FOR the purpose of determining the taxable income of a taxpayer engaged in trade or business or engaged in the practice of a profession, Section 34(E) of the Tax Code of 1997 allows the deductibility of debts actually ascertained to be worthless.
Revenue Regulations (RR) 5-99, as amended by RR 25-02 provides the requisites for valid deduction of bad debts from gross income, to wit: 1) There must be an existing indebtedness due to the taxpayer which must be valid and legally demandable; 2) The same must be connected with the taxpayer’s trade, business or practice of profession; 3) The same must not be sustained in a transaction entered into between related parties enumerated under Section 36(B) of the Tax Code of 1997; 4) The same must be actually charged off the books of accounts of the taxpayer as of the end of the taxable year; and 5) The same must be actually ascertained to be worthless and uncollectible as of the end of the taxable year.
Before a taxpayer may charge off and deduct a debt, he must ascertain and be able to demonstrate with reasonable degree of certainty the uncollectibility of the debt. The commissioner of internal revenue will consider all pertinent evidence, including the value of the collateral, if any, securing the debt and the financial condition of the debtor in determining whether a debt is worthless, or the assigning of the case for collection to an independent collection lawyer who is not under the employ of the taxpayer and who shall report on the legal obstacle and the virtual impossibility of collecting the same from the debtor and who shall issue a statement under oath showing the propriety of the deductions thereon made for alleged bad debts. Thus, where the surrounding circumstances indicate that a debt is worthless and uncollectible and that legal action to enforce payment would, in all probability, not result in the satisfaction of execution on a judgment, a showing of those facts will be sufficient evidence of the worthlessness of the debt for the purpose of deduction.
In Court of Tax Appeals Case 8541, the tax court disallowed the deductibility of a taxpayer’s bad debts from its gross income due to the taxpayer’s failure to comply with the requirements of establishing the worthlessness of a debt. In this case, the petitioner taxpayer was able to convincingly establish the following: i) existence of indebtedness due to petitioner; ii) the said indebtedness due to petitioner is in connection with its business; and iii) the amounts due to petitioner were actually charged off in its books of accounts.
However, petitioner failed to show supporting documentary evidence to prove that it exerted
diligent efforts to collect and that its receivables are worthless. The tax court noted that the testimony of petitioner’s accountant that the company’s agents and president repeatedly made several follow-ups and visits to the petitioner’s debtors to demand payment is simply self-serving evidence. Petitioner, likewise, failed to establish that it is not related to its debtors, which is an equally important requirement for deductibility of bad debts expense pursuant to Section 3(3) of RR 5-99, as amended by RR 25-02.
Citing GR 118794, the tax court ruled that, in the absence of supporting documentary evidence, petitioner’s allegation and the testimony of its witness are too weak and unconvincing to establish that petitioner exerted diligent efforts to collect and that its receivables are worthless. More so, petitioner failed to show compliance regarding the sending of statement of accounts and collection letters, giving/assigning of the account to a lawyer for collection, and the filing of a collection case in court.
Petitioner argued that its debtor’s total current liabilities exceeded its total current assets which, according to petitioner, may have an effect on its ability to continue operating in the normal course of business. However, the tax court brushed aside such argument ruling that such a financial condition should not ipso facto lead to a conclusion that the debtors debt to petitioner will not anymore be paid even in the future. In fact, debtors total assets of P357,101,000 consisting of total current assets of P248,304,000 and total noncurrent assets of P108,797,000 is more than enough to pay its total liabilities of P250,138,000.
Hence, to ensure deductibility of worthless receivables, it is important to document every effort to collect the same for a mere oral testimony does not suffice.
*****
Atty. Rodel C. Unciano is a senior associate of Du-Baladad and Associates Law Offices, a member-firm of World Tax Services Alliance. To contact the author of this column: Atty. Rodel C. Unciano at rodel.unciano@bdblaw.com.ph or call 403-2001 local 140. The article is for general information only and is not intended, nor should be construed as a substitute for tax, legal or financial advice on any specific matter. Applicability of this article to any actual or particular tax or legal issue should be supported therefore by a professional study or advice.