Intra-group trading bad debts

From time to time, in most large groups the situation will arise where one company has built up indebtedness to another by purchasing goods or services on trading account, which it is unable to pay for.

In an arm’s length situation, the supplier would undertake collection action, while simultaneously making at least partial provision against the debt for expected uncollectability.  Following the adoption of IFRS, strictly speaking there are no “bad debt provisions” only “impairment reserves”, but the underlying concept is similar.  The supplier would normally expect to get a tax deduction for its bad debt provision (UK GAAP) or impairment reserve (IFRS) if properly calculated in relation to specific debts.

Intra-group bad debts (old law)

Prior to the change in law discussed below, the strict technical position for a supplier which had made sales to an intra-group customer was the same as when the customer was at arm’s length; a properly calculated provision against a specific bad debt should have been tax deductible.

However, in real cases the facts were usually more complicated.  It was quite common to find the intra-group customer had been given significantly longer to pay than the time that would be given to a third party.  Furthermore, the intra-group supplier could rarely show that it had taken the type of robust collection action intra-group that it would have taken with a third party customer.

Accordingly, the Inland Revenue regularly contended with intra-group bad debts that the debt had changed its nature after it first arose.  The argument was that the supplier’s forbearance regarding collection activity had transmuted the debt from a straightforward trade receivable into a long term loan.  Such long term loans did not give rise to bad debt relief, as advancing loans was not part of the supplier’s trade.  Such Inland Revenue arguments were often well founded; sometimes bad debt relief was entirely disallowed while in other circumstances partial relief might be allowed by the Inland Revenue as a negotiated outcome.

Law change

FA 2005 made some amendments to FA 1996 s.100 for periods of account beginning on or after 1 January 2005.  While the changes were primarily made as part of adapting tax law to the introduction of International Accounting Standards, they also changed the treatment of intra-group bad trading debts, a point which may not be widely appreciated.

Impact of the law change

FA 1996 s.100 deals with money debts (i.e. debts repayable by the delivery of money as opposed to the delivery of something else) which did not arise from the lending of money. S.100 (1) (c) (iii) applies to a money debt where payment would be brought into account as a trade receipt (which applies to a trade receivable) and in relation to which an impairment loss arises to the company.

Where this state of affairs exists, s.100 (2) (a) provides that the loan relationships rules have effect in relation to the matters mentioned in s.100 (1) (c) (iii), which includes impairment, as they do for loan relationships generally.  The effect is to apply all of the provisions of the loan relationships legislation to determine if there is a tax deductible impairment.

As the debt is with a group company, (i.e. one under common control within FA 1996 s.87) the effect of FA 1996 Sch 9 para 6 is to deny the supplier relief for any impairment losses, and to also deny any relief for writing off the debt.  Accordingly, in all cases apart from the special exceptions contained in para 6 (which do not need to be discussed here) it is no longer possible to claim any tax relief in respect of intra-group bad debts that arise from trading transactions.  This mirrors the situation with intra-group loans of money.

The debtor’s position

FA 1996 s.100 only affects the position of the creditor of the intra-group trade debt.  Accordingly for the debtor, the loan relationship provisions are not applicable.

Unfortunately, this means that if the supplier writes off the debt, FA 1996 Sch 9 para 5(3) is not relevant.  The provisions of ICTA 1988 s.94 will instead apply, causing the release to be treated as a taxable trading receipt, unless the release is part of a statutory insolvency agreement.  However, a statutory insolvency agreement may be unpalatable to the group for reputational reasons.

Mohammed Amin