Coronavirus and the downturn in the economy are significantly changing the state of affairs: some customers and contractors, who have been reliable even yesterday, are going off-balance, and there are doubts whether their debt will be actually paid.

And what to do with such situation in the tax accounting? Should we pay tax, including the one on the imaginary “paper” profit, which is unlikely to be received in the “cashbox”, up to the official bankruptcy of the contractor in debt? Or are there any other options?

1.

A taxable profit is currently calculated on the basis of the financial result, determined under the accounting (financial accounting) rules with certain adjustments, stated directly in the Tax Code.

What should be born in mind on the general rules of accounting/financial statements due to reflection of contractors’ debt, the repayment of which is subject to reasonable doubts:

2.

Part 1 of Article 3 of the Law of Ukraine “On Accounting and Financial Reporting in Ukraine” (“the Law on Accounting”) establishes: “The purpose of maintaining accounting records and filing/preparing financial statements is to provide users with complete, truthful and impartial information about financial state of a company and its results of activity for the purpose of decision-making”. That is, the company shall reflect actual and credible state of affairs regarding its activities and indicators in the accounting.

According to subpara. 7, 9, 10 of para. 6 of Section III of the National Regulation (Standard) of Accounting 1 “General Requirements for Financial Statements”, approved by the Order of the Ministry of Finance of Ukraine as of February 7, 2013 No. 73, the financial statements of the company are prepared, in particular, in accordance with the following principles:

“the principle of completeness according to which financial statements shall contain all information about the actual and potential consequences of the transactions and events that may affect the decisions made on its basis;

…

the principle of prudence according to which the valuation methods applied in the accounting shall prevent understatement of liabilities and expenses and overstatement of assets and incomes of the company;

the principle of the prevalence of the substance over the form according to which transactions shall be recorded in accordance with their substance, and not only on the basis of the legal form”.

Thus, accounting rules and principles of the preparing financial statements of the company put the substance of transactions to the forefront (rather than a formal “picture”), require a reflection of the real state of affairs and objectivity of company’s assets and liabilities evaluations (first of all – under the principle of prudence, whiсh means preventing improvement of indicators in comparison with the real ones).

Amounts of cash, its equivalents or other assets, which legal entities or individuals owed to the company as a result of the past events, are the company’s accounts receivable.

Under para. 5 of the Accounting Regulation (Standard) 10 “Accounts Receivable”, approved by the Order of the Ministry of Finance of Ukraine as of October 08, 1999 No. 237 (“the Standard No. 10”), the receivables are treated as an asset if there is a probability to receive future economic gains by the company and the amount of the debt can be credibly determined.

And by the general definition under Article 1 of the Accounting Law: “assets are resources controlled by the company as a result of past events, the use of which, as expected, will bring future economic gains“.

This means that for recognition of a resource as an asset, the following requirements shall be simultaneously met:

  • controllability of such a resource by the company and
  • expectations that its usage will lead to receiving of economic gains.

However, what should one do if on the basis of the available information the company reasonably concludes that receivables are unlikely to be repaid in the foreseeable future?

Under such circumstances, accounts receivable will no longer meet the concept of an asset, and in view of the principle of prudence of financial statements preparation according to which the valuation methods applied in the accounting should prevent overestimation of the company’s assets and incomes, are not subject to be reflected as the assets of the company.

Paragraph 4 of the Standard No. 10 stipulates that: “Uncollectable receivables are current receivables regarding which there is a confidence that they will not be repaid by the debtor or the statute of limitations of which has expired”.

Meanwhile, para. 11 of the Standard No. 10 sets forth that the debt regarding which there is a confidence about its non-repayment by the debtor, is subject to be excluded (written off) from the company assets.

3.

As it is mentioned above, one of the grounds for recognizing receivables as uncollectable is the expiration of the limitation period. In such a case, the company no longer controls the debt, since the collection of such debt already can’t be forcibly provided by legal measures.

But what should one do if the confidence that the debt will not be paid has arisen before the statute of limitations’ expiration?

Besides the formal expiration of the limitation period, para. 4 of the Standard No. 10, also defines the following ground for writing off receivables as uncollectible – “the confidence that they will not be repaid by the debtor”.

Neither the Standard No. 10 nor the Law on Accounting explicitly state the criteria under which the company should assess such confidence.

