Have you made a credit sale in the course of business, and the debtor remains outstanding despite follow-up attempts? You may qualify to claim as a tax deduction the unpaid amount, provided that you meet specific requirements as provided under Section 15(2)(a) of the Income Tax Act of Kenya, read together with the guidelines under Legal Notice No. 37 of 2011.

Key requirements include:

  1. The bad debt must have arisen in the ordinary course of business, and the amount had been declared as income for tax purposes in the respective year of income;

  2. The amount written off in the books must be specific, i.e., it can be attributed to a particular debtor and not just a mere general provision;

  3. The bad debt should not be in relation to a capital item, e.g., shareholder funding, deposit payments made for fixed assets that are no longer recoverable;

  4. Proof of recovery efforts made, such as demand letters, reminder emails, engagement of debt collection agents and legal action undertaken (where applicable) 

In addition to the above requirements, the Commissioner, through Legal Notice No. 37 of 2011, has provided guidelines on when a bad debt qualifies for tax deduction. 

The Legal Notice provides that a debt is considered bad if proved to the Commissioner's satisfaction to be uncollectable after all reasonable steps have been taken to collect it. It sets out six specific circumstances under which a debt is deemed uncollectable, viz;

  1. the creditor loses the contractual right that comprises the debt through a court order;

  2. no form of security or collateral is realisable whether partially or in full;

  3. the securities or collateral have been realized but the proceeds fail to cover the entire debt;

  4. the debtor is adjudged insolvent or bankrupt by a court of law;

  5. the costs of recovering the debt exceeds the debt itself; or

  6. efforts to collect the debt are abandoned for another reasonable cause.

Emphasis: Many taxpayers fail to meet the threshold for deductibility of bad debts due to lack of evidence on what steps have been taken to follow up on the debt before being written off. It is therefore critical to maintain comprehensive documentation of all recovery efforts, including correspondence, demand notices, and any legal or collection actions undertaken, to demonstrate that reasonable steps were taken to recover the debt before claiming it as a deduction.

Legal precedent

Various tax disputes have arisen in the implementation of the guidelines on the allowability of bad debts, with the Commissioner disputing the deduction of bad debts for tax purposes. 

In Equity Bank Kenya Limited V Commissioner of Domestic Taxes. [2021] KEHC 8047 (KLR), where Equity Bank had written off thirteen loan accounts as bad debts, the Commissioner's position was straightforward that Equity Bank had not done enough to recover the bad debts before writing them off, and therefore the write-offs did not qualify as allowable deductions under the Income Tax Act.

In its argument, Equity Bank held that it had satisfied the requirements of section 15(2)(a) of the Income Tax Act and the guidelines in respect of each loan. In each case, Equity Bank maintained that at least one of the guidelines criteria had been met. 

The Commissioner's counterargument was essentially that Equity Bank had not exhausted all available avenues before writing off the debts.

The Legal issue

The central issue was whether the written-off debt qualified as a deductible expense under Section 15(2)(a) of the Income Tax Act, and whether Equity Bank had met the conditions outlined in Legal Notice No. 37 of 2011 for bad debt allowance.

The Court's Decision

The Commissioner had argued, in effect, that a taxpayer must exhaust every possible avenue before a write-off can qualify for deduction. Justice Majanja rejected this interpretation firmly.

The court affirmed that “The guidelines did not require that Equity Bank exhausts all the avenues for collecting the debt. It only needs to satisfy one or more of the guidelines to satisfy the Commissioner.”

Conclusion

The High Court's decision in Equity Bank Kenya Limited v Commissioner of Domestic Taxes (2021) KEHC 8047 (KLR) is a meaningful restatement of the correct legal standard for bad debt deductibility under the Kenyan Income Tax Act. It pushes back against an approach that would effectively require taxpayers to chase every possible recovery avenue to exhaustion before claiming a deduction. At the same time, it serves as a reminder that if you don’t properly document your reasonable recovery efforts, even a write-off that makes good business sense can be denied.
 

Caveat

This newsletter has been prepared by RSM (Eastern Africa) Consulting Ltd, and the views are those of the firm, independent of its directors, employees and associates. This newsletter is for general guidance, and does not constitute professional advice. Accordingly, RSM (Eastern Africa) Consulting Ltd, its directors, employees, associates and its agents accept no liability for the consequences of anyone acting, or refraining from acting, in reliance on the information contained herein or for any decision based on it. No part of the newsletter may be reproduced or published without prior written consent. RSM (Eastern Africa) Consulting Ltd is a member firm of RSM, a worldwide network of accounting and consulting firms. RSM does not offer professional services in its own name and each member firm of RSM is a legally separate and independent national firm.