With the implementation of the conditional movement control, businesses have started their operations. One of the key tax concerns that businesses will face during this period is the tax treatment of unpaid bills i.e. bad debts.
Section 34(2) of the Income Tax Act 1967 (ITA) sets out the specific bad debt deduction which are allowable in relation to a business source income. It provides that any debt as defined in Section 34(3) is deductible if the debt is reasonably estimated in all the circumstances of the case to be wholly or partly irrecoverable. Debt in this context means:
“a debt arising in respect of any matter referred to in subsection 24(1) or in respect of interest of the kind referred to in subsection 24(5), where the amount of any such debt has been included in the relevant gross income or in the gross income of the relevant person from the business for the basis period for a year of assessment prior to the year of assessment to which the relevant period relates; or
a debt arising in respect of a loan of the kind mentioned in subsection 24(5) granted in the course of carrying on the business in the relevant period or in the basis period for any such prior year of assessment.”
Determination Of Bad Debt
In short, for a debt to be deductible under Section 34(2), the following requirements must be satisfied:
• There must be a debt.
• The debt must be arising in respect of any matter referred to in Section 24(1) of the ITA.
• The amount of such debt must have been included in the relevant gross income of the business prior to the relevant year of assessment (YA) when the debt is written off.
• Such debt is irrecoverable or reasonably estimated in all the circumstances of the case to be wholly or partly irrecoverable.
There Must Be A Debt
The very fundamental requirement before a tax deduction can be taken against a debt which is irrecoverable is that there must be a debt due from the debtor to the taxpayer in the first place.
In the CKB Ltd case, the taxpayer knowingly made two illegal loans to two related companies. When the borrower defaulted on the second loan, the taxpayer sought to recover the debt in the High Court. The High Court held that both loans were void and unenforceable. The Supreme Court upheld the decision of the High Court. Subsequently, the Revenue refused to allow any deduction in respect of the said loan and issued additional assessments on the taxpayer for the amount which had previously been allowed as a doubtful debt.
On appeal, the Special Commissioners of Income Tax (SCIT) held that the effect of the High Court order was to render the loan void ab initio i.e. there was no contract from the beginning. Consequently, there was no debt due from the loan agreement within the meaning of Section 34(3). Accordingly, the amount was not deductible under Section 34(2).
Debt Arising In Respect Of Section 24(1)
Section 24(1) of the ITA states that:
“Where in the relevant period a debt owing to the relevant person arises in respect of -
(a) any stock in trade sold in or before the relevant period in the course of carrying on a business;
(aa) any stock in trade parted with by any element of compulsion including on requisition or compulsory acquisition or in a similar manner, in or before the relevant period;
(b) any services rendered or to be rendered at any time in the course of carrying on a business; or
(c) the use or enjoyment of any property dealt or to be dealt with at any time in the course of carrying on a business,
the amount of the debt shall be treated as gross income of the relevant person from the business for the relevant period.”
Therefore, the debt must be a trade debt for the purpose of deduction under Section 34(1) i.e. the debt must be in relation to the sale of stock in trade or services rendered in the course of carrying out the taxpayer’s business.
In the Sastep Sdn Bhd case, the High Court raised an issue of whether the debt actually arose in the course of the taxpayer’s business.
“Notwithstanding that, based on the documents and case stated, the Appellant did not exhibit any documents to establish that there was or there were such transactions between the Appellant and SPI and that these were genuine. A transaction carried out without the object of making a profit cannot be one done in the course of carrying on its business…
The Appellant did not disclose or exhibited any lease or rental equipment agreement entered into between the Appellant and SPI, the equipment rented, the total lease rentals, the monthly or yearly payments towards the lease rentals, the length of the lease and its expiry date, whether the equipment to be returned, either at the end or earlier termination of the lease, whether any option to purchase and whether SPI had exercised the option and the payments made.”
