REVENUE REGULATIONS NO. 5-99

March 10, 1999

DEDUCTIBILITY OF BAD DEBTS

As provided under Sec. 34 (E) of the 1997 Tax Code, a corporation, an individual engaged in trade or business, or a professional engaged in the practice of his profession is allowed to claim bad debts as deduction from gross income. "Bad debts" refer to amounts borrowed from the taxpayer by another person, whether corporate or individual, which have become worthless or uncollectible. These receivables may come from money actually extended as a loan or from uncollectible payments for goods sold or services rendered by the taxpayer.

A bad debt may be claimed as a deduction only if the following requirements are satisfied:

1. The debt due the taxpayer is valid and legally demandable;
2. It is connected with the taxpayer's trade, business or practice of profession;
3. The debt does not arise from a transaction made by the taxpayer with a related party as enumerated in the Tax Code.
4. The debt must be actually charged off the books of accounts of the taxpayer as of the end of the taxable year.
5. The debt must be actually ascertained to be worthless and uncollectible as of the end of the taxable year.

The rules discussed above will generally apply to all types of taxpayers, regardless of the nature of his business, except in the following cases:

• In the case of banks, the Bangko Sentral ng Pilipinas (BSP), thru its Monetary Board, will ascertain the worthlessness and uncollectibility of the bad debts and it shall approve the writing-off of the said indebtedness from the bank's books of accounts at the end of the taxable year.

• For an insurance or surety company, a receivable may be written off from the taxpayer's books of accounts and claimed as bad debt deduction only if such company has been declared closed due to insolvency or for any such similar reason by the Insurance Commissioner.

In the case of securities, particularly those held as capital assets and thereafter ascertained to be worthless and charged off within the taxable year, the resulting loss shall be considered as a loss from the sale or exchange of capital asset made on the last day of such taxable year. The taxpayer, however, has to prove through clear and convincing evidence that the securities are in fact worthless. Securities refer to shares of stock in a corporation and rights to subscribe for or to receive such shares. The term includes bonds, debentures, notes or certificates, or other evidence of indebtedness, issued by any corporation, including those issued by a government or political subdivision thereof, with interest coupon or in registered form.

"Actually charged off from the books of accounts" means that the amount of money lent by the taxpayer, which had been recorded in his books as a receivable, has actually become worthless and that the said receivable has been cancelled and written off from the taxpayer's books. The mere recording in the taxpayer's books of the receivables as estimated uncollectible account will not be a valid basis for claiming said receivable as a deduction from gross income.

Before a cancellation or write-off from the accounting records can be done, there must first be a determination that the receivable has actually become worthless. There is no inflexible formula or rule that can be applied to determine whether a receivable is worthless. Thus, the determination of worthlessness in a given case depends upon the particular facts and the circumstances of the case. A receivable, the amount of which is insignificant such that the filing of a legal case against the debtor may be more costly to the taxpayer, may be written off as a bad debt even without conclusive evidence that the taxpayer's receivable from a debtor has definitely become worthless.

The BIR will consider all pertinent evidence like the value of the collateral securing the debt and the financial condition of the debtor. The BIR may also rely on a statement issued under oath by an independent collection lawyer who is not under the employ of the taxpayer showing the propriety of claiming such alleged bad debts as deductions. Said statement must report on the legal obstacle and the virtual impossibility of collecting the same from the debtor.

A taxpayer may not postpone a bad debt deduction on the basis of a mere hope of ultimate collection or because of continuous attempts to collect such receivable which has long become overdue. A mere hope will not justify postponement of the deduction. However, the bad debt deduction may be deferred under the following circumstances:

1. The taxpayer can show that the surrounding circumstances for the receivables which he decided not to write off are different from those relating to other debts which were charged off in a prior year;
2. A reasonable possibility of recovery exists;
3. The creditor offers evidence to show some expectation that the debt would be paid in the intervening years.

If a bad debt that was previously allowed as deduction in the preceding year or years is collected, it shall be included as part of the taxpayer's gross income in the year of such recovery to the extent of the income tax benefit of said deduction. Thus, if the taxpayer realized a reduction of the income tax due him on account of a deduction for bad debts, his subsequent recovery of the same from the debtor shall be treated as a receipt of taxable income.

However, if the taxpayer did not benefit from the deduction of the said bad debt written off because it did not result to any reduction of his income tax in the year of such deduction, i.e., his business operations was a net loss even without such deduction of bad debt written off, then the subsequent recovery shall not be treated as receipt of realized taxable income. Instead, it shall be considered as a mere recovery or return of capital, thus, not taxable.