Edited version of private ruling

Authorisation Number: 1011509263122

This edited version of your ruling will be published in the public Register of private binding rulings after 28 days from the issue date of the ruling. The attached private rulings fact sheet has more information.

Please check this edited version to be sure that there are no details remaining that you think may allow you to be identified. Contact us at the address given in the fact sheet if you have any concerns.

Ruling

Subject: Misappropriated funds and unsecured deposit notes

1. Are you entitled to deductions for losses arising from the misappropriation of funds by an agent from your trading account?

No.

2. Are you entitled to a deduction for an amount your agent claimed to have used to acquire unsecured deposit notes issued by a company which has entered external administration?

No.

This ruling applies for the following period

1 July 2008 to 30 June 2009

1 July 2009 to 30 June 2010

The scheme commenced on

1 July 2008

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

You are a superannuation fund.

You entered an agreement with Entity A.

Under the agreement the entity:

· provided general advice and dealings in selected securities on your behalf

· established a trading account held on trust for you

· used the trading account funds to purchase securities in your name

· had signatory rights to the trading account, and

· sold securities and deposited the proceeds into your trading account.

Deposits into the trading account consisted of employer superannuation contributions, interest and dividends. The deposits into the trading account form part of your assessable income.

Withdrawals from the trading account included the purchase of securities, payment of BAS and monthly fees.

At times your trading account had a negative balance.

During the year ended 30 June 2009, the entity went into administration and was placed into liquidation a few months later. The director, B, has filed for personal bankruptcy.

You have provided bank statements from the entity. Contact with the liquidators ascertained the balance in the account was nil. You believe B withdrew the funds from your trading account.

You do not expect to receive any funds from the liquidator.

Unsecured deposit notes

The used funds from your trading account to acquire unsecured deposit notes issued by Entity C.

B was the sole director of Entity C.

Whilst you were issued with the unsecured deposit note certificates, you believe that Entity C had no intention of repaying the funds to you.

The notes were shown in your statements of financial position for the 2006-07 and 2007-08 income years as investment assets.

Entity C has entered into administration and you do not expect to receive any funds from the liquidator in relation to these notes.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 25-35

Income Tax Assessment Act 1997 Section 25-45

Income Tax Assessment Act 1997 Section 995-1

Reasons for decision

Summary

A requirement for deductibility under both sections 25-35 and 25-45 of the Income Tax Assessment Act 1997 (ITAA 1997) is that the monies in question must have been included in your assessable income. In your case it is considered that the monies no longer had the character of assessable income and therefore a deduction under these sections is not allowable.

A deduction is also not allowable under section 8-1 of the ITAA 1997 as the losses are considered to be capital in nature.

Detailed reasoning

Deduction as a loss by theft, stealing, embezzlement, larceny, defalcation or misappropriation

Section 25-45 of the ITAA 1997 provides for a deduction for a loss incurred by you through theft, stealing, embezzlement, larceny, defalcation or misappropriation by an employee or your agent. The loss must be in respect of money which has been included in your assessable income and must be discovered in the income year in which the deduction is claimed.

To be able to claim the deduction, the following requirements must be met:

· You must incur a loss - a loss is not the same as an outgoing. A loss is a "residual item arrived at after taking into account all relevant debts and credits" (EHL Burgess Pty Ltd v. FC of T 88 ATC 4517; (1988) 19 ATR 1407). In this case the taxpayer company was stripped of its assets (mainly cash) under a "bottom of the harbour" scheme. It was held that the company simply incurred an outgoing which it chose not to seek to recover because the company, by its directors, concurred in the transaction. Thus, the company did not incur a loss.

· The loss must be in respect of money - The words 'in respect of money' imply more than just the loss of cash. Accordingly, the loss of gold and silver bullion, cheques and other financial instruments are covered by this section.

· The loss must be discovered in the income year in which the deduction is claimed - this requirement implies that the loss must be discovered by a person other than the person(s) responsible for the loss, that is there must be an event separate from the knowledge of those person(s).

· The loss must be caused by theft, stealing, embezzlement, larceny, defalcation or misappropriation - it is not required that your employee or agent be convicted of an offence (of theft, stealing, embezzlement, larceny, defalcation or misappropriation) before you can claim a deduction for the particular loss.

Larceny is the wrongful or fraudulent taking and carrying away of the property of another person without the owner's consent, with the intention of permanently depriving the owner of the property. Theft or stealing catches all types of dishonest appropriation of another's person's property.

Embezzlement consists of the unlawful appropriation by a "clerk or servant" of any property received by him or her for, or on account of, his or her employer.

The chief distinctions between larceny and embezzlement are:

· larceny may be committed by anyone, whereas embezzlement can only be committed by a clerk or servant or a person deemed to be a clerk or servant

· embezzlement occurs in respect of property received by a clerk or servant from a third person for or on account of the employer before the property has passed into the latter's possession, that is before the possession acquired by the clerk or servant has been converted into mere custody on behalf of the employer. A clerk or servant who appropriated to their own use property which the employer had entrusted to the clerk's or servant's custody would be guilty of larceny (or theft) and not embezzlement.

