Introduction

Unpaid invoices are a reality of professional practice. For a law firm that has rendered services over several months, issued a large final invoice, and then faced a client dispute or non-payment, the tax and HST consequences of the unpaid amount interact with the firm's income recognition — and require specific steps to ensure the firm is not paying tax on income it never collected.

Scenario: Hollander LLP Invoices $85,000 and the Client Refuses to Pay

Hollander LLP, a boutique litigation firm, completes a complex commercial dispute matter and issues a final invoice of $85,000 plus $11,050 HST — total $96,050. The client, disputing the outcome of the case, refuses to pay and responds with a demand letter threatening a fee complaint to the LSO.

The matter is referred to collections. By year end, no payment has been received and counsel believes the amount is unlikely to be recovered in full without litigation.

The Income Recognition Problem

Hollander LLP is on the billed basis of accounting (as discussed in Article 44). Income was recognised when the invoice was issued. The $85,000 was included in the firm's revenue for the year, and the partners were allocated their shares of that income — paying personal tax on income they never received in cash.

This is not unique to law — any accrual-basis business faces this problem. The tax system provides two mechanisms to address it:

Reserve for doubtful accounts (section 20(1)(l)): In the year the invoice is outstanding and collection is in doubt, the firm can deduct a reserve equal to the amount expected to be uncollectable. The reserve reduces income in the current year but must be brought back into income in the following year (and a new reserve established if the debt is still outstanding).

Bad debt deduction (section 20(1)(p)): In the year a debt is established to be uncollectable — written off in the books, with reasonable grounds for concluding collection will not occur — the full amount is deductible as a bad debt expense.

The distinction matters: a reserve is a temporary deferral (the income comes back into the following year unless written off or collected); a bad debt deduction is a permanent deduction in the year of write-off.

The HST Recovery

When Hollander issued the invoice, it was required to collect and remit $11,050 HST. If the invoice is never paid, the firm has remitted HST to the CRA on a supply it was never compensated for.

Under section 231 of the Excise Tax Act, a registrant who has included an amount in net tax (remitted HST on a supply) and subsequently establishes that the amount has become a bad debt may deduct the HST amount from net tax in the reporting period in which the bad debt is written off.

The conditions: the full amount must previously have been included in net tax, the amount must have been written off as a bad debt in the books, and the amount must be genuinely uncollectable. The adjustment is claimed on the HST return for the period in which the write-off occurs.

For Hollander, the $11,050 HST recovery is claimed on the HST return for the period in which the $85,000 is written off as a bad debt. This requires formal write-off in the firm's books — not just an internal note that the invoice is disputed.

What If the Debt Is Recovered Later?

If Hollander subsequently collects all or part of the debt — perhaps through litigation that is ultimately successful — the bad debt deduction and HST adjustment must be partially reversed. The recovered amount is included in income in the year of recovery. The HST previously recovered from the CRA must be remitted on the portion collected.

This reversal requirement means that writing off a bad debt is not irreversible — if the money arrives later, the tax position is recalibrated.

When to Speak With a CPA

For law firms with significant outstanding accounts at year end — particularly where specific invoices have been outstanding for more than 90 days with no payment arrangement — a year-end review of the reserve for doubtful accounts and the formal bad debt write-off process ensures the tax and HST consequences are correctly managed.

Rotaru CPA works with law firms on income recognition, bad debt management, and HST compliance. Book a consultation to review your firm's receivables position at year end.