Takashi Yamaguchi, English Speaking Japanese Tax Accountant
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Bad debt losses

As the number of business transactions increases, you probably would have to accept selling on ”credit” or  “bill”.
In that case, you may become anxious whether your business partner settles the receivable as scheduled.
If it can not be done, it will affect your working capital, but taxation as well.
The theme of today is “bad debt losses” assuming the case of corporate taxpayers.

Accounting treatment

The right to claim certain benefits to specific other persons is called a “claim”.
Accounts receivable, bill receivable, etc. are called “monetary claims” because they are claims to enforce payment of consideration for transactions in monetary terms.
For accounting purpose, in principle, monetary claims are accounted for by face value of the claims (the amount that can be claimed to the debtors) .
If it is doubtful that the debtor is able to pay full amount of the receivable, you should record the receivable at estimated collectible amount.
The difference between the face value and the estimated collectible amount will be a “bad debt”, however at this point, this “bad debt” is an estimated loss of unrecoverable claim, therefore you need to observe the situation to know whether such loss really become a realized loss.
For example, the debtor may be able to make full payment later though it missed the dead line due to occasional funding issue.

However, in accounting, doubtful receivables should be stated on the balance sheet at realistic collectible amount estimating “bad debt” in earlier stage before its realization (the principle of conservatism).
The “Accounting Standard for Financial Instruments”, which is a guideline for accounting practice issued by ASBJ (the Accounting Standards Board of Japan), has the following provisions.

Balance sheet amount of accounts receivable, bills receivable, loans receivable and other receivables shall be the amount obtained by deducting the allowance for doubtful receivables calculated based on the estimated amount of bad debts from the acquisition cost of the receivables (Para 14).

Allowance for doubtful receivables, or bad debts reserve, is a reserve provided for possible uncollectible amount, i.e., “bad debt” of accounts receivable, loans, and other monetary claims due to bankruptcy of business counterparty.

For estimation of the uncollectible amount, it is necessary to classify the receivables into the following three classes according to the debtors’ financial condition and business performance (Para 27) then estimate bad debts for the respective class (Para 28).

Class of receivables Status of receivables Methodology for estimation of bad debts
Normal receivables Receivable from debtors who have no material issue in their business operation. Calculate possible bad debts amount based on a reasonable standard, such as historical bad debts ratio calculated in accordance with status of the receivables as a whole or by type, class of the receivables,
Concerned receivables Receivables from debtors not bankrupted yet but having serious concern or possibility of default events. Calculate possible bad debts amount by either one of the following methods, depending on the status of the receivables.
However, the same method shall be applied as long as the financial condition and business results of the debtors do not change.

  1. Deduct estimated collectible amount, by enforcement of securities such as collateral and guarantee, from the receivable amount, then estimate bad debt loss on the net receivable amount in consideration of the financial condition and business results of the debtor.
  2. Provided that the creditor is reasonably able to estimate cash flow of collectible amount of principal and interest of the receivables, estimate bad debts loss as the difference between book value of the receivable and discounted value of the cash flow, at the contracted interest rate, for the period from the end of fiscal year to the date of the collections.
Distressed receivables Receivables from debtors bankrupted or substantially in bankruptcy status. Estimate bad debt loss as the difference between estimated collectible amount, by enforcement of securities such as collateral and guarantee, and the receivable amount.

Bad debt losses for tax purpose

On the other hand, you can take tax deduction for the bad debt loss only when such loss is qualified as “amount of loss for the fiscal year” (Article 22 Para 3 item 3 of the Corporation Tax Law (hereinafter referred as the “Law”).
The “amount of loss for the fiscal year ” is also calculated in accordance with” generally accepted accounting standards” (Article 22 para 4 of the Law).
Since the Law does not specifically provide “special treatment” on bed debt loss, the amount of the allowance for bad debts recorded in the financial statements should have been treated as a tax deductible loss, however, it is not. 
According to the judicial precedent, to claim tax deduction for the bad debt loss as the 
amount of loss for the fiscal year”, a taxpayer have to clarify objectively that it is impossible to recover the entire amount of the receivable, based on the following circumstances, the economic environment, etc., and social norms as a whole (the Supreme Court, December 24, 2004).

