporting Standards regarding the derecognition and impairment of financial assets would be relevant in this discussion.
Bad debt from an accounting perspective
IFRS 09: Financial Instruments: Introduction discusses the derecognition and impairment allowance relating to the financial assets. Two key provisions under IFRS 9 come into play in bad debt recognition against financial assets. Under paragraph 3.2.3 of IFRS 9, an entity shall derecognize a financial asset when, and only when – the contractual rights to the cash flows from the financial asset expire, or it transfers the financial asset and the transfer qualifies for derecognition. Similarly paragraph 5.5 of IFRS 9 provides provisions relating to the principles for recognizing and measuring expected credit losses on financial assets under IFRS 9. This paragraph broadly categorizes the method of recognizing credit losses under General Approach and Simplified Approach.
But is the “recognition of bad debt” against a trade receivable a “derecognition” or “impairment allowance” under IFRS 9? This can be answered in two approaches for bad debt recognition – backward looking and forward looking approach.
Bad debt recognition through impairment allowance - A forward looking approach
Paragraph 3.2.3 of IFRS 9 allows for the derecognition of a financial asset when the contractual rights to the cash flows from the financial asset expire. However a receivable that is not recoverable is not considered an “expiration of the contractual rights to the cash flows from that asset” – unless that contract has run its natural conclusion. When a receivable becomes uncertain in collectability, it is not derecognized solely due to the fact that the debtor could be unable to pay. Instead, the impairment requirements come into play, and we need to assess and recognize expected credit losses. This involves estimating the loss in the value of the receivable due to the likelihood of default by the debtor.
Simplified Approach (For Trade and Lease Receivables)
The “simplified approach” under IFRS 9 streamlines credit loss recognition for specific financial instruments, including trade receivables, contract assets from IFRS 15 transactions without significant financing components, and lease receivables from IFRS 16. Rather than assessing credit risk changes, entities always measure the loss allowance at an amount equal to lifetime expected credit losses for these assets. This approach simplifies calculations by not considering significant increase in credit risk, reflecting a conservative view. It ensures consistent treatment for these assets and results in more straightforward impairment recognition based on the full expected life credit loss estimation. Disclosures still convey methods and key assumptions used for transparency. For more depth in this topic do visit this link here: How to calculate bad debt provision under IFRS 9 – CPDbox
The “general approach” of recognizing expected credit losses under IFRS 9 involves assessing credit risk for various financial instruments, determining if credit risk has significantly increased since initial recognition by evaluating the risk of default over the expected life, recognizing lifetime expected credit losses when significant increase is identified, or 12-month expected credit losses if not, measuring expected credit losses using unbiased, probability-weighted amounts reflecting time value of money and reasonable information, reassessing credit risk at each reporting date, adjusting loss allowance accordingly, recognizing impairment gain or loss in profit or loss, and providing transparent disclosures about methods, assumptions, and assessment of credit risk, thereby enhancing forward-looking transparency and accuracy in financial reporting. For more depth in this topic do visit this link here: How New Impairment Rules in IFRS 9 Affect You – CPDbox
Bad debt recognition through derecognition - A backward looking approach
In cases where the contract has run its natural course of conclusion (rather than the impairment in its collectability) and it is certain that the amount under the contract is no longer recoverable even when all available means are exhausted – the financial asset is then treated to have “expired the contractual rights to the cash flows”. These natural conclusions of the expiry of the contractual rights to expiry could come in situations like bankruptcy / liquidation of the debtor, death of the debtor, negotiated settlement, default and enforcement, early termination, contract cancellation, legal restrictions, material modifications to the contract etc.
Concluding accounting perspective with a summary
In a conclusion note, bad debt allowances in the form of impairment losses in relation to typical trade and lease receivables are recognized as a simplified approach as discussed above and the general approach applies to other forms of financial assets. In summary, the “expiration of contractual rights to the cash flows” is a criterion for derecognition of a financial asset, including a trade receivable, when the entity’s entitlement to the cash flows from the asset has ended due to past events. The impairment allowance provision, on the other hand, is a forward-looking concept that accounts for potential credit losses on financial assets and addresses the uncertainty of future cash flows. It’s important for entities to distinguish between these concepts and apply them appropriately when assessing and reporting trade receivables, especially in situations where a receivable becomes uncollectible due to bad debt – because their treatment for tax purposes heavily differ, which we will discuss below.
