Rapid advances in technology present businesses with unique opportunities and challenges they must navigate to maintain a competitive advantage. As businesses leverage technology to expand their avenues for profit, they also face an increased potential for losses. An example of this can be seen in the e-commerce industry. While the use of technology has led to a boost in sales volume, this naturally results in a rise in potential uncollectible receivables. Thankfully, taxpayers are offered some relief from paying income taxes on revenue which is uncollectible.
The Tax Code allows taxpayers to claim a deduction for debts that are actually ascertained to be worthless and charged off within the taxable year. In applying the law, the Supreme Court case of Philippine Refining Co. vs. Court of Appeals, et. al. (PRC case) is often cited. This case requires that the taxpayer show that: (1) there is a valid and subsisting debt, (2) the debt must be actually ascertained to be worthless and uncollectible during the taxable year, (3) the debt must be charged off during the taxable year, and (4) the debt must arise from the business or trade of the taxpayer. Additionally, before a debt can be considered “worthless,” the taxpayer must also show that it is indeed uncollectible even in the future.
The Court also outlined steps to prove that a taxpayer/creditor has exerted diligent efforts to collect the debts, such as sending a statement of account, sending collection letters, giving the account to a lawyer for collection, and filing a collection case in court.
Considering the steps outlined by the court, the question arises: Is it necessary to complete all these steps to prove that the taxpayer exerted diligent efforts to collect the debt? Will the absence of any of the steps disqualify the bad debt from being deductible?
Based on the facts in the PRC case, it would appear that not all the steps need to be completed. In the PRC case, most of the bad debts that were disallowed were due to the lack of adequate documentary evidence. In justifying the bad debts, only explanations or justifications were provided. As such, in disallowing the bad debts, the court noted the lack of documentary evidence such as demand letters, police reports, policy regulations, or written reports of investigations conducted. The court did not disqualify any deduction due to the absence of a collection case in court for some of the receivables. In fact, in evaluating one of the receivables, the court stated that “while it is not required to file a suit, it is at least expected by law to produce reasonable proof that the debts are uncollectible although diligent efforts were exerted to collect the same.”
In the case of Collector of Internal Revenue v. Goodrich International Rubber Co. (Goodrich case), which was also cited in the PRC case, certain accounts were found to have been properly written off even if no collection cases were filed in court. In justifying the write-off, one of the accounts was only supported by demand letters. For another account, the taxpayer interviewed the debtors, investigated their ability to pay, and even threatened lawsuits. However, the advice of the taxpayer’s counsel to write off the bad debts without going to court was considered sufficient basis for the write-off.
The Bureau of Internal Revenue (BIR) also released Revenue Regulations (RR) Nos. 05-99 and 25-2002 after Goodrich and PRC were decided. In those regulations, to claim a deduction for bad debt: (1) There must be an existing indebtedness due to the taxpayer which must be valid and legally demandable; (2) The debt must be connected with the taxpayer’s trade, business, or practice of profession; (3) It must not be sustained in a transaction entered into between related parties enumerated under Sec. 36(B) of the Tax Code; (4) It must be actually charged off in the books of account of the taxpayer as of the end of the taxable year; and (5) It must be actually ascertained to be worthless and uncollectible as of the end of the taxable year.
In defining the term “actually ascertained to be worthless,” the regulations stated that the determination of worthlessness in a given case depends upon the particular facts and circumstances of the case. In addition, accounts receivable which are insignificant in amount where the collection through court action may be more costly to the taxpayer may be written off as bad debts even without conclusive evidence that the taxpayer’s receivable from a debtor has definitely become worthless.
Technology has undoubtedly increased the capabilities of business throughout the years. Automating processes such as sending statements of account and collection letters have become common. However, does this automation diminish its value as a diligent effort to collect? Must taxpayers incur significant expenses by hiring lawyers for collection or filing a collection case in court? Based on the court cases and the regulations, I don’t believe so. There is some flexibility given the varied ways and documents that can be used to support the worthlessness of a debt. I would like to think that in formulating the guidance provided, the authorities also exercised good business sense because it is never wise to throw good money after bad.
The views or opinions expressed in this article are solely those of the author and do not necessarily represent those of Isla Lipana & Co. The content is for general information purposes only, and should not be used as a substitute for specific advice.
Marvin Joseph Manuel is a manager at the Tax Services department of Isla Lipana & Co., the Philippine member firm of the PwC network