Hence, it is important to retain documents to establish that the transactions under which any debt arises are genuine with the object of making a profit and are done in the course of carrying on the taxpayer’s business.
The Debt Was Part Of Gross Income
Section 34(3) expressly states that for the purpose of deduction of debt, the amount of the debt must have been included in the gross income of the business prior to the YA when the debt is written off as irrecoverable. It follows that each debt written off as irrecoverable should match an entry in the income account in any of the previous YA of the taxpayer’s business before a deduction can be taken against the income.
No tax deduction can be taken in relation to an irrecoverable debt written off if it has never been brought to tax in the previous years.
Debt Is Wholly Or Partly Irrecoverable
Case law suggest that whether a debt is bad or the extent to which it is bad is a question of fact.
In the Sastep Sdn Bhd case, the Inland Revenue Board (IRB) rejected the taxpayer’s bad debt claim on the basis that the taxpayer’s decision to write off the unpaid rental was not for the purpose of the business. This is especially when the legal action was only commenced against the debtor knowing that the debt was already time barred and it was only filed for the purpose of obtaining tax deduction. The question was whether the debt written off by the taxpayer was wholly irrecoverable so that it qualified as a deduction.
In disallowing the deductions, the High Court held that:
“…the Appellant did not set out when SPI defaulted in the lease rental payments, how long since the default, any action taken to recover the arrears and or the outstanding sum, any action taken to repossess or take back the lease equipment and how long did it take for the unpaid lease rentals to accumulate until they amounted to the sum of RM3,285,971.19.
…There were several letters of demand before the Appellant filed a suit dated 15.5.2013 against SPI, after 13 years of sending letters of demand, bearing in mind the Appellant leased the equipment to SPI in 1997…The Appellant did not take any legal action against SPI prior to 2013. Clearly the Appellant delayed in taking the necessary action to recover the debt for obvious reasons.
…Their dealings and financial transactions being as related parties, there were conflicts of interest in the financial management of both companies by him. In 2001 the Appellant made provision for bad debt and then wrote off the debt. The Appellant only filed the suit in 2013 after it was time-barred. Clearly the Appellant had delayed in taking actions to recover the debt owed by SPI and in writing off the debt. These decisions were not made bona fide. The SCIT had ruled that the decisions were not based on prudent commercial business considerations.”
In deciding what amounts to “prudent commercial business considerations”, the court will look at the reasonableness of the actions taken by the taxpayer as against the amount of debt owed by the debtor. The expression "bad and doubtful debt" is descriptive of a debt which cannot reasonably be expected to be realised. It would not do for the taxpayer to say that he became pessimistic about the prospects of recovery of the debt in question. The taxpayer must feel honestly convinced that the financial position of the debtor was so precarious and shaky that it would be impossible to collect any money from him. There is no acid test to ascertain whether a debt has become bad and doubtful, and if so, when.
Whether or not a debt is bad or doubtful is to be examined only on the existing facts during the time when a deduction is taken. Thus, the IRB cannot disallow a deduction merely because the genuine opinion formed at the relevant time turns out to be erroneous in light of the subsequent events, such as when the debt is subsequently repaid by the debtor.
Based on case law analysis and as recognised by the IRB in its public ruling, in the following circumstances, a debt can be considered bad:
• When the debtor has died without leaving any assets from which the debt can be recovered.
• When the debtor is bankrupt or in liquidation and there are no assets from which the debt can be recovered.
• When the debt is statute-barred especially in a genuine case.
• When the debtor cannot be traced despite various attempts and there are no known assets from which the debt can be recovered.
• When attempts at negotiation or arbitration of a disputed debt have failed and the anticipated cost of litigation is prohibitive.
• Any other circumstances where there is no likelihood of cost-effective recovery.
It is notable that before a bad debt deduction is permitted, the IRB expects the taxpayers to keep documentation of the debts owing to them and to take necessary actions or steps to recover the debts due before a deduction is taken.