18.06.09

Writing Off Bad Debt
Alexey Spirihin, Auditor, Alinga Consulting Group

All businesses in the Russian market have felt the financial crisis. Some have "gone under," while others have managed to stay afloat. If you are reading this, we assume that you are among the latter. However, you likely have seen some business partners go under. This situation is unpleasant enough, but sometimes even the closest partners can disappear without repaying their debts. This turns an unpleasant situation into a truly difficult one.

The only thing that can be done with such debt is to acknowledge the loss, and, best case scenario, to write it off. This article will lay out the circumstances under which debt can be written off in the Russian Federation and provide practical advice for those attempting to do so.

First note, however, that only companies using the general taxation system can write off non-recoverable debt. Companies that adopt special tax systems are barred by the Tax Code from treating a loss from non-recoverable debt as an expense.

The Tax Code of the RF (Point 2 of Article 266) splits bad debt into two categories: doubtful and non-recoverable. Before a debt can be written off it must move from “doubtful” to “non-recoverable” (Point 2 of Article 265 of the Tax Code).

A doubtful debt is understood as any debt that arises in connection to selling goods, fulfilling work, or rendering services, in the case that the debt is not paid when due as established by an agreement, and is not secured by a pledge, security, or bank guarantee.

However, a doubtful debt can not be written off; it must move from “doubtful” to “irrecoverable.”

An irrecoverable debt is one in which either  a) the debt has been legally terminated by a government act issued by federal or regional authorities, b) the debt has been terminated by a company liquidation due to the impossibility of fulfilling the obligation, or c) the validity period, that is, the period during which the creditor can take legal action to obtain the money has expired.

Only one of these three conditions must be met in order to write off the debt. In the following paragraphs we will expand on each of these three circumstances.

Debt Legally Terminated by Government Act

Debt can be terminated by laws, edicts, decrees, orders or regulations, including instructions from the Bank of Russia (for example, upon issuance of a moratorium for fulfilling loan obligations to the creditor).

A debt or obligation can be terminated by laws, edicts, decrees, orders or regulations, including instructions from the Bank of Russia (for example, upon issuance of a moratorium for fulfilling loan obligations to the creditor). This can happen when an obligation is impossible to fulfill, and neither side is guilty for it, or if the obligation cannot be fulfilled by the fault of the creditor.

For example, if one side puts an item in storage, according to the storage agreement, the second party is obligated to return the item. However, if the item is confiscated because it actually belongs to a third party, then the second party cannot fulfill its obligation to return the item, and the government act (from Russia’s militsia or the prosecutor’s office) regarding the item’s confiscation releases the second party from its obligation.

Another example might be if a construction agreement is concluded for a particular plot of land, but then the land is taken over for government use and thus the contractor cannot fulfill the obligation.

Government acts are also used other cases such as when a sales contract obligates the seller to return money for defective goods, but the goods had actually been destroyed through the fault of the purchaser.

Debt Legally Terminated By Company Liquidation

According to the Ministry of Finance the only document attesting to the company’s liquidation is the statement from the Unified State Register of Legal Entities received upon direct formal appeal to the Federal Migration Service (FMS). Note, however, that simply clicking the “print” button while looking at the Unified State Register of Legal Entities on the FMS website is not sufficient documentation of the company’s liquidation. The statement from the Unified State Register of Legal Entities regarding the company’s liquidation is one of the most commonly used documents for debt cancellation, as it is the most clearcut and incontestable.

Debt Legally Terminated By Validity Period Expiration

Using the validity period rule can be one of the most difficult methods of writing off debt. The period begins on the day that the legal entity found out – or should have found out – that the debt would not be paid on time. If a liability already has a specified due date for fulfillment, the validity period begins when the fulfillment period ends (Article 200 of the Civil Code).

This means that if you specified the terms of payment in an agreement, for example, that payment must be rendered within fifteen days of receiving the goods, then the validity period begins on day sixteen. If the terms were not specified in the agreement, then the supplier can send a written request for the debt to be satisfied within a specified time. If payment is not rendered within the allotted time, the period begins the day after the deadline.

How long is the validity period? In theory, it is three years, as established in Article 196 of the Civil Code. In practice, however, it can run from three years to eternity. This is because legislation provides for an “interruption” of those three years. If a client makes a request for a postponement of the payment, or acknowledges the debt in written form (for example through a signed reconciliation statement), or pays part of the debt (for example, 100 rubles), the period is officially "interrupted." After the interruption, the period starts over and the time that passed before the interruption does not count. This provides a loophole for debtors, and hardships for creditors.

Once you have established a debt as irrecoverable via one of the three criteria above, the next step is to actually write the debt off.

The following are important in that process: a) documentation proving the debt is irrecoverable, b) confirmation of the sum of debt, and c) documented evidence of the actions the creditor has taken in order to attempt to collect the debt up to the moment the debt was written off.

Documenting the debt can be done through: supplier agreements (for rendering of services) which contain the payment terms (or letter of credit that has the payment terms, if similar terms are not already specified in the agreement), work completion reports (for services rendered), merchandise invoices, statements of release and acceptance, and reconciliation statements with the purchaser. Two other potentially useful documents are an inventory report that acknowledges the debt and an order from the company head to write off the debt.

It is useful, though not mandatory, for the creditor to have evidence that attempts were made to settle the issue with the defaulter. For example, letters requesting the defaulter pay, and other letters aimed at settlement, can be useful if the write-off is questioned by the Tax Authorities. However, according to the courts, these documents are not mandatory to acknowledge the debt as irrecoverable.

One last issue to deal with is that of VAT. Fortunately, the official position on this issue is clear – when writing off non-recoverable debt the taxpayer has the right to write the entire sum of the debt off as an expense, including VAT (Letter of the MinFin №03-03-06/1/596 from 21.10.2008).

Writing off bad debt under Russia's ill-defined regulations can be a challenge. With the current financial crisis, however, it is important to treat the bad debt appropriately to have a correct understanding of your cash flow. In this case, contacting a professional services firm that helps you to document your case and do the write-off effectively can be your best option.

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