Bad debts refer to amounts that are deemed unrecoverable, allowing businesses to claim deductions under specific criteria outlined in the Income Tax Act of 1961. Doubtful debts, with uncertain recovery prospects, are handled differently, often requiring provisions for potential losses. The recovery of bad debts, as well as provisions for doubtful debts, is subject to specific tax guidelines, particularly for banks and financial institutions, ensuring proper accounting and tax treatment for these financial challenges.
If corporate and professional debt becomes unrecoverable in the preceding fiscal year, a deduction is permissible. If the debts cannot be wholly or partially recovered by the loans provided by banks or money lending institutions, a deduction may be allowed.
Eligibility Criteria for Deduction of Bad Debts
The eligibility of an individual for a deduction is contingent upon the existence of debts that are entirely unrecoverable under the law or by the courts. The Income Tax Act of 1961, Section 36(2), must be satisfied prior to the provision of any relief for delinquent debts. The circumstances are as follows:
The debt or loan is required for the assessee’s trade or occupation and is required to be associated with the applicable accounting period. Any debt irrelevant to the assessee’s occupation or business does not qualify for a deduction.
In case a debt due from retiring partners is non-recoverable, the assessee cannot disregard it and can file for a claim for a deduction due to capital loss.
Only those debts acknowledged throughout the present period or any preceding fiscal year's tax return calculation are entitled to receive a deduction by the assessee. Attention should be paid to the amount that is loaned in the ordinary course of business at the lending institute.
The deduction for bad debts should have been made in the accounting year in which any loan, debt, or portion thereof was considered bad.
The assessee is only eligible to claim the deduction for debts that were previously eliminated from their accounts books in the previous fiscal year, for which the reduction is also requested.
Debt with uncertain chances of recovery is known as doubtful debt. Consequently, the company can endure losses because of the presence of these debts.
The sum payable to customers’ accounts is tracked somewhere at the end of the financial year, and the probability that some of those amounts will be recovered is estimated to be not possible. In reality, the total whose recovery is uncertain cannot be classified as a loss on the day the accounting information is generated and, as a result, cannot be written off. It is necessary to apply it to the company's profit and loss account, contingent upon its prior performance.
A clause titled "Provision for Doubtful Debts" is also included to safeguard against the potential loss. The clause imposes a tax on profit. When we establish provisions to mitigate potential losses in the event that the uncertain debt proves to be detrimental, a specific sum is allocated.
Bad Debts from Closed Businesses
Bad debts from a no longer active firm examined before the commencement of the financial year cannot be written off from the assesse’s profits from their continuous operations.
As per Section 36(2)(iii), in case the bad debts have been removed from the accounts book but remain recoverable, A.O. declines to acknowledge them as a deduction. In the year when a debt or part of an obligation becomes unrecoverable, it should be subtracted from income.
How the Bad Debts are recovered?
In case the debt was classified as bad debt in the previous year and the necessary deduction was also accounted for. Nevertheless, the debt was subsequently recovered in whole or in part. The amount that was eventually recovered will be included in the income for the fiscal period in which it was recovered. Suppose that the assessee wrote off a portion of the debt in a previous year, the Assessing Officer approved the deduction, and the creditors subsequently repaid a portion of the debt. In that event, the recovered funds will be regarded as a standard realization of debts. If the amount recovered is less than the expected amount, the remaining balance will be considered bad debts.
Provision for doubtful and bad debts
The Income Tax Act of 1961, section 36(1) (viia), allows only banks and financial institutions to deduct expenses associated with provisions for poor and dubious loans. The deduction for the provisioning of problematic debts is not available to any other taxpayer.
The deduction that banks and other financial institutions may make is subject to the following restrictions:
Bank Types include Indian Banks, Foreign Banks, Public Financial Institutions and State Financial Corporations.
7.5% of the adjusted overall revenue plus 10% of the average total advances of rural branches
An adjusted 5% of the total income
An adjusted 5% of the total income Compute the advancements of each rural branch independently.
Divide the number of months outstanding by the average advances by branch.
The average total amount of advances made by each branch.
Treatment in accordance with the accounting standard
In accordance with Accounting Standard 29, "Provisions, Contingent Liabilities and Assets," the provisions that arise in the ordinary course of business must be recorded. The provisions are occasionally disallowed by the Income Tax Department, which leads to a temporal discrepancy between the accounting records and the accounts required by the I.T. Act.
Consequently, an assessee is also required to establish the requisite Deferred Tax Assets and Liabilities. For an assessee to have a deferred income tax asset or obligation, only the temporal mismatch of a transient transaction that has the potential to be undone in the future is necessary.
In conclusion, bad and doubtful debts are critical components of business accounting, with specific provisions for deduction under the Income Tax Act of 1961. While only banks and financial institutions can claim provisions for such debts, careful adherence to tax rules and accounting standards ensures proper financial management and tax compliance.
