Unpaid invoices can significantly impact cash flow and profitability for businesses. Fortunately, New Zealand tax law allows businesses to write off bad debts and claim them as deductions, reducing taxable income. However, specific conditions must be met to ensure compliance with Inland Revenue (IR) requirements.
This guide explains when a debt qualifies as “bad,” the steps to write it off, and how to claim it as a deduction.
1. What Qualifies as a Bad Debt?
A bad debt is an amount owed to a business that is unlikely to be paid by the debtor. To claim a bad debt deduction, the following conditions must be met:
- The business must have previously recognised the debt as income (i.e., it was included in taxable income when the invoice was issued).
- There must be reasonable evidence that the debt is irrecoverable (e.g., the debtor is bankrupt, has ceased trading, or is unresponsive after repeated collection attempts).
- The debt must be physically written off in the business accounts before the end of the financial year.
If these conditions are not met, IR may disallow the deduction.
2. How to Write Off a Bad Debt
Writing off a bad debt involves formally removing it from the business’s financial records. Follow these steps:
Step 1: Review the Debt
Assess whether the debt is genuinely irrecoverable. This typically involves:
- Reviewing payment history and communication with the debtor.
- Sending final reminders or demand letters.
- Attempting debt collection or legal action where appropriate.
Step 2: Adjust Accounting Records
Once it is clear that the debt is uncollectable, record the write-off in the business accounts:
- For GST-registered businesses:
- If GST was included in the original invoice, an adjustment must be made in the GST return to account for the GST portion of the bad debt. This is covered under Section 26 of the Goods and Services Tax Act 1985, which allows businesses to adjust their GST output tax when a debt is written off.
- The adjustment is recorded in the GST adjustments section of the return.
- For income tax purposes:
- Record the bad debt as an expense in the profit and loss statement.
- Ensure it is written off before 31 March (for businesses using a standard financial year) to claim the deduction in that tax year.
Step 3: Keep Supporting Evidence
Maintain documentation to justify the write-off in case of an IR audit. This includes:
- Copies of invoices and statements showing the unpaid balance.
- Emails or letters sent to the debtor requesting payment.
- Records of any legal or collection actions taken.
3. GST Implications of Bad Debts
If GST was charged on the original invoice, an adjustment is required to recover the GST previously paid to IR.
Example:
A business issues an invoice for $1,150 (including $150 GST). The customer fails to pay, and the debt is deemed bad. The business must:
- Write off the full $1,150 in its accounts.
- Adjust its GST return by reducing GST output tax by $150, since this amount was previously paid to IR.
4. What If the Debtor Pays After the Debt is Written Off?
If a debtor later settles the invoice after it has been written off, the business must:
- Recognise the payment as income in the year it is received.
- If GST was previously adjusted, the GST portion must be accounted for in the next return.
5. Common Mistakes to Avoid
- Failing to formally write off the debt before year-end: Simply acknowledging that a debt is uncollectable is not enough; it must be recorded in the accounts before 31 March.
- Writing off debts that are still recoverable: IR may reject deductions if reasonable efforts to collect the debt have not been made.
- Forgetting to adjust GST returns: If GST was originally accounted for, an adjustment must be made to recover it.
Writing off bad debts is an essential tax deduction for businesses dealing with unpaid invoices. To ensure compliance:
- Confirm the debt is irrecoverable.
- Write it off in accounting records before the end of the financial year.
- Adjust GST if applicable.
- Keep supporting documentation for IR audits.
Proper management of bad debts can help businesses maintain accurate financial records and optimise tax efficiency. If unsure about the process, consulting a tax professional is recommended.