• The impact of this case on ATO policy is discussed in Decision Impact Statement: Lean v Commissioner of Taxation (Published 21 September 2010).

LEAN v FC of T

Members:
Emmett J
Edmonds J
Perram J

Tribunal:
Full Federal Court, Sydney

MEDIA NEUTRAL CITATION: [2010] FCAFC 1

Decision date: 28 January 2010

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Emmett J

Introduction

1. This appeal concerns the effect of s 25-45 of the Income Tax Assessment Act 1997 (Cth) ( the 1997 Act ) in relation to the misappropriation of a substantial sum of money belonging to the appellant, Mr David Lean ( the Taxpayer ). The money was misappropriated after the Taxpayer transferred it to a bank in Hong Kong.

2. The Taxpayer ' s assessable income for the year ended 30 June 2002 included a net capital gain. The Taxpayer claimed deductions totalling $ 4,972,671 from his assessable income. The deductions included the sum of $ 3,287,749 in respect of the misappropriation. The respondent, the Commissioner of Taxation ( the Commissioner ), disallowed the deductions and issued a notice of assessment to the Taxpayer dated 12 May 2006. The notice of assessment showed an outstanding tax liability of $ 1,309,196. The Taxpayer objected to the Commissioner ' s assessment, disputing the Commissioner ' s disallowance of the sum of $ 3,287,749. On 28 August 2006, the Commissioner made an objection decision affirming his decision to disallow that sum as a deduction.

3. The Taxpayer then commenced a proceeding in the Administrative Appeals Tribunal ( the Tribunal ), seeking review of the Commissioner ' s objection decision of 28 August 2006. On 20 June 2008, the Tribunal set aside the decision under review. The Tribunal ordered that the matter be remitted to the Commissioner for reconsideration, with the direction that the misappropriation loss claimed by the Taxpayer is, as to the amount of $ 2,315,157, a deduction allowed by s 25-45 of the 1997 Act.

4. The Commissioner then appealed to the Federal Court pursuant to s 44 of the Administrative Appeals Tribunal Act 1975 (Cth), which permits an appeal from a decision of the Tribunal on a question of law. On 14 May 2009, a judge of the Court ordered that the appeal be allowed, that the decision of the Tribunal be set aside and that the Commissioner ' s objection decision of 28 August 2006 be affirmed. The Taxpayer has now appealed to the Full Court from those orders.

The relevant statutory provisions

5. Under s 6-1(1) of the 1997 Act, assessable income consists of ordinary income and statutory income. Section 6-5(1) provides that a taxpayer ' s assessable income includes income according to ordinary concepts, which is called ordinary income . Section 6-10(1) provides that a taxpayer ' s assessable income also includes some amounts that are not ordinary income. Amounts that are not ordinary income, but are included in a taxpayer ' s assessable income by provisions of the 1997 Act about assessable income, are called statutory income . Section 6-15(1) provides that, if an amount is not ordinary income and is not statutory income, it is not assessable income and a taxpayer does not have to pay income tax on that amount.

6. Section 102-5(1) of the 1997 Act provides that a taxpayer ' s assessable income includes the taxpayer ' s net capital gain, if any, for the relevant income year. Thus, net capital gain constitutes statutory income. Net capital gain is worked out as follows:

Step 1	Reduce the capital gains made by the taxpayer during the income year by the capital losses, if any, made during the income year.
Step 2	Apply any previously unapplied net capital losses from earlier income years to reduce the amounts, if any, remaining after the reduction of capital gains under Step 1.
Step 3	Reduce by the discount percentage (in this case 50 % ) each amount of capital gain remaining after Step 2.
Step 4	If any of the taxpayer ' s capital gains qualify for certain concessions, those concessions are applied to each capital gain.
Step 5	The sum of the amounts of capital gains, if any, remaining after Step 4 is the taxpayer ' s net capital gain for the income year.

7. Division 8 of the 1997 Act deals with deductions . Under s 8-1(1), a taxpayer can deduct from the taxpayer ' s assessable income any loss or outgoing to the extent that:

• • it is incurred in gaining or producing the taxpayer ' s assessable income, or
• • it is necessarily incurred in carrying on a business for the purpose of gaining or producing the taxpayer ' s assessable income.

However, a taxpayer cannot deduct a loss or outgoing under s 8-1 to the extent that:

• • it is a loss or outgoing of capital or of a capital nature,
• • it is a loss or outgoing of a private or domestic nature, or
• • a provision of the 1997 Act prevents the taxpayer from deducting it.

A loss or outgoing that a taxpayer can deduct under s 8-1 is called a general deduction . A taxpayer can also deduct from the taxpayer ' s assessable income an amount that a provision of the 1997 Act outside Division 8 allows the taxpayer to deduct. Such an amount is called a specific deduction .