For expenses to be recognized as actual cost incurred for tax purposes, – there should be opposite entitlement and obligation as a result of “the other payment” being received under Section 24(2) of the Income Tax Act, 2058. Because the forward looking approach for bad debt recognition through impairment allowance cannot fulfill “cost incurred” criteria under Section 24(2) of the Act, the impairment allowance recognized under the forward looking approach (both general and simplified) do not qualify for tax expense recognition. For more in depth analysis in this topic see this other post here: Certain & Provision Liability as per Income Tax Act. Therefore the bad debt recognition that we will talk further below are bad debts recognized through derecognition – A backward looking approach.
Bad debt from a tax perspective
Provisions under Income Tax Act, 2058
Under Section 25
२५. डुबेको ऋण लगायतका रकमहरूको रिभर्स:
(१) कुनै व्यक्तिले कुनै रोजगारी, व्यवसाय वा लगानीबाट प्राप्त गरेको आयको गणनामा प्राप्त गरेको रकम र व्यहोरेका खर्चको लेखा राख्दा देहायको कुनै अवस्थामा सो व्यक्तिले सोधभर्ना, असूलउपर, दाबी त्याग, अपलेखन, वा मिन्हा गरिएको समयमा उपयुक्त [समायोजन]^1 गर्नु पर्नेछः
(क) पछि गएर सो व्यक्तिले अवस्था अनुसार सो [रकम फिर्ता]^2 गरेमा वा खर्च असूल उपर गरेमा,
(ख) प्राप्त गरिएको रकमको लेखा एकुयल आधारमा राखिएकोमा पछि गएर सो व्यक्तिले सो रकम प्राप्त गर्ने आफनो अधिकार छाडि दिएमा वा सो रकम सो व्यक्तिको ऋण दाबी भएको अवस्थामा निजले सो ऋणलाई डुवेको ऋण मानी अपलेखन [गरेमा]^3, वा
(ग) खर्च गरिएको रकमको लेखा एकुयल आधारमा राखिएकोमा पछि गएर सो व्यक्तिले त्यस्तो खर्च गर्ने दायित्व छाडिदिएमा वा सो खर्च ऋण दाबी भएको अवस्थामा जुन व्यक्तिलाई सो ऋण तिर्नुपर्ने हो सो व्यक्तिले ऋण मिन्हा दिएमा ।
(२) कुनै व्यक्तिले देहायका अवस्थामा मात्र कुनै रकम प्राप्त गर्ने अधिकार त्याग गर्न वा सो व्यक्तिको ऋण दाबीलाई डुबेको ऋणको रूपमा अपलेखन गर्न पाउनेछः-
(क) कुनै वित्तीय संस्था वा बैकको ऋण दावीका हकमा सो ऋण दाबी तोकिएको मापदण्डहरू अनुसार डुबेको ऋणमा परिणत [भएमा]^4, र
(ख) खण्ड (क) मा उल्लिखित अवस्थामा बाहेक अन्य अवस्थामा भुक्तानी प्राप्त गर्न सो व्यक्तिले सबै उपयुक्त उपायहरू अपनाएपछि सो व्यक्ति सो अधिकार वा ऋण दाबी असुल उपर हुन नसक्ने कुरामा मनासिब रूपमा [विश्वस्त]^5 भएमा ।
^1: दफा १४ अनुसार व्याज खर्चकट्टि पाएकोमा सम्वन्धित वैकले सो व्याज मिनाहा वा कर्जा नै अवलेखन भएमा खर्च पाएको रकम आयमा समावेश गर्नुपर्ने- २०६२।६।२७ को परिपत्र
^2: २०६०।४।१ देखि “रकमको सोधभर्ना” प्रतिस्थापन
^3: आर्थिक ऐन, २०६४ (दफा २८): मिन्हा पाएको व्याज, हर्जाना खर्चकट्टी लिएपछि मिन्हा पाएको भए २०६५ पुषभित्र २० प्रतिशतले तिरेमा बाकी कर, शुल्क र व्याज मिन्हा गरेको
^4: डुवेको वा खराब ऋण सम्बन्धमा नेपाल राष्ट्र बैकको मापदण्ड लागु हुने नियम ९
