Cheat sheet: Bad debts, and how to write them off

Income you can’t recover, or money you’re owed that’s unlikely to be paid back — otherwise known as a bad debt — can sometimes be claimed as a deduction, depending on the accounting method you use.

The nitty gritty is covered by section 25-35 of the Income Tax Assessment Act 1997 and Taxation Ruling TR 92/18, which formally sets out the circumstances and conditions in which a deduction for bad debts will be allowable.

Put simply, the debt must be for an amount that’s been recorded as assessable income on a non-cash (accruals) basis, where revenue is recorded when it is actually earned, rather than when cash is received. 

If you record your income on a cash basis, it’s going to be impossible to claim a deduction for a bad debt, as the amount would never have been recorded as income in the first place.

Timing is everything

If you incurred a debt in an income year prior to the year you write it off, you’ll need to satisfy the ATO’s “continuity of ownership test”, which determines whether your business has maintained the same owners from the date when the debt was incurred until to the end of the year it’s written off.

It’s also important to understand that writing off a bad debt is different to waiving or forgiving one. 

A debt is deemed “forgiven” if you’ve gone through the motions of “freeing” someone from the obligation to pay it, and there are different tax consequences for yourself and the debtor in question under these circumstances.

How to do it properly

You’ll need to make sure that you treat the bad debt deduction correctly and according to ATO guidelines.

That means the bad debt must be:

• Current at the time of write off and not otherwise dealt with;
• Written off in the same year the deduction is claimed; and
• Genuinely unrecoverable, as opposed to being “a bit difficult” to recoup.

To be deemed “genuinely unrecoverable”, this doesn’t always mean you need to have commenced formal proceedings to recover the debt. 

There’s other ways to demonstrate this, such as evidence of communications seeking to obtain payment, including reminder notices issued and attempts to contact the debtor by phone, email or post. 

If you somehow manage to recover an amount that you wrote off as a bad debt and claimed it as a tax deduction, you’ll have to go back and include it in your assessable income when this happens.

GST considerations

Keep in mind that when you write a debt off, you might also be able to recover the GST you paid on the initial accrued income.

You can do this if:

• You made a taxable sale and have paid GST to the ATO for that sale;
• You haven’t received the payment, either in whole or in part, for the taxable sale; and
• You wrote the debt off as bad, or the debt had been overdue for 12 months or more.

Demonstrating a debt is considered bad for GST purposes uses the same criteria as demonstrating it’s bad for income tax purposes.

Record keeping

In case the ATO comes knocking, make sure you keep adequate records for each bad debt you write off. 

These records should include:

1. Evidence of communications seeking to obtain payment;

2. The debtor’s name and address;

3. The amount of the debt;

4. The reason why the debt is regarded as bad; and

5. The income year that the amount was recorded as income.

Minimising bad debts

At the end of the day, you can save yourself a heap of hassle, specifically money and time, if you simply minimise your bad debts.

Some of the ways you can do this might include:

• Asking new customers for more than one credit reference, and following up with these references;
• If possible, only sending out goods or providing services after customers pay their bill;
• Similarly, asking for upfront payments from repeat offenders;
• Making it as easy as possible for people to pay you;
• Invoicing customers as soon as you can;
• Offering discounts for paying on time or early; and
• Not providing large credit limits.