Public Ruling No. 1/2002 - Deduction For Bad & Doubtful Debts And Treatment Of Recoveries

Bad Debts

Trade debts written off as bad are generally allowable as a deduction against gross income in computing the adjusted income of a business for the basis period for a year of assessment [Y/A].

The writing off of a trade debt as bad requires judgement on the part of the person carrying on the business. All circumstances of the debt as to the likelihood and cost of its recovery should be considered before a decision is taken to write off the debt.

Action Taken to Recover the Debt 

All reasonable steps based on sound commercial considerations should be taken to recover the debt. 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:

a. issuing reminder notices; 
b. debt restructuring scheme; 
c. rescheduling of debt settlement; 
d. negotiation or arbitration of a disputed debt; and 
e. legal action (filing of civil suit, obtaining of judgement from the court and execution of the judgement)

To qualify for deduction for tax purposes, there should also be evidence to show: 
a. that each debt has been evaluated separately; 
b. when and by whom this was done; and 
c. what specific information was used in arriving at that evaluation.

Circumstances When a Debt Can Be Considered Bad 

After reasonable steps for recovery have been taken, a debt can be considered bad on the occurrence of any one of the following: 
a.the debtor has died without leaving any assets from which the debt can be recovered; 
b.the debtor is a bankrupt or in liquidation and there are no assets from which the debt can be recovered; 
c.the debt is statute-barred; 
d.the debtor cannot be traced despite various attempts and there are no known assets from which the debt can be recovered; 
e.attempts at negotiation or arbitration of a disputed debt have failed and the anticipated cost of litigation is prohibitive; or 
f.any other circumstances where there is no likelihood of cost effective recovery.

Debt has been included in gross income 

To qualify for deduction for tax purposes, the debt should be of a kind where the amount of such debt has been included in the gross income of the person for the basis period for the relevant year of assessment or for a prior year of assessment.

Example 1 

Syarikat A Sdn. Bhd., a wholesaler, supplies goods worth a total of RM 10,000 on various dates in 2002 to B Mini Market. Various payments totalling RM 6,500 are received. It is later discovered that the mini market has closed down and the sole proprietor cannot be contacted. As it is unable to trace the debtor despite visits to his last known business and residential addresses, the company decides to write off this debt in its profit & loss account for the year ended 31.12.2002. 

A deduction can be allowed for the bad debt of RM3,500 as the debt has arisen from transactions that have been included in the gross income and all reasonable steps have been taken to recover the debt.

Example 2 

Syarikat C Sdn. Bhd. takes over the retail business of an existing partnership. Among the assets taken over are trade debts amounting to RM 30,000. During its first 2 years of operation, the company manages to collect all the debts that had been taken over from the partnership, except for a debt of RM 1,000 as the debtor cannot be traced. The company decides to write off this debt in the profit & loss account for the second year. 

Although the debt was originally a trade debt in the accounts of the partnership, the amount constitutes a non-trade debt of the company (arising from taking over of the assets of the partnership and not from a transaction included as gross income of the company). Therefore, the amount of RM 1,000 written off as a bad debt cannot be allowed as a deduction in computing the adjusted income. Conversely, the recoveries amounting to RM 29,000 should not be regarded as taxable.

Exception for loans made in the ordinary course of business 

The condition that the debt should have been included in the gross income of the person prior to it being written off should not be applied in a case where the person habitually makes loans or advances in the ordinary course of his business (for example, a moneylender). 

In such a case, both the interest (which has been included as gross income from the business) and the loan (granted in the ordinary course of carrying on the business) should be considered as debts which, if written off as bad after taking into consideration all the circumstances, should be allowed as a deduction in arriving at the adjusted income of the business.

Specific Provision for Doubtful Debts

Where there are reasonable grounds (based on valid commercial considerations but not personal or other reasons) to believe that a trade debt is doubtful of being recovered, a specific provision can be made at the end of the accounting period for the amount of the debt that is not expected to be recovered. 

The amount that is reasonably determined to be irrecoverable can be allowed as a deduction against gross income for the relevant basis period.

Debt has been included in gross income 

To qualify for deduction for tax purposes, the debt should be of a kind where the amount of such debt has been included in the gross income of the person for the basis period for the relevant year of assessment or for a prior year of assessment.

Making the specific provision 

The making of a specific provision for doubtful debts requires the determination of the likelihood of recovery of each debt.

To qualify for a deduction for tax purposes, there should be evidence to show:
a. that each debt has been evaluated separately; 
b. how the extent of its doubtfulness was evaluated; 
c. when and by whom this was done; and 
d. what specific information was used in arriving at that evaluation.

Circumstances for evaluating a debt as doubtful should include: 
a. the period over which the debt has been outstanding; 
b. the current financial status of the debtor; and 
c. the credit record of the debtor.

