Losses from finance company investments - can you claim your losses as a bad debt?

We have had a number of enquiries from investors in failed finance companies asking whether they can write off the amounts they have lost as a bad debt, and claim a tax deduction.

As many of these finance companies are now in the hands of liquidators or receivers, investors are uncertain about the tax rules which might apply in cases where they are unlikely to receive full repayment of their investment.

Our recommendation is that you should obtain professional advice before making any decision about writing off bad debts. Nevertheless there are some general rules which apply to you if you are in this situation.

These rules do not apply to you if you are in the business of holding and dealing in debt securities (including finance company deposits).

General rules for writing off investment income losses

All income earned from investments is taxable. However some investors may find that they have been taxed on interest they have derived but not been paid yet. This is most likely to affect companies and trustees, but may also affect individuals. In general:

• You cannot obtain a bad debt or other tax deduction for any income you have actually been paid.
  
  For tax purposes, "paid" means distributed, credited, or dealt with in your interest or behalf, for example, interest paid to you in cash or interest you have chosen to reinvest. In most cases, if resident withholding tax (RWT) has been deducted from your interest payments, it is regarded as having been "paid".

• You may however be able to claim a bad debt deduction for the interest income you have included in your tax return, but which has not yet been paid. This includes interest you expected to reinvest, but have not received. You can claim a tax deduction for the amount of interest written off in the year in which you write off the debt as bad.
  
  This may, for example, also apply to "zero coupon" securities where all the interest is paid when the investment matures. If you have had to account for (or accrue) your interest income, you can write off the amount you have accrued if you consider it be unrecoverable.

General rules for individual (cash basis) taxpayers

Companies, trustees and some individuals are taxed on an accruals basis and could be liable for tax on their accrued income, and might therefore consider the bad debt provisions

Once interest has been reinvested it forms part of your principal or capital and no bad debt write off is available for capital amounts. In most cases RWT will have been deducted at the time your interest was paid to you, which is a clear indication that the interest has actually been "paid" for tax purposes.

Interest which is simply overdue is not considered as "paid" for tax purposes. So if you are taxed on a cash basis, which most individual investors are, you will not need to account for tax on any overdue interest. If you are not taxed that way however, you may have tax to pay and a bad debt write off could be an effective way to offset that liability.

If you do write off income, and later recover some of your investment from a receiver or liquidator, it will be first treated as a recovery of capital written off, then any balance will be treated as a recovery of interest written off  - and this amount will be taxable when you receive it.

General rules for writing off a bad debt

To write off a bad debt you must believe that there is no commercially realistic possibility of recovering your money (which may only be part of the total amount you are owed), and take steps to write the amount off in your accounts. You must take the deduction in the year in which you write off the debt.

If you do not prepare accounts, you will still need to record your decision in writing before 31 March in the relevant income year providing details of

• the amount to be written off
• your reasons for believing the debt is now bad
• declaring your decision to write it off
• And the date of the write off.

You should be able to demonstrate some reasonable basis for the write-off, such as a report from the liquidator. You should also make sure that any agent preparing your return is aware of your letter, and keep signed copies for yourself and your agent.

If you are partly writing off a debt you should also record in writing how much of the amount written off is unpaid income and how much is principal. We accept that the first amounts written off will apply to income previously accrued as long as you clearly record this. Remember that you cannot receive a tax deduction for any principal amount which you write off.

Treating a debt as bad for taxation purposes does not actually bring the debt to an end and you may still recover some amount from a liquidator or receiver. We would expect you to wait to hear what amount you are likely to recover, through the liquidator’s report for example, before making a decision about how much, if any, of your investment is bad.

If the debt has matured, been extinguished or remitted (perhaps by the liquidation of the finance company), or transferred to another party, you can no longer declare the debt to be bad and take a tax deduction. You should think carefully about making a bad debt declaration prior to any of these events occurring.

Preference shares in finance companies

Some investments issued by finance companies are in the form of shares, which pay dividends instead of interest. Unless you are actively trading or dealing in these investments, you cannot claim a loss, including any loss of expected dividends, if the investment proves to be partly or wholly unrecoverable.

In summary

While there are many different forms of deposits and investments held with finance companies, and individual situations will vary considerably, in general the above rules apply to investors who hold investments which have gone bad.

Recognising a bad debt is the only way in which you can make a taxation adjustment to balance off the investment income you have paid tax on, but which has not actually been paid to you.

Date published: 18 Feb 2009

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