According to the Academic Interpretative Dictionary of Ukrainian Language in 11 volumes, confidence is “a firm conviction on something”, and conviction, in its turn, is a “firm, firmly established opinion of something, a view on something.”

This means that the recognition of receivables as uncollectable depends on the company’s conviction in their repayment/non-repayment by the debtor, that is, on view about the possibility/impossibility of repayment of such debt.

Therefore, one may conclude that it is enough to have a company’s firm conviction that such debt will not be repaid to the company reasonably formed based on the available information (that is “a belief”, convictions cannot be just “blind” but shall be based on something) to write off the debt as uncollectable receivables.

Thus, according to the provisions of para. 4, para. 11 of the Standard No. 10, the company in its accounting can write off the debt as an uncollectible one by way of referring it to other operating expenses if there is a reasonable conviction that the repayment of this debt is not expected in the foreseeable future, and such repayment can hardly be provided by legal means.

4.

For the sake of completeness, it should be noted that similar approaches are used under international financial reporting standards.

It also should be noted that the abovementioned is referred to writing off a specific debt due to its recognition as uncollectible, and not to creating the provisions (reserves) for a bad/doubtful debt.

5.

And what is in the tax accounting?

First of all, the definition of the bad debt set forth in subpara. 14.1.11 of the Tax Code of Ukraine (“the Tax Code”) catches the eye:

“uncollectible debt is the debt that meets any of the following criteria:

а) debt under liabilities for which the limitation period has expired;

b) overdue debt of a deceased individual, in the absence of hereditary property, on which the collection can be imposed;

v) overdue debt of individuals declared by court as missing, deceased;

g) debt of an individual delayed by more than 180 days, the amount of the aggregate claims of the creditor under which does not exceed the minimum amount of the undisputed claims of the creditor for initiation of the bankruptcy proceedings established by the law, and for individuals – the debt not exceeding 25% of the minimum wage (calculated per year) established as of January 1 of the reporting tax year (in the absence of a legally approved bankruptcy procedure for individuals);

d) asset in the form of corporate rights or non-debt securities, the issuer of which is declared bankrupt or terminated as a legal entity due to its liquidation;

e) amount of the remaining lottery prize pool as of December 31 of each year;

ye) overdue debt of an individual or a legal entity that is not repaid due to the insufficiency of the property of the specified person, provided that the actions aimed at the forced collection of the property of the debtor have not resulted in the full repayment of the debt;

zh) debt that cannot be collected due to circumstances of irresistible force or a natural disaster (force majeure) confirmed according to the procedure prescribed by the legislation;

z) debt of the business entities declared bankrupt under the procedure established by the law or terminated as legal entities in connection with their liquidation…”.

And, consequently, the question arises: whether the criteria, established by subpara. 14.1.11 of the Tax Code shall be complied with to recognize the debt as a bad one, including for tax accounting purposes.

6.

To answer this, let us consider this question in the historical retrospect:

The definition of the bad debt, given in subpara. 14.1.11 of the Tax Code, was introduced as early as the original version of the Tax Code, when the object of taxation of corporate income tax was determined by special rules defined directly in the Tax Code, which, in particular, contained provisions on the bad and doubtful debt and these rules were mainly established by Article 159 of the Tax Code (in the version before January 1, 2015).

However, starting from 1 January, 2015, the whole Section III “Corporate Profit Tax” has been revised (by the way, having the Article 159 excluded from it), and the new fundamental approach was introduced, according to which the financial result before taxation shall be determined under the accounting rules and further adjusted on certain differences directly stated in the Tax Code.

Hence, since 2015, the definition of the bad debt set forth in Article 14 of the Tax Code has ceased to have a direct influence on the relevant question. The recognition of a debt as an uncollectible one and its writing off procedure, while determining the financial result according to the accounting rules, are determined actually by the accounting standards applied by the company (national or international).

7.

The bad debt is still mentioned in the Tax Code as the definition given in subpara. 14.1.11 being a part of the references in some other definitions, and as “vestiges” in the transitional provisions. They are not relevant to the issue under consideration.

The only reference worthy of separate consideration is contained in Article 139 “Differences arising from the creation of the reserves (provisions)”, namely in para. 139.2 “The doubtful debt reserve”, and in para. 139.3 “The reserves of banks and non-bank financial institutions”.