8. Division 25 sets out some amounts that a taxpayer can deduct. However, the general rules about deductions in Division 8 also apply to Division 25. Section 25-45 deals with loss by theft and other means. Section 25-45 provides that a taxpayer can deduct a loss in respect of money if:

• • the taxpayer discovers the loss in the income year,
• • the loss was caused by theft, stealing, embezzlement, larceny, defalcation or misappropriation by the taxpayer ' s employee or agent , and
• • the money was included in the taxpayer ' s assessable income for the income year or for an earlier income year.

The misappropriation

9. In January 2001, the Taxpayer attended a meeting for customers of Metashare International Pty Ltd ( Metashare ), a company that provided research and a share trading system. At the meeting, a Metashare employee informed the Taxpayer of Mr Shayne Heffernan. The Taxpayer was led to believe that Mr Heffernan was a reputable and highly successful securities trader and investment fund manager. In May 2001, the Taxpayer transferred $ 5,000 to a Hong Kong account nominated by Mr Heffernan. The Taxpayer was impressed by Mr Heffernan and the apparent growth of the $ 5,000.

10. As at July 2001, the Taxpayer was the holder of options to acquire shares in Microsoft Inc in the United States. Encouraged by Mr Heffernan to increase his investment, the Taxpayer exercised the options and shares in Microsoft Inc were allotted to him as a consequence of the exercise. He then sold the shares through a United States stockbroker, who received the proceeds of sale. The Taxpayer instructed the US stockbroker to transfer the proceeds of sale of the Microsoft Inc shares to the Hong Kong bank account nominated by Mr Heffernan.

11. While the precise instructions to the US stockbroker are not clear, on 11 July 2001, a transfer of $ AUS517,416 was made to the Hong Kong bank account from the proceeds of the sale of the Microsoft Inc shares. There is no evidence as to the Hong Kong bank to which that money was transferred. However, the Taxpayer received a document called an " E-ceipt " . The E-ceipt stated that the money had been credited to a numbered account in the name of the Taxpayer ' s wife. The E-ceipt was issued in the name of Our World Exchange Limited. Our World Exchange Limited, which is incorporated in Vanuatu, was totally subservient to Mr Heffernan and operated merely at his whim. As such, it was merely Mr Heffernan ' s agent and did not act, in any sense, independently of Mr Heffernan.

12. In August 2001, the Taxpayer attended a seminar in the Philippines conducted by Mr Heffernan. During the course of that seminar, Mr Heffernan offered the Taxpayer a " partnership relationship " in relation to investment of funds and told him that a " private client account " arrangement would be established, which would be a " true partnership " in which all investment decisions would be made jointly. Mr Heffernan promised that such an account would be in the Taxpayer ' s own name and that he would be able to maintain full control of the account. It is unclear whether the Taxpayer had the same understanding as to his relationship with Mr Heffernan at the time he effected the transfer in July 2001.

13. On 24 August 2001, on the basis of the assurances given by Mr Heffernan at the seminar, the Taxpayer instructed his US stockbroker, to transfer $ AUS4,112,898.59 to the Hong Kong bank account from the proceeds of a further sale of Microsoft Inc shares. The Taxpayer received two E-ceipts that stated that the money had been credited to two different numbered accounts in the Taxpayer ' s name and had been deposited to a " private client " account.

14. The Taxpayer regularly discussed with Mr Heffernan trading and other supposed investment activities involving the private client account. He requested documents confirming the details of the transactions, but none was provided and there was no documentary evidence to demonstrate, for example, that the Taxpayer incurred any trading losses in relation to the money he caused to be transferred to the Hong Kong bank account. The Taxpayer thought Mr Heffernan was trading as an agent for him or was in some business arrangement with him but did not ever have any clear understanding of the precise nature of his relationship with Mr Heffernan and Our World Exchange Limited.

15. The Tribunal found that the money sent by the US stockbroker was received in Hong Kong with general instructions that it be held on behalf of the Taxpayer and be applied for authorised investment purposes. However, the Taxpayer did not derive any investment income and could not show that any investment transactions actually occurred.

16. The Tribunal found, from the generality of the proposal discussed between the Taxpayer and Mr Heffernan, and the absence of clear evidence of more limited instructions from the Taxpayer to Mr Heffernan, that the private client account was a means of facilitating any kind of investment opportunity that presented itself and was recommended by Mr Heffernan to the Taxpayer. The Tribunal also found that it was not restricted to ordinary trading activities and was open to participation in capital investment opportunities. The Tribunal found further that the money transferred on 24 August 2001 was an amount that could be resorted to for any of a very wide range of possible investment activities, a range limited only by the subjectivity of Mr Heffernan ' s preferences and assessment of the potential profitability of individual proposals.