^5: अदालतबाट चोरलाई दोषी प्रमाणित भइसकेको र चोरबाट असुल हुन नसकेको अवस्थालाई अपलेखन गर्न मिल्नेः २०६५।१०।२२ को सार्वजनिक परिपत्र
Under Section 40
४०. सम्पत्ति वा दायित्वको निसर्ग
(१) कुनै व्यक्तिको कुनै सम्पत्तिबाट स्वामित्व हटेमा निजले सो सम्पत्तिको निसर्ग गरेको मानिनेछ, सम्पत्तिको निसर्गमा सो सम्पत्तिको स्वामित्व भएको व्यक्तिबाट सो सम्पत्तिको वितरण गरिनु सो सम्पत्ति अन्य सम्पत्ति वा दायित्वमा गाभिनु, किस्ताबन्दी विक्रीको माध्यमबाट विक्री गर्नु वा वित्तीय पट्टा अन्तर्गत कुनै अर्को व्यक्तिलाई पट्टामा दिइनु, रद्ध गरिनु, विनास हुनु, हराउनु, म्याद सकिनु वा समर्पण गरिनु जस्ता कार्य समेत समावेश गर्नु पर्नेछ ।
(२) कुनै व्यक्ति कुनै दायित्वको भारबाट हटेमा निजले सो दायित्वको निसर्ग गरेको मानिनेछ । दायित्वका निसर्गमा दायित्व फछर्यौट, रद्ध, मुक्त, समापन हुनु वा अर्को दायित्व वा सम्पत्तिमा गाभिनु जस्ता कार्य समेत समावेश गर्नु पर्नेछ ।
(३) उपदफा (१) र (२) मा जुनसुकै कुरा लेखिएको भए तापनि कुनै व्यक्तिले कुनै सम्पत्ति वा दायित्वको देहायका अवस्थाहरूमा निसर्ग गरेको मानिनेछ:-
(क) प्राकृतिक व्यक्तिको सम्बन्धमा सो व्यक्तिको मृत्युको तत्काल अघि,
(ख) कुनै सम्पत्तिको सम्बन्धमा सो सम्पत्ति वापतका आम्दानीहरूको योग सो सम्पत्ति वापतका खर्चहरूको योगभन्दा बढी भएमा,
(ग) ॠण दाबी भएको सम्पत्तिको सम्बन्धमा-
(१) बैंक वा वित्तीय संस्थाको ऋण दाबीको सम्बन्धमा तोकिए बमोजिमका मापदण्ड अनुसार खराब ऋण हुन [पुगेकोमा]^1 र
(२) अन्य कुनै अवस्थामा सो व्यक्तिले ऋण दाबी असूल उपर नहुने भनी मनासिब रूपमा विश्वास गरेकोमा । तर सो ऋण दाबी असूलउपर गर्न सो व्यक्तिले सबै उपयुक्त उपायहरू अवलम्बन गरी सकेको हुन पर्नेछ ।
(घ) कुनै व्यक्तिले व्यावसायिक सम्पत्ति, गैर व्यावसायिक करयोग्य सम्पत्ति, ह्रास योग्य सम्पत्ति वा व्यापार मौज्दातको [किसिम]^2 फेरिने गरी त्यस्तो सम्पत्ति निजले प्रयोग गर्न थालेको अवस्थामा सो सम्पत्तिको फेरिएको स्वरूप प्रयोग गर्नुभन्दा तत्काल अघि,
(ङ) कुनै निकायको सम्बन्धमा दफा ५७ बमोजिमका अवस्थाहरूमा, र
(च) नेपालमा अवस्थित जग्गा जमिन वा भवन बाहेक, सो व्यक्ति गैर-बासिन्दा व्यक्ति हुनुभन्दा तत्काल [अघि]^3।
(४) उपदफा (१) बमोजिम कुनै व्यक्तिले कुनै वित्तीय पट्टा अन्तर्गत कुनै सम्पत्ति पट्टामा दिएर सो सम्पत्तिको निसर्ग गरेमा निजले जुन व्यक्तिलाई सो सम्पत्ति पट्टामा दिएको हो त्यस्तो व्यक्तिले निसर्गको समयमा सो सम्पत्तिको स्वामित्व प्राप्त गरेको मानिनेछ ।
(५) सम्पत्ति तथा दायित्वहरूको निसर्गबाट कुनै व्यक्तिले प्राप्त गरेको लाभ गणना गर्ने प्रयोजनको लागि देहाय बमोजिम हुनेछ:
(क) यो ऐन प्रारम्भ हुंदाका बखत सो व्यक्तिको स्वामित्वमा रहेका कुनै सम्पत्ति वापतका खुद खर्चहरूको रकम सो बखत उक्त सम्पत्तिको प्रचलित बजार मूल्य बराबर मानिनेछ,
(ख) यो ऐन प्रारम्भ हुदाका बखत कुनै व्यक्तिको दायित्व वापतका खूद आम्दानीहरू त्यस बखत उक्त दायित्वको प्रचलित बजार मूल्य अनुसारको रकम बराबर मानिनेछ ।
^1: बैंकको ऋण डुवेको वा खराब ऋणमा परिणत हुने सम्बन्धमा राष्ट्र बैकको मापदण्ड लागु हुने – नियम ९ बिसौनी: दफा ५९ (१क) को व्यवस्थामा यो रकमबाहेक खर्चकट्टी हुने