For each doubtful debt, the specific proportion or amount of the debt that is regarded as doubtful should be determined after taking into consideration the following: 
a. the person's history of bad debts, 
b. the experience for the particular trade/industry; and/or 
c. the age-analysis of the debts.

Increase or decrease in the specific provision

Where a specific provision for doubtful debts has been made for a particular accounting period and the amount has been allowed in the relevant basis period for a particular year of assessment, and there is a change in the amount of the specific provision in a subsequent year: 
1) A deduction (in the amount of the increase in the specific provision) should be made against the gross income for the subsequent year; or 
2) An addition (in the amount of the decrease in the specific provision) should be made to the gross income for the subsequent year.

Example 3

Syarikat D Sdn. Bhd. makes a specific provision for doubtful debts of RM 3,500 for the financial year ending 30.06.2001. For the financial year ending 30.06.2002, the specific provision for doubtful debts is RM 4,300. In its profit & loss account, the company shows the specific provision of RM 3,500 for the year ending 30.06.2001 and the increase in specific provision of RM 800 (RM 4,300 - RM 3,500) for the year ending 30.06.2002. 

Provided that the above-mentioned conditions have been met, the specific provisions made in the accounts are allowable for the relevant years and no adjustment is required in the tax computation.

Example 4 

Syarikat E Sdn. Bhd. makes a specific provision for doubtful debts of RM 3,500 for the financial year ending 30.06.2001. For the financial year ending 30.06.2002, the specific provision is reduced to RM 2,000 because some payments have been received. The decrease in the specific provision of RM 1,500 (RM 3,500 - RM 2,000) is shown as 'specific provision written back' in the profit & loss account. 

No adjustment is required in the tax computation since the decrease in the specific provision of RM 1,500 should be taxed.

Circumstances Where Write Off or Provision Not Allowed as Deduction

General provision for doubtful debts

General provision made in respect of doubtful debts (for example, based on a percentage of total sales or of all trade debts) is not allowable for tax purposes, even if there is a legal requirement or an accounting convention for the particular trade or industry to make such a provision. 

Any increase in the general provision is not allowable and any decrease is not taxable.

Forgiving or waiving payment of debt 

A decision to forgive or to waive payment of a trade debt (either wholly or in part) should not be regarded as a valid business or commercial consideration for tax purposes. Such an amount should not be allowed as a deduction in the tax computation. 

Example 5

Syarikat F Holdings Sdn. Bhd. is negotiating the take-over of one of its subsidiaries, Syarikat G Sdn. Bhd., by a consortium of businessmen. At the request of the consortium and in order to facilitate the deal, the directors of Syarikat F Holdings Sdn. Bhd. decide to forgive an accumulated debt on account of goods and services supplied amounting to RM 100,000 owed by Syarikat G Sdn. Bhd. 

A letter to that effect (enclosing a copy of the directors' resolution) is issued to Syarikat G Sdn. Bhd., which then proceeds to extinguish the debt in its balance sheet as at 30.09.2002. In its accounts for the year ending 30.09.2002, Syarikat F Holdings Sdn. Bhd. writes off the amount as a bad debt. 

In its tax computation for the relevant year of assessment, Syarikat F Holdings Sdn. Bhd. should not be allowed a deduction for the amount written off as the decision is made for reasons other than in the ordinary course of business and on the basis of considerations other than the likelihood of recovery. 

In the accounts of Syarikat G Sdn. Bhd, the forgiveness of the debt should, by normal accounting convention, be reflected in its profit & loss account. No adjustment is required in the tax computation since the amount written back is taxable, being a reduction in the cost of goods and services previously charged in full in the profit & loss account.

Non-trade debts 

Non-trade debts that are written off as bad, or specific or general provisions made in respect of non-trade debts that are doubtful, are not deductible in the computation of adjusted income. Similarly, recoveries relating to non-trade debts written off earlier are not taxable.

Debt Due From Related or Connected Person

Any decision to write off or to make a specific provision for a trade debt due from a related or connected person should be subject to stringent examination before it can be considered for deduction for tax purposes.

There should also be evidence to prove that the decision is made on an arm's length basis and for valid business or commercial reasons, rather than private, personal or other non-commercial reasons.

Example 6 

Syarikat H Holdings Sdn. Bhd. provides colour separation and other ancillary services to one of its subsidiaries, Syarikat J Printers Sdn. Bhd.. Based on the draft accounts for the financial year ending 31.10.2002, Syarikat J Printers Sdn. Bhd. is expected to incur a substantial loss in respect of its printing business. 

