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Tax Rules for Bad Debts

March 28, 2017

Tax Question:

How do income tax rules treat bad debts?

Facts:

There are two provisions in the Income Tax Act (ITA) for bad debts.

Discussion:

The first way to claim a bad debt is covered in Section 20 of the ITA if the following requirements are met:

(a) the debt was owing to the taxpayer at the end of the taxation year, (b) the debt became bad during the taxation year, and (c) 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. 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.

If you would like more information on this topic, please contact a member of the Empire CPA team by filling out the contact form below.

Canadian and foreign tax laws are complex and have a tendency to change on a frequent basis. As such, the content published above is believed to be accurate as of the date of this post. Before implementing any tax planning, please seek professional advice from a qualified tax professional. Empire, Chartered Professional Accountants will not accept any liability for any tax ramifications that may result from acting based on the information contained above.

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