Many of the costs associated with running a business can be claimed as a tax-deductible expense, but not all. The Income Tax Act dictates that to be deductible, expenses must be incurred in the course of deriving assessable income, or in running a business.
Bad debts are one such example. Bad debts are real losses suffered by a business, arising when credit has been extended to customers who are ultimately unable to pay the amount owed. The timing of a bad debt can be subject to a degree of subjectivity. Hence, although they are commonly recorded as an expense in the financial statements after a certain period of time, there is no automatic right to a tax deduction. The default position in the Income Tax Act is to deny a deduction for a bad debt, except where the debt has been written off during the income year or certain other legal steps have been taken to formally release the debtor from payment.
Whether a bad debt deduction could be claimed was the subject of a recent High Court decision, Boon Gunn Hong v Commissioner of Inland Revenue , where the taxpayer was ultimately unsuccessful.
The taxpayer was a barrister and solicitor working as a sole practitioner. He made loans of $50,000 and $122,280 respectively to two of his legal practice’s clients, both of whom were facing financial difficulties. The court referred to them being made from a “benevolence on the conscience loan fund” intended to help clients facing financial difficulties. When the debtors became unable to pay, the taxpayer claimed a tax deduction for the bad debts in the 2011 year.
The Court denied the deduction on several grounds. Firstly, the Court considered the general principle requiring a connection between an expense and the income derived by the business. The taxpayer was not in the business of lending money nor was there a connection between the taxpayer’s legal services business and the bad debts, hence the loans were not expenses incurred in deriving his assessable income.
Secondly, under the specific bad debt provisions, the taxpayer’s own accounting procedures failed to show that the loans had been written off in the 2011 year. Furthermore, he had failed to establish that the debtors were legally released from making any further repayments. One debtor was only released from bankruptcy in 2013 and the other had not been adjudicated bankrupt at all.
The case had initially been heard in the lower courts, with the taxpayer charged shortfall penalties for taking a lack of reasonable care in forming his tax position. In addition to finding against the taxpayer, the High Court upheld the penalty, with the taxpayer also forced to pay the legal costs involved in taking the case to the High Court.
This case highlights the importance of ensuring the deductions claimed in your tax return are properly allowable under the Income Tax Act 2007. If you have any expenses that could possibly raise red flags it is important to take specialist tax advice to avoid the potentially costly consequences of mistakes.