To avert adverse publicity, the directors of Syarikat H Holdings Sdn. Bhd. (who are also directors of Syarikat J Printers Sdn. Bhd.) decide to waive payment of an amount of RM 20,000 from the total amount owing by the subsidiary company on account of services rendered. Syarikat J Printers Sdn. Bhd. is informed of this by way of a letter and it proceeds to reflect this in its final accounts which show a small net profit. In the profit & loss account of Syarikat H Holdings Sdn. Bhd for the financial year ending 31.10.2002, the amount is written off as a 'trade discount'. 

The amount written off should be disallowed in the tax computation of Syarikat H Holdings Sdn. Bhd. for the relevant Y/A since there is no commercial basis for the 'discount' and the decision cannot in any way be regarded as being made at arm's length in view of the relationship of the 2 companies and the status of the directors. 

No adjustment is necessary in the tax computation of Syarikat J Printers Sdn. Bhd. since the discount has been correctly treated for both accounting and tax purposes.

Example 7 

Encik K, a sundry goods wholesaler, has been supplying goods on a regular basis to Encik L, a sundry shopkeeper, for the past 25 years. In the course of their long business relationship, they have become good friends. In 1993, Encik L married Encik K's sister. Since 1998, the business of Encik L has been in steady decline (amongst other reasons, due to the opening of a hypermarket in the vicinity) and in 2002, Encik K decides to write off the whole amount of the accumulated debts of Encik L (who is being sued by several of his other creditors). 

In view of their relationship as brothers-in-law, the decision by Encik K to write off the debt of Encik L should be regarded as more for personal rather than for valid commercial reasons and should not , therefore, be allowed as a deduction for tax purposes. 

If, however, it could be shown that the financial position of the debtor is the criterion for the decision (for example, Encik L has already been adjudged a bankrupt at the time the decision is made to write off the debt), then a deduction should be allowed since the write off is based on a valid commercial consideration.

Example 8 

Syarikat M Bhd. writes off RM15,000 in its profit & loss account for the year ending 31.07.2002, being the trade debt of its subsidiary Syarikat N Sdn Bhd, which has been liquidated and deregistered in the same period. 

Since the trade debt is written off due entirely to the financial position of the debtor (the liquidation of Syarikat N Sdn Bhd.), the amount should be allowed notwithstanding the relationship between the 2 companies.

Recoveries

A bad debt written off reduces the balance in the relevant debtor's account. Therefore, any recovery of a trade debt previously written off as bad should be shown in the profit and loss account for the period in which it is received. If the recovery is not entered into the profit & loss account but is instead entered into a reserve or other account, an adjustment is required in the tax computation.

Example 9 

Syarikat P Sdn. Bhd. writes off RM 2,700 being the trade debt of Encik Q (who has passed away) for the year ending 30.09.2002. During the same financial year, the company receives RM 2,000 from Encik R, whose trade debt had been written off and allowed for tax purposes 3 years ago because he could not then be contacted. 

The RM 2,700 written off as a bad debt is allowable as a deduction and the recovery of RM 2,000 is taxable. If both these amounts are shown in the profit & loss account for the year ending 30.09.2002, no adjustment is required in the tax computation. 

If the recovery of RM 2,000 is not entered into the profit & loss account, an adjustment for that amount should be made in the tax computation.

Settlement of Trade Debt With Assets

A debt may be settled by the foreclosure of an asset held as security for the debt or by an asset (such as a property or shares in a company) given in exchange for the debt. In such a case, the net proceeds from the sale of the asset or the market value of the asset given in exchange is the value to be taken as settlement for the debt.

Any balance of the debt still outstanding can be claimed as a bad debt if one of the circumstances mentioned is satisfied.

Example 10 

Syarikat S Sdn. Bhd., a construction company, is owed RM 300,000 by Syarikat T Development Sdn. Bhd., a property developer which has many unsold houses in its stock. After some negotiation and in view of the severe cashflow problems of the debtor, Syarikat S Sdn. Bhd. agrees to accept a completed shophouse (which Syarikat T Development Sdn. Bhd. normally sells at RM 280,000) as full settlement of the debt. However, soon after the agreement is reached, the market for properties sharply weakens. 

On completion of the transfer, Syarikat S Sdn. Bhd. decides not to sell the shophouse immediately. Instead, the shophouse is let out. In the transfer documents for the property, the consideration is shown as RM 280,000 and stamp duty based upon that value is duly assessed and paid. In its profit & loss account, Syarikat S Sdn. Bhd. writes off RM 20,000 (RM 300,000 - RM 280,000) as a bad debt. 

The write off amounting to RM 20,000 should be allowed for tax purposes as the market value of the asset accepted in exchange for the debt is RM 280,000, as evidenced by its acceptance by the Collector of Stamp Duty.

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Edited by: 浪子

Source: http://lampiran1.hasil.gov.my/pdf/pdfam/PR1_2002.pdf