Is a collection case filed in fourt required before a write-off of a bad debt?

Businesses usually focus on generating revenue and sales. However, in the eagerness to generate sales and revenue, some businesses, who we shall refer to as the taxpayers, sometimes accept risky accounts or customers with doubtful ability to pay for merchandise or services purchased or contracted. The taxpayer subsequently realizes that the customer does not have the means to pay and, they will have to consider the accounts receivables as uncollectible and a bad debt.

In sales where payment for goods or services are agreed to be made at a later time, the taxpayer at the time of sale issues a Sales Invoice or Billing Statement. For that month when the sale is booked, the taxpayer pays for the value added tax and later, income tax.

It is only after the taxpayer receives payment that they will issue an Official Receipt.

Should the customer subsequently not pay, the way to reverse the sales already declared and taxes paid is to treat the receivable or debt as a bad debt and deduct the same from the gross income pursuant to Section 34 (E) (1) of the National Internal Revenue Code of 1997 (Republic Act No. 8424, as amended), which allows the taxpayer to deduct from gross income its bad debts and/or accounts receivables that have become worthless and uncollectible. This will result in lowering the taxes payable at the time when the bad debts are booked.

For bad debts, the taxpayer cannot simply declare a receivable or debt as a “bad debt”. It must comply with a set conditions and standards, otherwise the deduction will be disallowed.

This is because deduction of bad debts will result in the reversal of a declared sale and reduction of inventory of the taxpayer, thereby lowering income and taxes to be paid by the taxpayer.

In the case of Philippine Refining Company (now known as “Unilever Philippines [PRC], Inc. v. Court of Appeals, Court of Tax Appeals, and the Commissioner of Internal Revenue (G.R. No. 118794. May 8, 1996) the Supreme Court stated that for debts to be considered as “worthless,” and thereby qualify as “bad debts” making them deductible, the taxpayer should 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 taxpayer, in order to establish the essential requisites that the debt is worthless and cannot be collected, must show that it exerted diligent efforts to collect the debts by (1) sending of statement of accounts; (2) sending of collection letters; (3) giving the account to a lawyer for collection; and (4) filing a collection case in court.

Note that in the Philippine Refining Company case, diligent efforts to collect the receivable or debt includes the filing of a collection case in court by the taxpayer. Accordingly, is the filing of a collection case in court a requirement before a write-off can be validly made ?

The cited pronouncement should be read together with the rules issued by the Bureau of Internal Revenue (BIR) which is the agency mandated by law to assess and collect taxes, fees and charges, and to enforce all forfeitures, penalties and fines. There are two relevant issuances by the BIR and these are Revenue Regulation No. 5-99 and its amendment, Revenue Regulation No. 25-02.

The regulations tackle bad debt or receivables to be deducted from the gross income of a corporation, banks and insurance companies, individual, estate and trust that is engaged in trade or business, or a professional engaged in the practice of his or her profession.

Revenue Regulation No. 25-02 provides that the requisites for deductibility of bad debts to be:

1. There must be an existing indebtedness due to the taxpayer that is valid and legally demandable;
2. The debt is 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 of 1997;
4. The debt must be actually charged off the books of accounts of the taxpayer as of the end of the taxable year;
5. It is ascertained to be worthless and uncollectible as of the end of the taxable year; and
6. There are additional requirements for banks and insurance companies.
It is important to note the fifth element in the above enumeration. This means that before a taxpayer may charge off and deduct a debt, it must ascertain and be able to demonstrate with a reasonable degree of certainty the un-collectability of the debt.

For example, in the case Philippine Refining Company, the Supreme Court declared that the evidentiary support given by the company for its claimed deductions was only the explanation or justification made by its financial adviser or accountant which were not supported by any documentary or verifiable evidence. The company declared several accounts for write-off as bad debts, such as that the debtor’s establishment was burned down, another where the debtor was said to have died, where the debtor has absconded, cannot be found and had no properties that could be identified, and yet another account where a debtor was claimed to be insolvent. In all those instances, the company did not provide any supporting documents to establish the fact, claim or basis for un-collectability. The Supreme Court declared that the company did not establish that the debts were indeed worthless and uncollectible.

In accepting the claim of worthlessness and un-collectability of a receivable or debt, the BIR 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.

The efforts made by the taxpayer in its attempt to collect the receivable or debt such as sending statement of accounts and collection letters, sending of demand letters, engaging the services of a lawyer to collect the debt as well as filing a collection case, are critical to the consideration of the BIR as to whether to allow or disallow the bad debt claimed.

In practice, the BIR, in making its assessment on whether to accept the receivable as a bad debt or not, looks to or inquires as to whether a collection case has been filed against the debtor.

Revenue Regulation 25-02 provides that the matter may be assigned for collection to an independent collection lawyer. The lawyer shall prepare a report under oath detailing the legal obstacles and virtual impossibility of collection from the debtor, indicating that the debt is worthless and uncollectible, such that filing a collection case to enforce payment would, in all probability, not result in a satisfaction of execution on a judgment. This will be sufficient evidence of the worthlessness of the debt for the purpose of deduction.

Some examples of the lawyer’s report that the filing of a collection case would not result in satisfaction of the claim are: where the debtor is found to be insolvent; that the debtor does not have any property sufficient to satisfy the debt; that other creditors have already taken the property of the debtor for payment of their claims leaving insufficient assets for the taxpayer to claim against; or when the expenses for an action to collect the receivable will be greater than the amount to be collected.

Accordingly, the filing of a collection case is not a mandatory requirement before a taxpayer can legally and properly consider a receivable or debt worthless and a bad debt for write-off.

(The author, Atty. John Philip C. Siao, is a practicing lawyer and the co-managing partner of the Tiongco Siao Bello & Associates Law Offices [TSBLaw]). He may be contacted at [email protected]. The views expressed in this article belong to the author alone and do not in any way reflect the view or opinion of TSBLaw or any member thereof.)