You’ve been generous enough to give your customers credit, and now one of those customer’s debt has become uncollectible. You need to determine just how old is the debt, and what are your chances of collecting it. You can definitely write-off any debts that become uncollectible during the year; however, you must take steps to show that you at least tried to collect said debt. For our purposes today, we’re talking about customer invoices, and not loans or other debts.
Canada Revenue Agency (CRA) considers a debt to be bad when:
(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.
You can’t claim a bad debt where a debt was sold, discounted or assigned absolutely by the taxpayer during the course of the year, even though the taxpayer may remain liable to indemnify the purchaser or assignee if the debt should prove to be uncollectible. If you use a factoring company, where you sell off your accounts receivable (customers who owe you money) then you wouldn’t be able to write off the debt as bad until the factoring company reassigned that debt back to you. This would also apply if you have assigned the debt over to a collection agency. Once the collection agency has determined the debt absolutely uncollectible then you can claim the bad debt as a business expense.
As with anything to do with the CRA, you must have proof, and the same goes for bad debts. You can’t just say that the debt is bad and write it off. You need to show a trail of letters, emails, etc. that prove you have tried to collect the debt (of course, you need to have the actual invoice too).
You determine what bad debts you have at the end of your fiscal year. Look through your customer accounts and decide, which accounts you are not going to be able to collect. Have you really tried to collect the debt? Have you kept an audit trail of your attempts to collect the debt? If you’ve done all that and it still appears not to be collectible then by all means write it off.
Allowance for Doubtful Accounts
You may find at the end of your fiscal year there are some accounts, which you think you may not be able to collect; however, as per the rules you can’t just claim a bad debt because you think it may be uncollectible. In this case you can claim a reserve for doubtful accounts. For example, you have $10,322.50 in invoices that you think you won’t be able to collect. In this case you claim a reserve for this amount, or lower, in the current fiscal year. If you do happen to collect them during the next fiscal year, you just reduce this reserve by the amount of that particular debt.
However, any doubtful account reserve claimed in one taxation year, must be included in income in the next fiscal year, even if the debt wasn’t collected. Basically, you’d take the leftover reserve as income and then write-off the debts completely as bad debt to get rid of the reserve. It’s basically a neutral effect on your bottom line.
You must establish that a reserve for doubtful debts is reasonable in amount, it is necessary to identify the debts that are doubtful of collection having regard for such indications as the period of arrears or default, the financial status and prospects of the debtor, the debtor’s past credit record both with the taxpayer and, if available, with other creditors, the value of any security taken and any other factor that is relevant in judging the debtor’s ability or willingness to pay.
Don’t despair that you have uncollectible accounts, as you get to write those debts off eventually. You do have to be careful though as a debt may be thought to be bad by you, however, CRA may have a different idea. You need to do your due diligence when it comes to customer debts, and that you keep a paperwork trail.
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