Insolvency and tax: Here are the tax consequences if you're the creditor

'There's a great deal of confusion when it comes to the role of the taxman in the case of an individual or business entity going insolvent,' says the Practical Tax Loose Leaf Service.

If you're also uncertain about this, don't fret, the Loose Leaf Service has you covered.

If you're a creditor, it's important to establish where you stand in line when it comes to any payouts. In this case, SARS has a preferential place in the queue.

As a creditor, when an individual or business that owes you money goes insolvent, you're required to 'prove' your claim if you' want to share in any proceeds relating to the of the insolvent's affairs (referred to as the estate).

To prove your claim, you must provide the administrator of the estate with evidence of the amount owed to you.

This evidence could include contracts between you and the insolvent, invoices issued for services rendered or goods sold and signed delivery notes indicating that goods have been delivered.

You must also state whether any assets have been pledged to you as a security for the amount owing.

So what are the tax consequences for creditors when a business goes insolvent?

According to the Loose Leaf Service, if you're making a claim against an insolvent estate for money that's owed to you, the proceeds won't be subject to tax in your hands.

This is because the underlying transaction would either have already been included in your taxable income (for example, sales made on credit), or would have been related to a transaction of a capital nature (for example, in the case of a loan granted).

If you've written off a bad debt, which qualified for a deduction in a prior year, you must include the recoupment of the bad debt in your gross income in the year in which the bad debt is subsequently recovered.

But what happens if you incur a loss as a result of being unable to recover a portion of the amount claimed? Will you be able to deduct the amount lost against your taxable income, to reduce your tax bill?

The answer to this question depends on the nature of the transaction, as well as the type of business that you're in.

If the unrecoverable amount relates to a transaction that was included in your taxable income, then you would be entitled to deduct the loss.

In the case of loans made to third parties that are ultimately unrecoverable, the position is different.

Unless you're in the business of money-lending (for example, a bank), you won't be able to deduct the unrecovered amount for tax purposes as it's capital in nature.

In the case of a money-lender, the unrecovered amount will qualify as a deduction as this would then constitute a business transaction.

Well there you have it. There are tax consequences even for creditors when a business goes insolvent. Make sure you comply with SARS.