A High Court decision released this week reminded us all of the importance of the rules relating to deductions for bad debts. In the case of Hong v CIR, Mr Hong, a solicitor had made loans to two of his clients that were facing financial difficulties. In his 2011 tax return he claimed deductions for the outstanding balances, asserting that the debts were “bad”.

In order for a bad debt deduction to be claimed the legislation requires that debt be “written off” as bad during the income year, or the debtor is released from the payment obligation by the operation of law, such as the Insolvency Act.  For most trade debts, taking action to write off the debt prior to balance date is sufficient to ensure the deduction is allowed.

However, an additional provision contained in the financial arrangement rules denies a bad debt deduction for a financial arrangement unless the lender carries on a business involving dealing or holding financial arrangements of the same nature as the debt being written off.

In this case Mr Hong could not demonstrate that his business included making loans of this nature. Rather the lending had arisen from benevolent intentions, where Mr Hong was seeking to help some of his clients who were in need.  Although there was interest income arising from the loans, the activity was not enough to support the existence of a “business” of this nature.

This case is a useful reminder to look at the source of debts being written off as bad.  An ordinary trade debt arising from the lenders business operations will be deductible, assuming the write-off is appropriately made.  Any other type of debt being written off should be examined in more detail to determine whether a deduction is allowed.