One of the IRA’s (Internal Revenue Service) stipulations under Section 61 is on canceled debts. Accordingly, in the event that a debt is forgiven, canceled, or discharged for an amount less than the one initially agreed to be paid upon, such an amount must be reported as income for taxation. This type of income should not be taxed due to a variety of reasons. First, the law does not account for the reasons behind such cancellation. Usually, businesses, which are the prime affected parties by this law, allow for doubtful debts in their books of accounts. The law permits bad debts as deductible expenditure. However, there is no certainty that such liabilities will be unrecoverable eventually. It follows, therefore, that taxing the party from whom the amount is relieved is unreasonable and unfair. Also, the complexity of doubtful debts makes them relatively difficult to audit and substantiate. In effect, this may lead to double-taxation instances.
The change in the policy effectively holds the elements of taxation proposed by Adam Smith in 1776. Smith suggested four principles – certainty, fairness, efficiency, and convenience – all of which influence taxpayers’ attitudes toward paying taxes. Not only is relieving individuals from taxes on income earned when their debts are canceled but also convenient. Also, doing the contrary – levying forgiven debts – is subject to complexities and uncertainty, which is against the principle of certainty as opined by Smith.
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In consequence, individuals whose debts have been canceled will enjoy the exemption. It is worth noting that companies may also benefit from the amendment since they engage in credit transactions. One of the unintended consequences of the change in policy is a rise in tax evasion schemes devised to be perceived as merely tax avoidance (which is legal). Individuals or firms may claim to be bankrupt to be relieved of debts and still be exempted from taxation as such income would not be taxable.