Debtor’s status Status of the asset, the solvency, etc.
Creditor’s situation The amount of labor to collect the receivable from the debtor, balance of the collectible amount and necessary costs, possible damage on business operation for discord with other creditors arose due to forcible collection by the creditor, etc.

Although this method is not stipulated in the Law, the Basic Circular Notice of the Corporation Tax Law (the guideline on interpretation of the Law for the tax officials, hereinafter referred as the “Circular”) provides the following interpretations consistent with the judicial precedent.

When the receivable is written off (for a legally binding debt waiver) 

The amount written off based on the following events is tax deductible for the business year in which such event occurred (The Circular 9-6-1).

  1. The written off amount in accordance with the provisions of the Corporate Reorganization Act, the Act on Special Measures for the Reorganization Proceedings of Financial Institutions, the Companies Act, and the Civil Rehabilitation Act
  2. The written off amount based on reasonable standard approved by non-statutory procedure such as the creditors’ meeting, mediation by administrative bodies and financial institutions, etc.
  3. Written off amount indicated to the debtor by written notice because of the fact that the debtor has been insolvent for a considerable period of time and the creditor is not able to collect the receivable.

When entire amount of the receivable became uncollectible (for insolvency of the debtor)

If it becomes clear that the entire amount of the receivable cannot be collectible considering the status of debtor’s assets and solvency, the creditor is allowed to claim tax deduction of bad debt loss for the fiscal year in which it became clear (the Circular Notice 9-6-2).
However, if the receivable is secured by a collateral or guarantee, tax deduction is allowed only after enforcement of such securities.

When no settlement had been made for certain period of time since the last transaction (pro-forma loss)

In the case of the following events, the creditor is allowed to claim tax deduction of bad debt loss for the accounts receivable (i.e.,except loans receivable etc.) leaving a nominal value of 1 (one) yen on the balance sheet as the memorandum (the Circular Notice 9-6-3).

  1. Elapsed more than one year from the last transaction with or the last payment from the debtor when the creditor had terminated continuous business relationship with the debtor due to deterioration of the debtor’s assets, solvency etc. (except the case the receivables are secured by collateral etc.).
    This ruling is not applicable to the accounts receivable arose from one-off transaction such as buy/sell of real estate.
  2. Aggregated amount of accounts receivable in one region is less than amount of expense necessary for collecting the receivables from debtors in that region and no payment had been made from the region despite the reminder.

Bad debt reserve for tax purpose

However, the aforesaid rules are kind of harsh for taxpayers because they cannot get prepared until a concern of bad debt becomes real event. Therefore, the Law allows tax allowance for bad debt reserve under certain conditions (Article 52 of the Law).
The tax allowance is allowed for only the following corporate taxpayers.

  • Ordinary corporation with share capital of 100 million yen or less  as of the end of fiscal year (except an wholly owned subsidiary by corporations with share capital of 500 million or more)
  • Public interest corporations or cooperative associations etc.
  • Unincorporated associations etc.
  • Banks or insurance companies
  • Other companies engaging in certain financial services (such as leasing, broker-dealer of financial instruments, pawnshops, installment sale

The following receivables are not qualified for the tax allowance as they are substantially either bankruptcy remote or prepayment of liabilities.

  • Accrued interest on bank deposits, bonds
  • Deposits
  • Earnest money
  • Advance payment
  • Advance or suspense payment of expenses such as prepaid compensation and advance payment of travel expense.

The tax allowance for bad debt reserve is divided into two types: “reserves for respective receivable” and “general reserve” depending on recoverability of the receivables.
The tax allowance is calculated differently by type of the reserve and receivable.
A taxpayer is able to select whichever method as long as conditions are met, so you can choose the most favorable method confirming the outcome of the both method.

Bad debt reserves for respective receivable

“Respective receivable” means monetary claims for which bad debt loss is anticipated because of which payment is subject to certain debt restructuring procedures such as court approval for reorganization plan under the the Corporate Reorganization Act etc.
Provision for the reserve is tax deductible up to the total amount of the following allowances (Article 52 para 1 of the Law).