^2: बिसौनी: लिक्विडेशनमा गएका निकायका स्थिर सम्पति यस व्यवस्थाले निशर्ग मानिइ व्यापारिक मौज्दातमा रूपान्तर हुनेहुदा बजार मूल्यमा मूल्यांकन गरी कर लाग्ने हुनाले अव्यवहारिक हुन जाने
^3: बिसौनी: गैर बासिन्दाको घरजग्गा बाहेकका सम्पति विदेशी श्रोत मानिने
Section 25(2) of the Income Tax Act, 2058 allows tax write off for bad debts where the person has followed all proper measures to receive the payment and is reasonably satisfied that the right or the debt claim cannot be realized or recovered. In case of the debt claim related to banks and financial institutions a separate provision relating to loan losses under Section 59 as well – which we will not discuss in some other post in future.
Section 40 is a provision for disposal of asset and liability that computes the gains or losses arising due to the derecognition of the receivables as bad debt. Section 40(3)(c) applies in the case of disposal of debt claim by the reason of being irrecoverable.
Under Section 40(3)(c) the difference between accounting expense and tax expense for irrecoverable claim is calculated as follows as per Section 41 of the Act:
= Financial Expense – Tax Expense
= [Net Financial Expense] – [Incomings – Outgoings]
= [ – Carrying Value] – [Market Value – Tax Base]
= Tax Base – Carrying Value – Market Value
The amount so derived is a permanent difference. The amount that computed as Tax Expense (i.e. Market Value – Tax Base) is the amount that can be written off as bad debt if it qualifies to be recognized as write off expense under Section 25 and is included as “net gains” under Section 7(2)(c) or Section 9(2)(b) as calculated under Chapter 8.
Why are tax laws generally stringent on writing off bad debts?
In tax accounting, Section 25 and Section 40 addresses the complexities that arise when recording bad debts and social obligations. It acknowledges that while tax accounting practices involve numerical calculations, the underlying obligations and responsibilities associated with these financial transactions have social and economic implications – so the taxpayers are trusted to have applied all reasonable means to recover the claim. This judgment, trusted to the taxpayer by the Revenue Authority, recognizes that these obligations may not always align with the specified timelines or numbers or the terms of the contract in all cases of recovery, but are inherent and dependent on the complexities of business. From a tax law standpoint, the section establishes guidelines for accurately accounting for these financial adjustments in taxes – thereby deviating slightly from the accounting perspective.
