Writing Off Bad Debts in Canada: CRA Rules for Unpaid Invoices

If you run a business or freelance in Canada, you will eventually deal with a client who does not pay. When an invoice becomes uncollectible, the Income Tax Act allows you to deduct it as a bad debt. But the CRA has specific rules about when a debt qualifies and what documentation you need. Getting it wrong can mean a denied deduction on audit.

The Two Mechanisms

The Income Tax Act provides two separate provisions for dealing with unpaid receivables:

1. Reserve for doubtful debts (ITA 20(1)(l)) -- a partial deduction for debts you think might not be collected
2. Bad debt write-off (ITA 20(1)(p)) -- a full deduction for debts you have established are uncollectible

These serve different purposes and can be used together.

Reserve for Doubtful Debts: ITA 20(1)(l)

A reserve lets you deduct a reasonable amount for receivables that you are not confident you will collect, even if you have not given up on them entirely.

When to Use It

• A client is significantly overdue (90+ days) but you are still attempting to collect
• A client is in financial difficulty and you are uncertain whether they can pay
• You have multiple outstanding receivables and historical data suggests a percentage will go unpaid

How It Works

1. At year-end, review your accounts receivable
2. Identify specific receivables that are doubtful
3. Claim a reasonable reserve for those amounts on your T2125
4. The following year, you must include the previous year's reserve back in income (ITA 12(1)(d)), then claim a new reserve if amounts remain doubtful

This creates a rolling adjustment. If the client eventually pays, the reversed reserve adds the income back. If they do not, you move to a full write-off.

What Is "Reasonable"?

The CRA does not prescribe a formula. What qualifies as reasonable depends on the facts: how overdue the debt is, the debtor's financial situation, your collection efforts, and your historical collection rates. A reserve of 100% for a 30-day-old invoice would likely be challenged. A reserve of 50% for a 180-day-old invoice from a client in financial distress is more defensible.

Bad Debt Write-Off: ITA 20(1)(p)

This is the full deduction. You can write off the entire amount of a debt (or the uncollected portion) once it has been established to be bad.

The "Established to Be Bad" Test

This is the critical threshold. The CRA and the courts have established that a debt is "bad" when a reasonable person would conclude the debt is uncollectible. You do not need to prove it is literally impossible to collect -- but you must show you have made genuine efforts and the prospects are bleak.

Factors the CRA considers:

• Age of the debt. The longer it goes unpaid, the stronger the case.
• Collection efforts. Have you sent reminders, made phone calls, sent demand letters, or engaged a collection agency?
• Debtor's financial situation. Are they bankrupt, insolvent, or have they ceased operations?
• Communication. Has the debtor stopped responding?
• History. Is this debtor historically reliable or historically problematic?
• Cost of further pursuit. If the debt is $500 and legal action would cost $2,000, that supports writing it off.

What You Need to Document

Keep a file for each bad debt that includes:

• The original invoice and any contracts
• A record of all collection attempts (emails, letters, phone call dates)
• Any correspondence from the debtor
• Evidence of the debtor's financial situation (bankruptcy notice, news of business closure)
• Your internal decision memo noting when and why you determined the debt was uncollectible
• The date you wrote off the debt in your books

The CRA can ask for all of this on audit. A debt that you simply stopped tracking without any collection effort is likely to be denied.

Recovering Previously Written-Off Debts

Sometimes a client pays months or years after you have written off the debt. Under ITA 12(1)(i), any amount you recover on a previously deducted bad debt must be included in income in the year you receive the payment.

This is straightforward: if you deducted $5,000 as a bad debt in 2024 and the client pays $3,000 in 2026, you include $3,000 in your 2026 income.

GST/HST Bad Debt Adjustment

If you charged GST/HST on the original invoice and the debt has gone bad, you can recover the GST/HST you remitted. This is handled separately from the income tax deduction.

Requirements

Under the Excise Tax Act (section 231), you can claim a bad debt adjustment if:

• You have already accounted for (reported) the GST/HST on a return
• The debt is written off in your books as a bad debt
• The debt has been outstanding for at least 120 days after the day payment was due

How to Claim

Report the adjustment on your GST/HST return (line 107 or the equivalent in your filing software). The amount you recover is the GST/HST fraction of the bad debt.

Example: You invoiced $10,000 + $1,300 HST (13%) = $11,300 total. The client never paid. After writing off the debt, you can claim a $1,300 bad debt adjustment on your GST/HST return.

If the Client Pays Later

If you recover all or part of the debt after claiming the GST/HST adjustment, you must repay the corresponding portion of HST on your next return.

Step-by-Step: Writing Off a Bad Debt

Here is the typical sequence for a self-employed individual:

1. Invoice the client and include the amount in your business income
2. Follow up with payment reminders at 30, 60, and 90 days
3. At year-end (if still unpaid): consider claiming a reserve for doubtful debts on your T2125
4. Continue collection efforts -- send a formal demand letter, consider a collection agency
5. When collection is exhausted: write off the debt in your accounting records
6. On your T2125: deduct the full amount under bad debts (ITA 20(1)(p))
7. On your GST/HST return: claim the bad debt adjustment for the GST/HST portion (if eligible)
8. Keep your documentation file for at least six years

Common Mistakes

Writing Off Too Early

The CRA expects genuine collection efforts. Writing off a 60-day-old invoice without sending a single reminder is unlikely to survive an audit. Give it time and document your attempts.

Not Reversing the Doubtful Debt Reserve

If you claimed a reserve in Year 1, you must include it back in income in Year 2 (and then claim a new reserve if appropriate). Forgetting to reverse creates an under-reporting issue.

Ignoring the GST/HST Adjustment

Many self-employed individuals claim the income tax deduction but forget to recover the GST/HST they already remitted on the unpaid invoice. That is money left on the table.

No Documentation

A bare entry in your accounting software is not enough. The CRA wants to see the trail: invoices, reminders, demand letters, and your reasoning for concluding the debt was bad.

Sources

1. CRA Bad Debts - Business Expenses
2. CRA Income Tax Folio S4-F2-C2 - Bad Debts and Reserves for Doubtful Debts
3. CRA GST/HST Bad Debt Adjustment
4. Income Tax Act, Section 20(1)(l) - Reserve for Doubtful Debts
5. Income Tax Act, Section 20(1)(p) - Bad Debts