Tax Law Note: How Should the Doubtful Debt Reserve Deduction Be Computed?

Tax Law Note:
How Should the Doubtful Debt Reserve Deduction Be Computed?

Legal Department

Last Updated: December 02, 2004

Introduction

Both overdue loans and other trade receivables may be considered bad or doubtful debt for tax purposes. Bad debt refers to debt whose collection is considered hopeless, while doubtful debt is debt whose collection is uncertain. Bad debt is taken off ("charged off") the balance sheet of companies once it is written off for financial purposes. A tax deduction for bad or doubtful debt may be allowed either when it is written off for financial accounting purposes (the charge-off method)^¹ or through the creation of tax deductible provisions (the reserve method). A third alternative is not to allow the deduction of bad debt at all, or to deny the deduction in certain circumstances. This note refers to a doubtful debt reserve, but this may also be called a "reserve for bad debts,"² or bad debt reserve, namely a reserve set up to provide for the contingency of debts going bad.

The reserve method requires an accurate estimation of doubtful debt on the basis of which all or part of the reserve becomes deductible for tax purposes.

This note focuses on the methods of establishing the amount of the tax deduction for a doubtful debt reserve. The discussion is confined to debts that arise in the course of a business.

However the amount of the reserve is determined, the mechanics for calculating the tax deduction for the year are as follows: closing reserve (amount of reserve at year-end) - opening reserve (amount of reserve at end of prior year) + debts written off during the year - recoveries of previously written off debts = deduction for the year.³

Country Practice

1. Reasonable reserve based on appraisal of specific debts⁴

One of the methods of establishing the tax deduction for doubtful debt reserves is to require the taxpayer to perform an appraisal in the case of each individual account and to determine a reasonable percentage reserve based on the circumstances of the particular debtor.⁵

2. General reserve creation rule based on all outstanding debt

Some countries determine the amount of the doubtful debt reserve as a percentage of all the outstanding accounts receivable. In some countries this percentage is based on the taxpayer's assessment with respect to the overall ratio of uncollectible debt and in others the allowable percentage is stipulated in the law.⁶

3. General reserve based on age of debt

A third method is classifying outstanding debt claims according to their age (the time the debt has been in default) and determining the reserve as a percentage of the outstanding debt. The percentage increases with the age of the debt.⁷

4. Banks

Due to the nature of their business, banks (and other financial institutions) usually have relatively accurate methods of establishing the doubtfulness of a debt or a debt portfolio and are generally bound by regulations issued by the central bank or other regulatory body with respect to the creation of doubtful debt reserves. The rules applicable to the tax deduction of bad debt reserves usually follow the special accounting and financial rules applicable to financial institutions.⁸

Fashioning a Solution

Business bad debts are a cost of doing business and so should be allowed as a deduction. The difficult issue is when the deduction should be allowed - when the debt becomes worthless and is charged off in the taxpayer's books, or earlier. The simplest approach is not to allow a deduction for contributions to bad debt reserves (except in the case of financial institutions). In this case, the deduction will be delayed until the debt becomes worthless.

What is at stake in fashioning these rules is the time value of money - generally, taxpayers have an interest in accelerating deductions and the tax administration has a corresponding interest in delaying them. In addition, the rules on doubtful debt reserves may give taxpayers some flexibility in timing their income.⁹

If a country decides to allow a tax deduction related to doubtful debts through the creation of a deductible reserve, it has two options in practice: either it can permit setting up reserves based on the risk associated with specific accounts or it may allow a general deductible bad debt reserve calculated as a percentage of all outstanding debts. Both approaches present problems in practice.

Allowing the creation of a general reserve based on the assessment of the taxpayer may be easy to manipulate by taxpayers and costly and complicated for the tax authorities to monitor. At the same time setting out in the tax law or regulations a general percentage of all outstanding debt as a deductible reserve may not result in a just situation in the case of individual taxpayers.

If greater accuracy is sought by allowing reserve deductions based on the assessment of specific debts, the conditions under which a debt may be considered partly or wholly doubtful need to be defined in detail in the tax law or regulations. Relevant factors could include: the value of any collateral; security for the debt; financial situation of the debtor (is there a formal bankruptcy procedure against the debtor?); if the debt is overdue, the time it has been in default; any legal action required (based on the commercial law rules of the country in question for collecting receivables). Forming a tax deductible bad debt reserve may be made contingent on default on payment of the debt, i.e. an addition to the reserve could only be made possible once the debt is due and enforceable; having such a provision could significantly limit the possibility of taxpayer manipulation and would include an objective condition that is easy to control.¹⁰

In the case of banks the creation of bad debt reserves is typically obligatory based on regulations of the central bank or other banking supervisory body. Setting up such reserves is aimed at minimizing the risks associated with the banking sector. Therefore the bad debt provisions prescribed by the banking regulations tend to be conservative to ensure that assets are not overstated. As a result there is an argument for allowing as the deductible reserve for tax purposes a smaller amount than the full provision required by banking regulations, for example, 80-90 percent of the provisions. Whatever the allowed percentage (e.g., 80% or 100%), defining the tax deduction as a percentage of the addition to reserves required by the regulators allows the tax authorities to rely on the regulations issued and audits carried out by the central bank/supervisory body with respect to the correct calculation of the reserve.