Reference: Vidyadhar Mallik, नेपालको आधुनिक आयकर प्रणाली, 2060 Page 111
While financial accounting rules may allow for bad debt recognition even when certain subjective evidence of impairment is seen, it is not so in the tax laws. In financial accounting we rely on subjective test of asset impairment (especially in Bad debt recognition through impairment allowance – A forward looking approach, discussed above), the probability of recovery, collective matrix assessment for bad debt and so on – there generally has to be a objective proof under tax laws for a financial asset to be written off as bad debt. That is why tax laws might indeed be more stringent when it comes to allowing bad debts as deductible expenses compared to the accounting standards like IFRS or GAAP.
Tax laws generally place restrictions on a person’s right to disclaim entitlement to an amount or write off a debt as bad. This is because the adjustments on disclaimer or writing off will often provide a reduction in income of the person in question. The manner in which financial institutions write off bad debts is often governed by prudential regulation. However, countries should consider whether their local prudential regulations are too liberal in this regard and expose the tax base to erosion.
Reference: Para 119 of the Commentary for the Income Tax of Symmetrica
Here are a few reasons why tax laws might be more stringent in the context of writing off bad debt:
- Evidence Requirement: Tax authorities often require more stringent evidence to support the deduction of bad debts. They may require specific documentation, such as written off invoices, communication records, and evidence of collection efforts.
- Timing of Deduction: Tax laws might have specific timing rules for when a bad debt can be deducted as an expense. This timing could be different from the accounting standards, which could potentially lead to differences in the timing of recognizing the expense for tax and accounting purposes.
- Provisions and Requirements: Tax laws might have specific provisions or requirements that need to be met for a bad debt to be considered deductible. These provisions could relate to the type of business, the nature of the debt, and the steps taken to recover the debt.
- Recovery Requirements: Some tax jurisdictions might require businesses to make reasonable efforts to recover the bad debt before allowing it to be deducted as an expense. This could involve legal actions, collection agencies, or other recovery methods.
- Documentation and Reporting: Tax laws might have stricter documentation and reporting requirements for bad debts. This could include providing details about the nature of the debt, the efforts to recover it, and any legal proceedings.
- Anti-Avoidance Measures: Tax authorities might implement anti-avoidance measures to prevent businesses from inflating bad debt expenses to reduce their taxable income. This could involve closer scrutiny of bad debt claims.
The “willy-nilly” - ies surrounding Section 25(2)(Kha)
Here is a challenge – Section 25 of the Income Tax Act, 2058 doesn’t particularly provide any specific guidelines for evidence requirement, timing of deduction, recovery efforts, documentation or reporting in relation to claiming the tax expense of bad debts. It simply provides that the taxpayer should have adopted all proper measures to receive the payment and is reasonably satisfied that the debt claim cannot be realized or recovered.
In the domain of the Income Tax Act, 2028, Section 25 sets forth a sole condition: “भुक्तानी प्राप्त गर्न सो व्यक्तिले सबै उपयुक्त उपायहरू अपनाएपछि सो व्यक्ति सो अधिकार वा ऋण दाबी असुल उपर हुन नसक्ने कुरामा मनासिब रूपमा विश्वस्त भएमा” – A lacuna ensues from this phrasing, giving rise to often illogical and ad-hoc interpretations by tax authorities concerning the write-off of bad debts. This disconcerting trend appears to have culminated in a situation where bad debts are summarily negated as permissible tax expenses by tax authorities, seemingly bereft of rationale or the courtesy of affording taxpayers an opportunity for explication.
Frequently, we encounter notably nonsensical and arbitrary interpretations from tax authorities when it comes to the matter of writing off bad debts. This trend has led us to an almost inevitable juncture where bad debts are, as a default, denied recognition as tax expenses by tax authorities, devoid of any reasoning or consideration for taxpayers’ rationale.
