Tax Accounting — Bad Debts, the Bad Debt Allowance and Retirement Benefit Adjustments

Accounting builds a loss allowance for receivables based on expected credit losses (Principles of Accounting chapter 7) and measures defined benefit obligations actuarially (Intermediate Accounting chapter 14). Tax law does not accept these estimated costs as deductions as they stand: bad debts require a ground specified by law, and allowances have limits.

1. Bad debts

To deduct a receivable that has become uncollectible, there must be a ground for bad debt specified by law (Enforcement Decree of the Corporate Tax Act, Article 19-2).

Classes of bad debt grounds
Class	Example grounds	Timing of deduction
Return-based grounds	Expiry of the limitation period (Commercial Act, Civil Act, etc.); uncollectibility confirmed by approval of a rehabilitation plan or a discharge	The business year in which the ground arises (deductible by tax adjustment even if not in the books)
Book-based grounds	Bills and cheques, and SMEs' trade receivables, six months or more past the date of dishonour; uncollectibility due to the debtor's bankruptcy or compulsory execution; receivables of ₩300,000 or less six months or more past due	The business year in which the bad debt is recorded in the books

Provisional payments lent to related parties without a business purpose and reimbursement claims arising from subrogated payment of guaranteed debts are not recognized as bad debts.

2. Limit on the bad debt allowance

Deductible limit on the bad debt allowance

\begin{aligned}\text{Limit} &= \text{Tax receivables at year-end} \times \max(1\%,\ \text{Bad debt ratio}) \\ \text{Bad debt ratio} &= \frac{\text{Tax bad debts this year}}{\text{Tax receivables at the end of the previous year}}\end{aligned}

Tax receivables are book receivables plus or minus receivable-related retained items (such as disallowed bad debts). Financial institutions and others have separate rates.

Tax law uses the gross method: the company’s whole year-end allowance balance is compared with the limit, and the amount disallowed (retained) as above the limit in the prior year is first reversed as a deduction (negative retained) this year.

A. Worked example

TM’s tax receivables at the end of the previous year were ₩800 million, and its tax bad debts this year are ₩12 million. Book receivables at year-end are ₩950 million, and there is a retained item of ₩50 million for receivables whose write-off was previously disallowed for not meeting the bad debt conditions. The year-end allowance balance is ₩20 million, and the prior year’s excess over the limit was ₩3 million.

Bad debt ratio: $1{,}200 / 80{,}000 = 1.5\%$ (above 1%, so 1.5% applies)
Tax receivables: ₩950 million + ₩50 million = ₩1 billion
Limit: ₩1 billion × 1.5% = ₩15 million
Excess over the limit: $2{,}000 - 1{,}500 = 500$ → ₩5 million disallowed (retained)
Prior year’s excess of ₩3 million → deducted (negative retained)

3. Retirement benefit provision and retirement pensions

Retirement benefit provision: since 2016, the cumulative tax limit has been cut to 0% of estimated retirement benefits. In effect, additions to the provision recorded in the books are disallowed (retained). When retirement benefits are actually paid, the retained balance is revived as a deduction.
Retirement pension contributions: instead, contributions to a defined benefit pension plan can be deducted through a return-based adjustment. The limit is roughly year-end estimated retirement benefits − the tax balance of the retirement benefit provision − pension contributions already deducted. Contributions to defined contribution plans are deductible in the year paid.

So even though the company presents defined benefit obligations and plan assets for accounting, for tax the deduction is centred on the amount paid into the pension fund. Remeasurements of defined benefit plans (in OCI) are also a separate matter for tax adjustment.

Check your understanding

TN’s tax receivables at the end of the previous year were ₩2 billion and its tax bad debts this year ₩16 million. Tax receivables at year-end are ₩2.5 billion and the company’s year-end allowance balance is ₩30 million. There was no prior-year excess. What is the allowance limit and the tax adjustment?

The bad debt ratio is $1{,}600 / 200{,}000 = 0.8\%$ , below 1%, so the 1% rate applies. The limit is ₩2.5 billion × 1% = ₩25 million, and the ₩5 million excess is disallowed (retained).

References

Corporate Tax Act, Article 19-2 (disallowance of bad debts), Article 33 (deduction of retirement benefit provisions) and Article 34 (deduction of bad debt allowances) — Korea Law Information Center
Enforcement Decree of the Corporate Tax Act, Article 19-2, Article 44-2 (disallowance of retirement insurance premiums, etc.) and Article 61
National Tax Service, Guide to Corporate Tax Returns