Type of receivable Status of the receivables Maximum allowance
  1. Accounts receivable, loan receivable, and other similar monetary claims
  2. Refund claims for deposit, advance payment, etc.
Reorganization plan in accordance with provisions of the Corporate Reorganization Act is approved by the court and payment has been suspended or rescheduled to installment. The amount other than total payable amount scheduled in next 5 years of the fiscal year in which the the plan was approved.
The debtor had been in insolvency status for considerable period of time and has no turn-around plan etc. Estimated uncollectible amount.
Petition for commencement of reorganization procedure under the Corporate Reorganization Act is filed for the debtor. 50% of the receivable
Receivables from the governments, the central bank etc. of the  foreign states which has been in long lasting default and unlikely able to make payment due to hyper-inflation.

If the creditor has any payables (such as advance receipt) to the debtor, receivables secured with collateral or guarantee, such amounts should be excluded from the above receivable amounts.
The creditor should keep proof of the above status of the receivables so that it can demonstrate legitimacy of the tax allowance calculation.

General reserve for bad debts (Principle method)

General reserve is provided for the receivables other than the above respective receivables.
The reserves is calculated by the below formula based on the historical default ratio (Article 52 para 2 of the Law).

 

General reserve for bad debt (exceptional provision at statutory rate) 

Ordinary corporation with share capital of 100 million yen or less as of the end of fiscal year, public interest corporations, and cooperative associations are allowed to provide the general reserve applying the following statutory provision rate in lieu of the historical default ratio (Article 57-9 of the Special Taxation Measures Law (hereinafter referred as “STML”), Article 33-7 of the Enforcement Order of the STML).

Business segment Statutory Provision Rate
Whole seller, retailer 1.0%
Manufacturer 0.8%
Finance, insurance 0.3%
Installment sales retailer 1.3%
The others 0.6%

However, please be aware of the following two conditions:
Firstly, the statutory rate is not applicable to the following corporations even if it it an ordinary corporation with share capital of 100 million yen or less.

  • Corporation of which average amount of taxable income for the latest three years is more than 1.5 billion yen (from fiscal years starting on or after April 1, 2019, Article 57-9 para 1 parentheses, Article 42-4 para 8 item 6-2 of the STML)
  • Mutual Company or Foreign Mutual Company defined in the Insurance Business Act of Japan (Article 57-9 para 1 parentheses of the STML, Article 33-7 para 1 of the Enforcement Oder of the STML)

Secondary, the amount of “not regarded as receivable” should be excluded from the receivables for the general reserve calculation.
“Not regarded as receivable” means the receivables can be legally offset against the payables to the debtor (accounts payable, bills payable, and borrowings, etc)   

Special rule for public interest corporations, cooperative association, etc. (additional provision)

Public interest corporations and cooperative associations are entitle to the 10% additional allowance on general reserve, regardless of principle method or statutory rate method, for the fiscal years starting between April 1, 2017 and March 31, 2019.

Reconciliation of difference between accounting and tax

As above, it is likely that bad debt causes different implication for accounting and tax.
The difference should be adjusted in calculation of taxable income on the tax returns.
To claim tax deduction of bad debt reserve, the provision for the reserve should be booked as an expense on the financial statements.
Tax deduction cannot exceed the provision amount actually booked for accounting purpose.
Accordingly, even if it turned out that the tax allowance is greater than the booked provision, you are not able to claim additional deduction by the tax filing.
Contrary, if you provide more reserve than the tax allowance, you can make the best use of the tax allowance, however, excess provision will reduce profit for the year.
If you try providing the reserve exactly same amount to the tax allowance, you would have to calculate the  tax allowance before final closing of the books.
Besides, even if you did not use the reserve and maintain the same amount until end of the next fiscal year, you have to release the carry-forward balance on the tax return, i.e, include taxable income,  then claim new tax allowance comparing the booked provision and the tax allowance for the next year.

***

Calculation and booking arrangement may take time but the bad debt reserve is one of the few tax deductible reserves.
Why don’t you make the best use of it for tax saving and credit risk management?

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