How do income tax rules treat bad debts?
There are two provisions in the Income Tax Act (ITA) for bad debts.
The first way to claim a bad debt is covered in Section 20 of the ITA if the following requirements are met:
- the debt was owing to the taxpayer at the end of the taxation year,
- the debt became bad during the taxation year, and
- the debt was included or is deemed to have been included in the taxpayer’s income for that taxation year or a previous taxation year.
The second more generous but temporary way to claim a bad debt is also covered in section 20. It discusses the concept of a reserve for doubtful debts. A reserve claimed by a taxpayer under this section is for one taxation year must be included in income in the following taxation year. Thus the reserve claimed for a taxation year is always a new reserve and the whole of the reserve is reversed each year.
In our experience we have seen businesses use reserves like—50% of all Accounts Receivable over 90 days or 100% of Accounts Receivable over 120 days. The key reason the tax authorities allow this in our opinion is that the bad debt and the resulting tax savings are temporary, thus any tax saved this year is going to be due next year.
Sales taxes are also important to consider. The above rules are from the ITA not the sales tax acts. (see FAQ #202 on PST vs. GST). When you decide to reverse sales taxes charged and trigger a refund, it is not the same as when you can get income tax relief by declaring a bad debt or allowance for bad debt. Recovering sales taxes will be discussed in a future FAQ.
Please also see FAQ #206 for a general discussion of Accounts Receivable.
If you have any questions about bad debts, get in touch.
Author: Grant Gilmour has been in the CA business since 1988, starting his own practice in 1994. His tax expertise encompasses tax planning, international tax issues, and Scientific Research and Development tax credits. He is a graduate of the CICA In-Depth Tax Course and in 2012, Grant received the CA Community Service Award and the Scout Leader Medal.