For further reference:

Lee Burns and Richard Krever, Taxation of Income from Business and Investment, in 2 Tax Law Design and Drafting 629-32 (1998).

Brigitte Granville, Particular taxes—Corporate income tax treatment of loan-loss reserves, in Taxation of Financial Intermediation: Theory and Practice for Emerging Economies (Patrick Honohan ed., 2003)

The series of Tax Law Notes has been prepared by the IMF staff as a resource for use by government officials and members of the public. The notes have not been considered by the IMF Executive Board and, hence, should not be reported or described as representing the views of the IMF or IMF policy.
¹There may be additional limitations. For example, the tax law may require taxpayers to wait until judicial action to recover the debt has been undertaken and proven fruitless. In some cases, these rules unduly delay deductions for bad debts.
²Treas. Reg. §1.166-4 (United States).
³See 2 Tax Law Design and Drafting 629-632 (1998).
⁴Once the amount of the reserve is established, a separate problem arises with respect to the annual calculation of the deductible addition to the reserve. See the table.
⁵In France the provision for doubtful debts must be based on the taxpayer's assessment of the individual accounts. CGI 39 1 (5); Code Pratique Fiscal 81-83, Francis Lefebvre, 1999. The same approach is used in countries such as Belgium, Ireland, and the UK. IBFD, European Tax Handbook (2001).
⁶Bulgaria allows the deduction for tax purposes of 30% of the provisions made by non-financial institutions and 100% in the case of financial institutions. In Italy reserves are deductible up to 0.5% of trade receivables not covered by insurance. European Tax Handbook 84, 342 (2001). In the U.S., before repeal of this rule by the Tax Reform act of 1986, taxpayers were allowed to elect to use a tax deductible general reserve for bad debts. If so elected, the taxpayer established a reasonable addition to a reserve for bad debts in lieu of deducting specific bad debt items. What was considered reasonable was not specifically regulated and was based on the judgment of the taxpayer. The taxpayer had to file with the tax return a statement showing - among other related items - the volume of its business transactions and the percentage of the reserve to such amount. Treas. Reg. § 1.166-4. The 1986 Act repealed section 166(c), which had allowed this deduction, on the basis that it allowed an undue acceleration of deductions for bad debts. Currently in the U.S. bad debts are deductible under section 166 only when actually charged off.
⁷In Canada the taxpayer has the option in calculating the doubtful debt reserve to use any of the three following methods: (1) calculating a percentage of the outstanding accounts; (2) performing an appraisal of each account; and (3) classifying accounts by age and increase percentage based on age. Par. 3459, Canadian Master Tax Guide 56^th Edition, 2001, CCH Canadian Limited. Czech Republic: general provision is 20% if debts are overdue more than 6 months, 33% if more than 12 months, 50% if more than 18 months, 66% if more than 24 months, 80% if more than 30 months and 100% if more than 36 months. Hungary applies the same principle (2% if debt is overdue for 90-180 days, 5% if 181-360 days, 25% if more than 360 days). European Tax Handbook 142, 284 (2001, IBFD).
⁸In Hungary even though the general tax rules apply to banks, with respect to establishing the deductible bad debt reserve special rules apply. In general the reserves are created on the basis of the age of the debt; however financial institutions have to use the individual assessment method for determining the reserves. PM Rendelet 14/2001 (III.9.). In Greece a general percentage is set for different groups of receivables (0.5% of receivables from sale of goods or services, 1% of receivables of commercial credits and a maximum of 35% of other trade receivables) for ordinary taxpayers, while special bad debt provisions apply to banks. In Norway banks calculate their reserves based on the accounting standards applicable to financial institutions based on banking regulations. European Tax Handbook 259, 434 (2001).
⁹For example, a taxpayer may want to accelerate income to take advantage of an expiring loss carryover deduction. This could be done by reducing the size of the bad debt reserve.
¹⁰The U.S., for example, in its pre-1986 rules did not require a debt to be overdue in order for the taxpayer to determine that it is wholly or partly worthless. Regs. 1.166-1 (c) Other countries like the Czech Republic or Hungary do. European Tax Handbook 142, 284 (2001, IBFD).

NOTE: The series of Tax Law Notes has been prepared by the IMF staff as a resource for use by government officials and members of the public. The notes have not been considered by the IMF Executive Board and, hence, should not be reported or described as representing the views of the IMF or IMF policy.