Bad debt deductions for holders of debt - compliance

(Clauses 26, 29)

Summary of proposed amendment

Two changes are being made to the bad debt deduction rules in the Income Tax Act 2007.

The first change is a measure to reduce compliance costs. It will make the law fairer for taxpayers by allowing them to take bad debt deductions in certain situations when they would ordinarily be entitled to them on the cessation of the arrangement, but for technical compliance issues.

The second change is a base maintenance measure and is discussed in the following item.

Application date

The compliance changes apply from the 2008–09 year, subject to a grandparenting provision so that taxpayers who relied on the current law will not be able to re-open previous years’ tax assessments to take advantage of new provisions for prior years.

Background

One function of the bad debt write-off rules is to ensure that taxpayers are not taxed on amounts which may have been derived and included as assessable income, but are never actually received. If deductions for bad debts were not allowed, taxpayers would pay too much income tax because they would be assessed on income which substantively was not received.

There is a required process for taking bad debt deductions. Bad debts for amounts owing under a financial arrangement must be written off before the financial arrangement ends (for instance, by liquidation). This means that if a taxpayer fails to take a bad debt deduction before that time, a bad debt deduction cannot be taken later.

Currently, the tax rules require that where a debtor goes into liquidation or bankruptcy, the creditor (holder) can take a bad debt deduction only if the debt was written off as bad in the same income year, and before the liquidation or bankruptcy took place. This requirement can be unnecessarily onerous for certain creditors (for example, “mum and dad” investors in failed finance companies), as it means they would need up-to-date knowledge of the financial state of the debtor in order to take the bad debt deduction in time. In some situations, creditors are not informed of upcoming liquidations or bankruptcies so they would need to regularly check the companies register or public listings for updates on the financial status of debtors.

The same strict write-off criteria apply to creditors when the debtor company has entered into a composition[4] with them. In these cases, the creditor can take a bad debt deduction only if the debt was written off as bad in the same income year and before the composition took place. Again, the write-off requirement can be unnecessarily onerous for creditors because the timeframe to write off the debt can be short (the period between being informed of the financial difficulties of the debtor and the composition itself).

Creditors who fail to write off the bad debt in time will have a tax obligation in respect of accrual income they have never received, or remission income that was never written off. This result is unfair and leads to unnecessarily high compliance costs.

The proposed changes will allow creditors to take bad debt deductions where the debt has been remitted by law (for example, after the debtor is liquidated/bankrupted), or where a debtor company has entered into a composition with the creditors.

Key features

At present holders of debt can only take bad debt deductions when the debt has been correctly written off as bad. Under the proposed new rules, bad debt deductions will also be allowed if the debt has been remitted by law, or a debtor company has entered into composition with creditors in relation to the debt.

If a bad debt deduction is sought following a remission by law or after a debtor company has entered into composition with creditors, the deduction must be taken in the year that the base price adjustment is performed.

For clarification, the requirement that the debt be “bad” before any deduction can be taken is unchanged.

4 A composition with creditors is a deed or agreement where the debtor is released from making all remaining payments (for example, when the creditor agrees to accept 70 cents for every dollar owed by the debtor).