So, in accordance with the subpara. 139.2.1 of the Tax Code the financial result before taxation is increased by:

“the amount of expenses on creation of the reserve for doubtful debts according to the national accounting regulations (standards) or international financial reporting standards;

the amount of expenses on writing off the accounts receivable on the amount exceeding the amount of the doubtful debts reserve”.

At the same time, according to subpara. 139.2.2 of the Tax Code the financial result before taxation is decreased by:

“the amount of adjustment (decrease) of the doubtful debt reserve, by which the financial result before taxation was increased according to the national accounting regulations (standards) or international financial reporting standards;

the amount of written off accounts receivable (including at the expense of the created reserve for doubtful debts), which meets the criteria, specified in subpara. 14.1.11 of para 14.1 of Article 14 of this Code”.

However, are such provisions applicable to those taxpayers who have written off uncollectable receivables without creation of the reserve for doubtful debts?

In accordance with subpara. 134.1.1 of the Tax Code the tax base for Corporate Profit Tax is:

“the Ukrainian-sourced and foreign income determined by way of adjustment (increase and decrease) of the financial result before taxation (profit or loss) specified in the company’s financial statement in accordance with the national accounting regulations (standards) or international financial reporting standards, on differences arising according to the provisions of this Code”.

This means that the tax base is the financial result determined under the accounting rules, adjusted on the differences, exclusively in the cases directly prescribed by the provisions of Section III of the Tax Code.

Therefore, the basic determination of the financial result before taxation is carried out under accounting rules.

Article 139 of the Tax Code defines differences arising while “creating the reserves (provisions)”. Thus, if the company does not create such reserves (does not form provisions), there are no legal grounds to apply this Article.

Article 139 of the Tax Code also sets forth that “the financial result before taxation shall be increased by the amount of expenses on creation of the provisions (reserves)” (subpara. 139.1.1.), but “decreased by the amount of created provisions used” (subpara. 139.1.2.). This means that the adjustment towards the increase is executed by the amount of expenses, and therefore, the presence (recognition) of the expenses on creation of the provision that covers the corresponding debt is a precondition under which the adjustment is actually possible.

That is, in case no provision covering the corresponding debt is/was created (and no expenses were recognized in accounting in connection with this), the company should not carry out an adjustments in case of writing off such a debt recognized as a bad one under the accounting rules.

The issue of the inapplicability of the provisions of Article 139 of the Tax Code in respect of the bad debt, provided that the company does not create the reserve for doubtful debts, has already been considered by the courts.

Thus, for instance, the Kharkiv Administrative Court of Appeal in the Resolution of July 13, 2018 in case No. 820/4050/17 reached the following conclusion:

“In accordance with the Article 1 of the Law of Ukraine “On Accounting and Financial Reporting in Ukraine” assets are resources controlled by the company as a result of past events, the use of which, as it is expected, will bring future economic gains.

…

Therefore, a debt recognized as a bad one ceases meeting the criteria of assets.

Consequently, the reclassification of receivables into the category of uncollectable means the disposal of an asset, which leads to a decrease in equity that causes the recognition of expenses in accounting.

From the analysis of the stated provisions it also follows that the reserve for doubtful debts is calculated, determined and accrued by the company purposefully and is confirmed by reflecting the amount of created reserve for doubtful debts in the statement on financial results within the other operating expenses.

As it is established by the panel of judges and reflected in the act of audit, the plaintiff had written off the accounts receivable, meeting the criteria of uncollectable, in the amount of UAH 137 796 to the account 94 “Other expenses”.

As stated in the act of audit, the reserve for doubtful debts according to accounting data has not been created at all by the company-plaintiff.

In view of above mentioned it follows that in the absence of creation of the reserve of doubtful debts there are no legal grounds for LLC “Foc Tuba Ltd” to apply the provisions of subpara. 139.2.1 of the Tax Code of Ukraine and to increase the financial result before taxation”.

Therefore, the definition of the bad debt given in subpara. 14.1.11 of the Tax Code is more of a rudiment. The basic purpose of introduction of this definition directly into the Tax Code was lost along with replacement of the entire section of the Tax Code on Corporate Profit Tax back in 2015 without the specific provisions on the bad debt that used to be in that section (in Article 159) before 2015. And the definition of the bad debt set forth in the Tax Code is not relevant for accounting purposes; as mentioned above, the rules of the accounting standards shall be applied.

