I have three unconnected clients who make general provisions for bad debts in their accounts. One is a wholesale stationer, another runs a money-lending business, while the third is a jobbing builder. The stationer is a sole trader, the other two are companies. Each client has a turnover of less than £2 million.
I have three unconnected clients who make general provisions for bad debts in their accounts. One is a wholesale stationer, another runs a money-lending business, while the third is a jobbing builder. The stationer is a sole trader, the other two are companies. Each client has a turnover of less than £2 million.
In all three cases, the general provision is currently disallowed for tax purposes. I am not clear whether the position is now different as a result of FA 2004, s 50 and other changes aimed at bringing tax into line with accounting treatment. There is also an oblique reference to general bad debt provisions in paragraph 10 of the Revenue's Budget Note 13 on international accounting standards, which was issued on 16 March 2005.
My questions are as follows.
- Can any of these clients now claim tax relief on these provisions?
- If so, do they have to change the way in which they calculate the provisions for accounting purposes?
Readers thoughts are welcomed.
Query T16,602 — Shebeen.
Reply by 'Thicket'
Many who have been in the practice for a number of years will have been trained that specific provisions are good and general provisions are bad for tax allowance purposes. Is this still true? Shebeen's three clients operate in different businesses and separate rules apply for money debts for companies.
For traders subject to Schedule D, Case I or II, TA 1988. s 74(j) sets out the tax law. This section prohibits the deduction of an expense for a debt except (for these purposes) a bad debt or a doubtful debt estimated to be bad. The Revenue has always taken a strict line with this and will have expected the taxpayer to have taken action to have collected the debt and to have a good reason before accepting that the debt is doubtful or bad. The rule is to be applied to each single debt in turn, and no general provision (e.g. based on a percentage of sales ledger balances) would be allowed. Has anything changed?
FA 1998, s 42 for the first time required profits for the purposes of Schedule D, Case I or II to be prepared in accordance with generally accepted accounting principles (GAAP), subject to any adjustment required by tax law. Both companies and unincorporated bodies are expected to prepare accounts under GAAP and this includes compliance with relevant financial reporting standards that are materially relevant. Smaller entities, including Shebeen's clients may adopt the Financial Reporting Standard for Smaller Enterprises (FRSSE), but this does not exempt them from the main parts of Financial Reporting Standard 12 (FRS 12). This is the standard which sets out the rules for accounting for accruals, provisions and contingencies. The main reason for this standard was to tighten up the rules in this area making it less easy to anticipate provisions for future expenditure, including a provision for bad or doubtful debts. Whilst the FRS did not change tax law, it is part of UK GAAP and profits prepared to this standard will comply with s 42. However, the examples accompanying FRS 12 appear to legitimise certain provisions of a general nature. For example, a provision for making good warranty claims on goods sold calculated by reference to past experience is allowed, (see FRS 12, example 1). FRS 12, example 4, allows a provision to be made for the cost of refunds of purchases made by dissatisfied customers from a retail store that is generally known to have this policy. These provisions may in certain cases both be similar, in principle, to a 'general provision' for bad debts. So, can such a general provision now be an allowable tax deduction?
The Revenue's view remains that a general bad debt provision will not be allowed for tax. However, booklet IR150, dealing with the taxation of rental income, now calculated on Schedule D, Case I principles, contains an interesting statement in paragraph 166. Whilst reiterating that a general bad debt reserve is not tax deductible, it says:
'But if exceptionally, you have a large number of tenants and also records which show a stable past pattern, you may be able to calculate with sufficient accuracy the chance that a tenant already in arrears will never pay. A doubtful debt provision calculated on that basis may be deducted.'
This seems to be taking the examples from FRS 12 noted above and recognising that a tax deduction may be allowed in some specific cases.
Shebeen's money lending company client's debts will fall in to the 'loan relationship' rules of FA 1996. These rules allow for a deduction for bad and doubtful debts (except in the case where creditor and debtor are connected) in the usual manner as described for trade debts above. The Revenue's Company Taxation Manual at CT12471 describes the relief available and sets out similar views to those applying to TA 1988, s 74(1)(j) on when a debt is bad or doubtful. It specifically states that a general provision is not allowable. Nevertheless, it is left to speculation whether or not an FRS 12 compliant provision of a general nature might not be allowed if it could be shown to have been established with reasonable certainty based on, for example, past experience.
FA 2004, s 50 would not seem to affect Shebeen's clients directly. It is designed to modernise the definition of GAAP to include companies or other entities who prepare their accounts under international accounting standards (IAS). It seems doubtful that Shebeen's clients will go to the expense and trouble of this any sooner than they have to and provisions are in place to prevent tax avoidance by early adoption of IAS.
In summary, it will be the exception rather than the rule that a general bad debt provision will be allowable tax deduction. However, the topic is currently being debated.
The case of Small v Mars (ChD 12 April) has recently seen the High Court overturn the Commissioners' decision and allowed the Revenue's appeal. Although dealing with s 74(1)(f), the judge held that tax law in that case overruled accounting principles regarding depreciation. It may be expected that a similar result would hold for bad debts. The case will certainly be appealed to a higher court and so even this may not be final. — Thicket.
Reply by 'Bear'
One might expect that one or more of these categories of business would have customers of sufficiently distinct financial status to require the making of specific bad debt provisions. There is a basic distinction or opposition between a specific and a general provision.
A trader who is unconcerned with maximum tax relief or who does not wish to exert himself to consider the soundness of his book debts could nevertheless set up a general provision as a constraint on the level of profits available to be drawn out — a matter of greater importance in a partnership or company. The adjective 'general' need not imply that the amount of the provision is not consistent with past and future (apprehended) experience, but it does mean that it cannot be related to the subjects at risk if merely a percentage of total book debts or a multiple of past amounts written off. For a provision to be allowable as specific it would need to represent the aggregate of amounts directly related to specific debtors whose financial status is in question.
It is not without interest that at present the government is considering legislation that would require banks and other institutions to surrender unclaimed balances — mention has been made of a ten year cut off. This time factor is the converse of that applicable to some classes of debt, where an apprehended long delay in collection could reasonably justify a proportionate bad debt reserve.
Commercial practice in some large concerns is to schedule debts by age, to apply a factor and to form the opinion that a certain proportion will prove irrecoverable. The resultant sum has the character of a specific provision because it can be expressed as the sum total of small sums annexed to each constituent debt. The reason for starting at the top, so to speak, is because of the unnecessary labour in aggregating particulars on a name by name basis when, in fact, the judgements exercised are predictably uniform in their (aggregate) outcome.
TA 1988, s 74(1)(j)(iii) permits the exclusion from profits of a doubtful debt to the extent estimated to be bad, with a separate rule for bankrupt or insolvent debtors. It is important to recognise that it is the trader, not the tax Inspector, whose responsibility it is to make the estimates. Moreover, in the event of a subsequent enquiry (or alleged discovery) the Revenue could not retrospectively disallow earlier provisions made in good faith merely because subsequent experience might show that the provisions were not fully required — see Anderton & Halstead v BIrrell 16 TC 200.
Shebeen does not state in what way existing provisions are calculated but, if specific, targeted, reserves are made and the records of their composition preserved, it should be safe to submit future returns in which those reserves are recognised for tax.