17. The Tribunal rejected the view that the transfer of the money to Hong Kong gave rise merely to a debtor and creditor relationship, either with Mr Heffernan or Our World Exchange Limited, that merely gave the Taxpayer a contractual entitlement to share in the growth of the investments that was supposed to be made. The Tribunal concluded that Mr Heffernan and Our World Exchange Limited held the money for the absolute benefit of the Taxpayer and subject to his instructions. The Tribunal concluded that they were, in relation to their custody and control of the Taxpayer ' s private client fund, his agents.

18. The Tribunal characterised the position of Our World Exchange Limited and Mr Heffernan as " custodial agents " in relation to the money, although it is not entirely clear what the Tribunal meant by custodial agent. However, whatever the relationship between the Taxpayer, on the one hand, and Mr Heffernan and Our World Exchange Limited, on the other, was, it is clear that Mr Heffernan had a very wide discretion as to the investments that he could make with the money. Nevertheless, he clearly had no authority to apply the money for his own benefit.

19. The Tribunal found that, as a result of misappropriation by Mr Heffernan, the Taxpayer lost the net balance of the money that the US stockbroker transferred to the Hong Kong bank account. The Tribunal concluded that the money was misappropriated when it was received and that the intention to do so existed from the outset, as did the intention to avoid the return of the money. The Tribunal found that the misappropriation and losses should be regarded as having occurred soon after the money was transferred in August 2001. However, there was no evidence and no finding as to the precise mechanism of the misappropriation by Mr Heffernan.

Application of section 25-45

20. The question in the appeal is whether the money in respect of which the Taxpayer has incurred a loss, being the money that was transferred to Hong Kong and misappropriated, was money that was included in the Taxpayer ' s assessable income. In order to satisfy s 25-45, the money that was misappropriated must be capable of being characterised as the same money that was included in the Taxpayer ' s assessable income. It must be possible to identify the misappropriated money with the money included in the Taxpayer ' s assessable income. The act of a taxpayer in applying money of the taxpayer towards expenses or investment is sufficient to break the necessary connection between money included in the taxpayer ' s assessable income and a subsequent misappropriation. By applying the money towards expenses or investment the taxpayer has received the benefit of the money that was assessable income.

21. Where money that was included in the assessable income of a taxpayer has left the taxpayer ' s hands, there can be no relevant misappropriation of, or in respect of, that money. Money will have left a taxpayer ' s hands where it has been used to pay off that taxpayer ' s debts (see
EHL Burgess Pty Ltd v Federal Commissioner of Taxation 88 ATC 4517 ; (1988) 80 ALR 639 at 647 ). Similarly, where money that was included in the assessable income of a taxpayer is applied by way of investment, the money has left the taxpayer ' s hands, and there can be no relevant misappropriation of or in respect of that money.

22. In the present case, the proceeds of sale of the Microsoft Inc shares, which were received by the Taxpayer, through his US stockbroker, constituted money that was included in the assessable income of the Taxpayer by the operation of s 102-5 of the 1997 Act. While the precise details are not clear, the money was transferred to the Hong Kong bank account and was credited to an account or accounts with Our World Exchange Limited in the name of the Taxpayer. It is clear that the US stockbroker dealt with the proceeds of the sale of the Taxpayer ' s Microsoft Inc shares in accordance with the instructions of the Taxpayer. That is to say, the Taxpayer instructed the US stockbroker to transfer the proceeds to an account with a bank in Hong Kong and the US stockbroker acted in accordance with those instructions. While the particulars of that account are not known, the proceeds of sale were in fact dealt with and applied in accordance with the instructions of the Taxpayer. So far as the Taxpayer was concerned, the money was then available for investment at the direction of Mr Hefferman. The Taxpayer thus received the benefit of the proceeds of sale that constituted assessable income. That money left the Taxpayer ' s hands.

23. Accordingly, the money that was misappropriated from the account in the name of the Taxpayer with Our World Exchange Limited was not the money that had been included in assessable income of the Taxpayer. The primary judge did not err in concluding that the Taxpayer is not entitled to a deduction under s 25-45 in respect of the money that was misappropriated.

24. The Commissioner sought leave to raise, by notice of contention, the possible application of s 51AAA of the Income Tax Assessment Act 1936 (Cth) ( the 1936 Act ). That question had not been ventilated before the Tribunal and had not been raised before the primary judge. The Taxpayer objected to the raising of the question on appeal on several bases. Since the Commissioner sought to raise that matter only if he failed in relation to the primary question of the application of s 25-45, it is unnecessary to deal with the matter.

Conclusion

25. The appeal should be dismissed. The Commissioner does not ask for his costs of the appeal.