The stated above is confirmed, for instance, by the conclusions of the Seventh Administrative Court of Appeal set forth in the Resolution of October 10, 2019 in case No. 560/1631/19:

“According to para. 8 of the Regulation (Standard) of Accounting 10 “Accounts Receivable”, approved by the Order of the Ministry of Finance of Ukraine as of October 08, 1999 No. 237, registered at the Ministry of Justice of Ukraine on October 25, 1999 No. 725/4018, the amount of doubtful debts determined at the balance sheet date on the basis of the classification of receivables is the remainder of the reserve for doubtful debts. Adjustment of the reserve for doubtful debts previously accrued as of the next balance sheet date in the direction of decrease in accounting is debited to an income account in accordance with the Instruction, approved by the Order of the Ministry of Finance of Ukraine as of November 30, 1999 No. 291.

Consequently, the panel of judges agrees that the financial result before taxation is decreased only when the amount of reserve for doubtful debts is adjusted downwards, and the financial result before taxation is increased by this amount according to the national accounting regulations (standards) or international financial reporting standards. In case of writing off the uncollectable receivables at the account of the reserve of doubtful debts, the financial result before taxation, defined in the financial statements, is not subject to be decreased by the amount of the written off debt.

At that, the financial result before taxation is subject to be increased by the amount of expenses on writing off accounts receivable not meeting the criteria specified in subpara. 14.1.11 of para. 14.1 of Article 14 of this Code by the amount exceeding the amount of reserve for doubtful debts.

At the same time if in case of the insufficiency of the amount of the accrued reserve for doubtful debts uncollectable receivables, meeting the criteria, specified in subpara. 14.1.11 of para. 14.1 of Article 14 of this Code is written off from assets by way of referring it to other operating expenses, the financial result before taxation shall not be increased.

If the reserve is used for writing off receivables, such debt shall be checked for compliance with the criteria of uncollectable defined in subpara. 14.1.11 of para. 14.1 of Article 14 of the Code. In case it meets the criteria, the financial result before taxation shall not be adjusted by the amount of expenses from writing off the accounts receivable on the amount exceeding the amount of the reserve for doubtful debts according to part 2 of subpara. 139.2.1 of para. 139.2 of Article 139 of the Code.

In accordance with the definition in para. 4 of the Regulation (Standard) of Accounting 10 “Accounts Receivable” uncollectable receivables are current receivables regarding which there is a confidence that they will not be repaid by the debtor or the statute of limitations of which has expired. This definition correlates with subpara. 14.1.11 of the Tax Code of Ukraine, and, in fact, completely overlaps all clear criteria established by the Code”.

This means that checking whether the debt meets the criteria set forth in subpara. 14.1.11 of the Tax Code is carried out in case the company uses the reserve for writing off the debt.

In all other cases, such debt is referred to other operating expenses without any adjustment on the differences because no such differences are established by the Tax Code.

8.

To sum up, if there are any reasonable expectations that certain receivables will not be paid, there is no requirement to wait for the expiration of the limitation period regarding such debt or to comply with the formal criteria under subpara. 14.1.11 of the Tax Code to write off receivables by way of referring to expenses in the tax accounting included. It should be sufficient to comply with the accounting standards to write off a debt.

In such a way, one can cut tax expenses and thus save working capital now.

It also should be noted that the current circumstances allow to use the definition of the bad debt under subpara. 14.1.11 of the Tax Code in case there is a desire and grounds for it. According to subpara 14.1.11 (zh) the bad debt includes the debt that cannot be collected due to force majeure. Amendments introduced to the legislation (including to the procedural legislation) allows to consider the current measures introduced as force majeure. So why should one not use such an opportunity if it is possible to confirm force-majeure in specific cases?

Moreover, this will not be a tax evasion regarding the certain incomes if the debt written off in such a way is eventually repaid. Upon receipt of the payment, such debt will be included to the incomes and shall be subject to taxation. That is to say, the income recognition is simply transferred to the “cash method”, which makes it possible to save on income tax now when companies are so much in need of working capital.

In general, this should be centrally done by the state, since many businesses are already experiencing delays in receiving payments and liquidity problems. And if the state does not care about it, “the rescue of a drowning man is the drowning man’s own job” by any possible means. In this newsletter we have considered one of such means that may be particularly relevant now.

The above commentary presents the general statement for information purposes only and as such may not be practically used in specific cases without professional advice.