Yes – it is understood and agreed that tax authorities are responsible for collecting government revenue, which funds public services and programs. Stricter rules for recognizing bad debts help prevent businesses from using aggressive accounting practices to reduce their taxable income and, consequently, their tax liability. Tax laws aim to ensure that deductions claimed are legitimate and backed by solid evidence. But it doesn’t mean that every genuine claim for writing off bad debt is an attempt in tax avoidance. Rigorous requirements for claiming bad debts could have been a solution but outright rejection and disallowance of bad debt write off from tax purposes have deterred the principle of commercial expediency among businesses in Nepal.
Tax authority really needs to set a criteria to determine what is actual business loss arising out of the genuine bad debt losses and what arose out of speculative or non-business related reasons. By imposing an unwarranted logic of disallowing all tax expenses for bad debts (which we have seen often in practice, if not – at all times) really has put a disadvantage to the genuine claim to the business losses arising from bad debts – which is a normal occurrence in commercial transactions.
Million Dollar Questions
“having followed all proper measures” - what is it?
Based on the provided excerpt from the Income Tax Act in Nepal, the phrase “having followed all proper measures to receive payment” suggests that a person (or entity) must undertake reasonable and appropriate efforts to recover the outstanding amount before considering it as a bad debt and relinquishing the right to receive payment. In other words, the person must demonstrate that they have taken all necessary steps to collect the debt before writing it off for tax purposes.
While the specific actions required to meet this criterion have not been explicitly defined in Section 25 of the Income Tax Act, 2058 – the intention is likely to ensure that individuals or businesses do not prematurely classify debts as bad debts without making a genuine effort to collect what is owed to them. The phrase implies a level of due diligence and proactive action on the part of the debtor to recover the debt.
These “proper measures” might include, but are not limited to:
- Communication: Attempting to contact the debtor through various means such as phone calls, emails, or letters to remind them of the outstanding payment.
- Personal Visits: Making personal visits to the debtor’s location to discuss the outstanding payment.
- Negotiation: Engaging in negotiations with the debtor to explore possible payment arrangements or settlement options.
- Collection Agencies: Engaging the services of a debt collection agency to assist in recovering the debt.
- Legal Action: Considering legal action or formal proceedings if other efforts have been unsuccessful.
- Documenting Efforts: Keeping records of all communication, efforts, and actions taken to recover the debt.
The interpretation of “proper measures” may also take into account the nature of the debt, the debtor’s financial situation, industry best practices and industry averages for bad debts. It’s crucial for individuals or businesses in Nepal to adhere to these requirements and be able to demonstrate that they have made reasonable attempts to collect the debt before considering it as a bad debt for tax purposes.
Is “legal action” necessarily a compulsory part of “all attempts to recover”?
In my view No. Let me explain why.
I think it’s not necessarily required to exhaust all steps as listed in the above section, including taking legal action, to classify a receivable as a bad debt for tax purposes in all cases. The specific steps and efforts needed to classify a receivable as a bad debt can vary depending on factors such as the nature of the debt, amount of the debt, the debtor’s financial situation, the industry practices, the regulations of the jurisdiction, and precedents.
The excerpt from the Section 25 Income Tax Act in Nepal states that a person can relinquish the right to receive an amount or write off the debt liability as a bad debt “after having followed all proper measures to receive payment.” The term “proper measures” is open to interpretation and can encompass a range of reasonable efforts to collect the debt before considering it as uncollectible.
In many cases, legal action might be one of the last steps taken if all other attempts to collect the debt have failed. However, whether legal action is necessary in every case would depend on factors such as the amount of the debt, the cost and feasibility of legal action, and the probability of successfully recovering the debt through such means. In practice, businesses and individuals typically assess the specific circumstances surrounding the debt and make a determination based on what is considered reasonable and appropriate given the situation. The goal is to demonstrate that genuine efforts have been made to collect the debt before it is written off.
