Dedon Manufacturing, Inc.

May 30, 2008 BIR RULING [DA-332-08] 34 (E) (1); DA136-05 Dedon Manufacturing, Inc. Zone 7, Birds of Paradise Riverside, Canduman Mandaue City Attention: Ms. Grace Cabradilla VP-Admin-Finance Gentlemen : This refers to your letter dated August 31, 2007 stating that Dedon Manufacturing, Inc. is a domestic corporation duly registered with the Securities and Exchange Commission (SEC) dated April 7, 2002; that it is primarily organized to engage in the business of manufacturing goods such as furniture made of aluminum frame and kularo synthetic fiber and to trade the same on wholesale basis; that on September 30, 2003, a Software Agreement was entered into by Dedon Manufacturing, Inc. and ASP, Inc.; that the transaction started in October 2003 and implementation lasted until June 2005 but unfortunately, it was a failure due to several factors, one of which is the death of the consultant assigned in Cebu; that Dedon Manufacturing, Inc. cannot afford to wait for a long period of time to prove that the system works and fits the nature of its business transactions/activities; and that reimbursement of the cost from the supplier is not feasible. Based on the foregoing representations, you now request for an opinion that Dedon Manufacturing, Inc. is entitled to write-off the software purchased from ASP, Inc. and claim the same as bad debts deduction from its gross income on the taxable year/s that they were ascertained to be worthless pursuant to Section 34 (E) (1) of the Tax Code. In reply thereto, please be informed that Section 34 (E) (1) of the Tax Code of 1997 provides, as follows: "Sec. 34. Deductions from Gross Income . (E) Bad Debts. (1) In General. Debts due to the taxpayer actually ascertained to be worthless and charged off within the taxable year except those not connected with profession, trade or business and those sustained in a transaction entered into between parties mentioned under Section 36(B) of this Code: Provided, That recovery of bad debts previously allowed as deduction, in the preceding years shall be included as part of the gross income in the year of recovery to the extent of the income tax benefit of said deduction." Corollarily, Revenue Regulations No. 25-02, amending Revenue Regulations No. 05-99, and implementing the above provision, provides the requisites for valid deduction of bad debts from gross income: "Sec. 3. Requisites for valid deduction of bad debts from gross income . The requisites for deductibility of bad debts are: (1) There must be an existing indebtedness due to the taxpayer which must be valid and legally demandable; (2) The same must be connected with the taxpayer's trade, business or practice of profession; (3) The same must not be sustained in a transaction entered into between related parties enumerated under Section 36(B) of the Tax Code of 1997; (4) The same must be actually charged off the books of accounts of the taxpayer as of the end of the taxable year; and (5) The same must be actually ascertained to be worthless and uncollectible as of the end of the taxable year." The Court of Tax Appeals (CTA) in interpreting the above requisites held that the taxpayer is not required to be an "incorrigible optimist" in enforcing collection of a debt ( Western Pacific Corporation v. Commissioner of Internal Revenue, CTA Case No. 720, 22 May 1961 citing White Dental Mfg. vs. US, 274 US 398 ). He may not postpone a bad debt deduction on the basis of a mere hope of ultimate collection but rather, should exercise sound business judgment based upon information reasonably obtainable in determining worthless debts and in the examination of all the circumstances. Thus, this Office in BIR Ruling No. UN097-95 dated March 8, 1995, ruled that ". . . [B]ad debts are allowed as deductions in the year when ascertained to be worthless and not at the time when the taxpayer may finally 'give up' on the possibility of recovering any part of the debts and decide to charge them off. (CCH, 60 Vol. 2, p. 21.009; (page 252, updated National Internal Revenue Code with Notations and Appendices, 1988 Edition, Jose Araas) The taxpayer must take reasonable steps to collect the debt. He does not have to go to court if it can be shown that a judgment once obtained would be worthless because the debtor is insolvent or 'judgment proof'. If, in the exercise of sound business judgment a taxpayer believes there is no likelihood of recovery at any time in the future, the debt has been worthless. (Western Pacific Corporation v. Collector of Internal Revenue, CTA Case No. 720) In applying the above principle under the circumstances, it is crystal clear that Dedon Manufacturing, Inc. need not go through the lengthy process of hiring a collection lawyer and/or filing a collection case against the supplier since, in all probability, it will not result in the satisfaction of the debt or execution of the judgment. Accordingly, Dedon Manufacturing, Inc. may write-off its accounts receivable due from the supplier and claim it as a bad debt deduction from its gross income pursuant to Section 34 (E) (1) of the Tax Code of 1997. WHEREFORE, in view of the foregoing, this Office hereby confirms your opinion that Dedon Manufacturing, Inc. is entitled to write-off the account receivables from ASP, Inc. and claim the same as bad debts deduction from its gross income on the taxable year/s that they were ascertained to be worthless. This ruling is being issued on the basis of the foregoing facts as represented. However, if upon investigation, it will be disclosed that the facts are different, then this ruling shall be considered null and void. Very truly yours, (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service