What are Bad Debts and their treatment under income tax

In the world of businesses and finances, the most feared factor by any establishment is the occurrence of bad debts. Bad debts are those incomes which were supposed to be realised but those have eventually turned out to be non-collectible. They are considered as an expense when it comes to accounting. This is basically a repayment of credit previously extended to a client which is now non-collectible. In the context of income tax, bad debts refer to amounts that were previously included in a taxpayer’s income but have become uncollectible and are therefore written off as a loss.

Bad Debts in income tax:
A bad debt is a receivable that is no longer expected to be collected. For businesses, this typically refers to amounts owed by customers that have become uncollectible. 

To claim a bad debt as a deduction, the debt must be considered worthless within the said accounting year. This deduction of bad debts is allowed against any of the taxable income of such businesses. Bad debts provide certain benefits to taxpayers, especially businesses where a deduction is allowed in respect of such bad debts. If a bad debt has become irrevocable in the previous financial year, it will qualify for deductions. Income tax act, 1961 has laid down certain conditions u/s 36(2) which shall be followed before any deduction is claimed in respect of such bad debts. These conditions are as follows:

• The bad debt is related to the said business or profession for the respective accounting year.
• The deduction is allowed only when such debts are previously considered in the computation of income.
• The assessee will only be eligible to take the deduction in respect of those debts only which they have written off from the books of accounts in the previous financial year in which the deduction is also claimed.

Tax treatment of Bad Debts recovered:
It is highly possible that, after a certain period of time has lapsed, some debtor will present himself with the payment of bad debts. This situation is called for analysis of such bad debts recovered.

If the bad debts recovered are less than what was expected, then the remaining amount will be treated as bad debts. Similarly, if the bad debts recovered are more than the expected bad debts, then such excess amount will be treated as income in the year in which such bad debts are recovered.

Special provisions:
As per section 36(1) of the Income Tax Act, 1961, only banks and financial institutions are allowed a deduction in respect of the provisions made for bad and doubtful debts. Other assessees are not permitted to claim the deduction on the provision of bad debts.

As per Accounting Standard 29 “Provisions, Contingent Liabilities and Assets” an assessee must account for the provisions that occur in the ordinary course of business. Since the provisions are disallowed sometimes by the Income Tax Department, it creates a timing difference between the books of accounts and books as per the income tax act.

An assessee should create deferred tax asset/liability only when the timing difference of the transaction is temporary and have the possibility of getting reversed in the future.

Conclusion:
Sections 36(1)(vii) and 36(2) of the Income Tax Act govern the treatment of bad debts, allowing businesses to deduct such debts from their gross income if the conditions are met. Bad debts represent receivables that a taxpayer deems uncollectible and writes off as losses. A bad debt has to be included in the income, shall be bona-fide i.e. it arises out of genuine debtor creditor relationship, and it is deemed wholly or partly worthless within the said accounting year.

About Author:
CA Chinmay Shirish Agate
Chinmay Agate is a Practicing Chartered Accountant having 4+ years of experience and expertise in the field of Direct Taxation and Auditing compliances. In the past, he worked in various CA firms and comes with wide industry experience from services, retail to manufacturing to trading where he has handled various complex assignments. He has keen interest in Forex and Derivative knowledge as well as fundamental analysis.