Case against the “legal action” as an exhaustive action
There can be cases where a debt is not recoverable through legal action but it still could be considered a genuine bad debt for the company. The concept of a bad debt goes beyond the feasibility of legal action and encompasses situations where the company has exhausted reasonable efforts to collect the debt, but external factors prevent recovery. Legal action might not be feasible or effective due to various reasons, such as high legal costs, lack of available assets for recovery, or complexities in the legal process. Here’s an example to illustrate this scenario:
Example One: Legal Complexity
Imagine a small business that provides consulting services to clients. The business enters into a contract with Client A to provide a series of consulting sessions over a period of six months. Client A makes an initial payment but then fails to pay the remaining installments for the services received. The business owner takes the following steps to recover the outstanding payment:
- Communication: The business owner contacts Client A multiple times through emails and phone calls to remind them of the overdue payments and the contractual obligations.
- Negotiation: The business owner offers to discuss alternate payment arrangements with Client A and provides options to ease the financial burden.
- Legal Action: Despite repeated efforts, Client A remains unresponsive and shows no willingness to pay the outstanding amount. The business owner consults a legal expert, who advises that pursuing legal action would likely be costly and time-consuming, with no guarantee of success due to Client A’s financial instability.
In this case, even though legal action might not be viable due to Client A’s financial situation, the business owner has taken genuine and reasonable measures to collect the debt. The debt could be considered a bad debt for the company, as the business has exhausted all practical efforts to recover the amount owed. The inability to take legal action doesn’t negate the fact that the debt has become uncollectible based on the business’s diligent attempts.
This example highlights that the classification of a debt as a bad debt doesn’t solely depend on the success of legal action but rather on the overall assessment of the company’s efforts to collect the debt. If it’s evident that despite sincere efforts, the debt is unlikely to be recovered, the company may classify it as a bad debt for financial and tax reporting purposes.
Example Two: Evidence of bankruptcy
Imagine a small business that provides IT consulting services to clients. The business had a long-standing client who owed a significant amount for services rendered over a period of time. Despite repeated attempts to collect the outstanding payments, the client consistently ignored communication and legal notices.
The business considers legal action to recover the debt, but upon consulting with market experts and legal experts, the client’s financial situation is deteriorating, and it’s unlikely that there are sufficient assets to recover the debt even if a legal judgment is obtained.
In this case, the debt owed by the client is a genuine bad debt for the business. Despite the fact that legal action can be pursued and a favorable decision could be obtained, it is identified that the debt is uncollectible based on the client’s behavior, deteriorating financial situation, and lack of response to collection efforts. The business would proceed to write off the debt as a bad debt expense, reflecting the economic reality that the debt will not be recovered, even though legal action might not be pursued.
This example underscores the concept that a debt can be genuinely uncollectible for financial reporting purposes even if legal action is not taken or if legal action is not expected to result in recovery. The decision to write off a bad debt should be based on a comprehensive assessment of the debtor’s ability and willingness to pay, along with practical considerations regarding the cost and feasibility of legal action.
Example Three: Symmetric Interpretation
Let’s dissect this example from Income Tax Directive, 2077
मानौं, हिमाल पब्लिक सर्भिसेज प्रा.लि.ले ग्राहकहरूलाई उधारोमा समेत सामान बिक्री गर्दै आएको रहेछ । उक्त प्रा.लि.ले आ.व.२०६४।६५ मा बिक्री गरे बापत एक्रुयलमा आम्दानी जनिएको रु.६०,०००।– लिन बाँकी रकम (आसामी) रहेछ । उक्त प्रा.लि.को लिन बाँकी आसामीमध्ये एक आसामी चिपालु कम्पनीसँग रु.१०,०००।– लिन बाँकी रहेछ । यस लेनदेन सम्बन्धमा विवाद भएको र विवाद मिलाउने सन्दर्भमा अदालतको आदेशले सो प्रा.लि.ले रु.२,०००।– छाड्ने भए चिपालु कम्पनीले बाँकी रु.८,०००।–भुक्तान गर्ने शर्तमा सो प्रा.लि.ले मिति २०६६।२।५ मा रु.२,०००।–माथि आफ्नो (ऋण) दाबी गर्ने अधिकार छोडेको रहेछ । यसरी दाबी गर्ने अधिकार छोडेको रु.२,०००।– सो प्रा.लि.ले दाबी छोडेको मितिमा कट्टी दाबी गर्न सक्नेछ । चिपालु कम्पनीका लागि तिर्न बाँकी रहेको रकम तिर्न नपरेकाले यो रकम आयमा समावेश हुन्छ ।
Short summary: Himal Public Services Pvt. Ltd. engaged in credit transactions, selling goods with an income of NPR 60,000 in FY 2064/65. An outstanding balance of NPR 10,000 remains from a trustworthy company. A dispute led to a court order deducting NPR 2,000 – reducing the balance to NPR 8,000 – with the option to reclaim the relinquished debt claim.
