Revealed: Four things you SHOULD know about insolvency and tax

According to the Practical Tax Loose Leaf Service, being declared insolvent means that the person or entity concerned (the debtor) is unable to meet their obligations in respect of money owed to third parties (the creditors).

But insolvency can also refer to the process where a debtor reaches a point where obligations can't be met in the normal course of business, or from ordinary regular earnings.

It's the point at which the debtor's assets are handed over to an administrator appointed by the Court with the aim of selling the assets to meet claims lodged by one or more creditors.

While this is quite an unfortunate event, there are tax consequences.

Here's what you should know about insolvency and tax

#1: If you're the person being declared insolvent, this is probably one of the most traumatic periods of your life. But the Insolvency Act is a mechanism whereby your assets can be disposed of and the proceeds distributed among your creditors in an orderly fashion.

#2: Once the process has been completed, you won't be able to get credit for quite some time. But, after a specific time frame has elapsed (usually ten years), you're regarded as having been 'rehabilitated' and you'll be able to start over without your old debts coming back to haunt you.

#3: If you're the person to whom money is owed, having one of your customers declared insolvent can be equally traumatic. In fact, in extreme cases, the insolvency of a major customer could lead to your own insolvency as well.

#4: While the Income Tax Act does allow you (creditor) to deduct losses incurred as a result of the other party's insolvency, this deduction is only available if the underlying transaction originally formed part of your taxable income.

This'll effectively put you in a 'tax neutral position', as though the original transaction had never taken place. But it doesn't compensate you for the cost of the goods supplied, nor will it cover you for the time spent.

'While the points raised here concern the tax effects of insolvency, any tax relief available should not be seen as a substitute for good credit control practices,' says the Loose Leaf Service.