Although it may not be always persuasive – I will present another case on why the bad debts that meet the commercial expediency criteria should be eligible to be expensed off. In this example, Himal Public Services Pvt. Ltd. engaged in credit transactions, recording an income of NPR 60,000 during the fiscal year 2064/65. Amidst these dealings, an outstanding balance of NPR 10,000 emerged from a Chipalu Company. The narrative took a turn when a dispute arose, prompting a court-ordered deduction of NPR 2,000 from the balance, reducing it to NPR 8,000. Under the prevalent tax law this differential income of NRP 2,000 is to be considered for the purpose of reliable company’s tax considerations, ultimately making the same NPR 2,000 a potential contender for deduction as a bad debt expense by Himal Public Services Pvt. Ltd. This curious intersection highlights the interconnectedness of tax adjustments within intricate business dynamics. Although the expense recognition criteria for tax might be stringent in terms of the bad debt expenses, when there is a income recognition on one side of the transaction, certainly a potential expense recognition on the other other side of the translation should not be negated in a willy-nilly manner.
In a landscape already clouded by frustrations of tax related compliances, it’s disheartening to note that tax authorities in Nepal have adopted an inflexible stance towards claims for bad debt write-offs for tax purposes. The genuine struggles behind these bad debts are disregarded, as the lack of enabling regulations fails to offer taxpayers an avenue to substantiate the authenticity of these financial losses. This glaring gap in regulations shows the pressing need for improvements in the system, to ensure that businesses can effectively demonstrate the legitimacy of their bad debt claims.
Regrettably, the practice of disallowing tax deductions for bad debts has grown so pervasive that it seems almost accepted as the norm. A somber consensus appears to have emerged, silently accepting the notion that bad debts are not to be granted the tax expense, placing additional strain on businesses grappling with the challenges of non-recovery.
Adding to this predicament is the fact that the absence of clear guidelines has perpetuated a climate of uncertainty. Businesses find themselves caught in a disheartening cycle, unable to secure the relief they require and deserving of, while the narrative remains unchallenged in the courts. This uncertainty is so deeply ingrained that it has stymied any emergence of judicial decisions to provide clarity on the matter. This silence adds another layer of ambiguity, leaving businesses grappling in a disheartening limbo where their genuine business losses remain unaddressed, unrecognized, and unanswered.
Even as I was into my research to compose this post, I observed that there is a serious absence of any rulings from Courts or Tribunals that have decided in the context of tax expense of bad debts (except for one). एभरेष्ट इन्स्योरेन्स कम्पनी लि विरुद्ध ठूला करदाता कार्यालय, हरि हरभवन २०७३।०७४ सालको निर्णय नं ६३० Contained within the purview of the Revenue Tribunal’s decision is the following excerpt: In instances where an individual encounters challenges in the recovery of debt claim, the individual should be able to demonstrate the extent of the due diligence exercised in the pursuit of such retrieval or the initiation of any legal measures. The visible absence of precedents concerning this subject makes this particular decision profoundly significant. This ruling, while lacking in precedence, does provide a welcomed consensus, highlighting that a bad debt claim supported by a demonstrable degree of diligence in retrieval endeavors or the commencement of legal proceedings is conceivably eligible for deduction as an expense.