The terms defalcation and misappropriation refer to a fraudulent defalcation or misappropriation and do not refer to a loss brought about by mere negligence or inadvertence. Fraudulent misappropriation, which may be described as the fraudulent conversion or dealing with anything by the person to whom it is entrusted, is neither larceny or embezzlement. Defalcation is a fraudulent deficiency in money matters.

· The theft, stealing, and so on must be by your employee or agent - a loss is not deductible, however, if caused by an individual employed solely for private purposes (for example, a housekeeper or nanny). If the employee concerned is employed only partly for private purposes, the loss may be deductible.

o 'Employee' is not defined in the ITAA 1997 and therefore should have its ordinary meaning. Whether a person is an employee (as opposed to an independent contractor) is a question of fact.

o 'Agent' is defined in section 995-1 of the ITAA 1997 to include, where the taxpayer is outside Australia, any entity in Australia that, for or on behalf of the taxpayer, holds, or has control, receipt or disposal of the taxpayer's money. However, whether a person is an agent of another will usually be a determined in accordance with the general principles of agency law.

· The money must have been included in the taxpayer's assessable income for the income year in which the loss is discovered or an earlier income year - in FC of T v. Lean 2009 ATC 20-102; (2009) 73 ATR 34 (Lean's case) the taxpayer had exercised share options and transferred the profits from such to a Hong Kong bank account nominated by his investment fund manager, H. When he was unable to recover the bulk of his investment the taxpayer sought to deduct $2.8 million (being the amount of assessable income to which the loss related) under section 25-45 of the ITAA 1997 as having been misappropriated by H. The Commissioner argued that once the taxpayer had directed the proceeds of the share sale to be transferred to H for investment in the stock market the money lost its character as income and became part of the capital of the taxpayer. The taxpayer argued that the section did not provide that the money must retain its character as income; rather that it was sufficient to establish that a loss caused by misappropriation by the taxpayer's agent could be traced to money that had been included in assessable income.

At first instance Stone J found that it was necessary but not sufficient for a taxpayer to establish that a loss caused by misappropriation by the taxpayer's agent could be traced to money that had been included in the taxpayer's assessable income. The characterisation must also remain the same. Once money received as income was deployed by the taxpayer, personally or by way of an agent, for expenditure or investment, the characterisation was no longer appropriate and the loss could not be said to have been incurred in respect of money included in assessable income. On appeal the Full Federal Court agreed, saying that the act of the taxpayer in applying their money towards expenses or investment was sufficient to break the necessary connection between money included in the taxpayer's assessable income and a subsequent misappropriation.

Application to your trading account

You entered into an agreement with Entity A to establish a trading account which was used, in part, to purchase securities on your behalf. The agreement appointed Entity A as your agent for operating the trading account and gave Entity A authorisation to withdraw funds from the account. Money deposited into the account formed your assessable income. When Entity A entered liquidation the liquidators advised the balance of your account was nil.

Your situation meets the requirements of section 25-45 of the ITAA 1997 to the extent that:

· you have incurred a loss of money as funds were withdrawn from your bank account by Entity A

· it is accepted that the loss was discovered during the 2008-09 income year when the liquidator was appointed

· the loss was caused by theft, stealing, embezzlement, larceny, defalcation or misappropriation as funds withdrawn were not used for any purpose on your behalf, and

· the loss was caused by B who was your agent.

The funds deposited into your trading account for more than 10 years consisted of employer superannuation contributions, interest, dividends and proceeds from the sale of shares. These deposits all formed part of your assessable income in the year they were received.

However, given that some of the funds were used to purchase shares and other investments and that the account balance fluctuated over the years, including a negative position, we believe that Lean's case applies. That is, the withdrawal of the funds for investment and to pay tax liabilities has changed the character of the funds breaks the connection between money previously included in your assessable income and the subsequent misappropriation.

As such, you have not met all of the requirements of section 25-45 of the ITAA 1997. Therefore, you are not entitled to claim a deduction for the funds removed from your trading account without your permission.

Application to the funds used to acquire unsecured credit notes in a company which has entered administration

As your agent, Entity A used funds from your trading account to acquire unsecured deposit notes issued by Entity C. Entity A and Entity C were both operated by B. Entity C has entered administration. You believe that the deposit note certificates are a sham and Entity C never intended to repay the capital provided. You do not expect to receive any funds from the liquidator in relation to the notes.

In this situation, the requirements of section 25-45 of the ITAA 1997 are not met as it is considered that a loss has not occurred. By their very nature investment in unsecured deposit notes does not guarantee the investor a return of the funds invested. A loss would not be considered to have occurred until the liquidator advises you that you will not receive a return of any of your capital.

Additionally, as discussed above, Lean's case would apply. Whilst the funds deposited into your trading account are characterised as assessable income the use of the funds to acquire the deposit notes removes that characterisation.

Based on the above, you are unable to obtain a deduction under section 25-45 of the ITAA 1997 for the funds invested in unsecured deposit notes as a loss has not occurred. In the event of the liquidator advising there will be no return of the deposit note capital, a loss will not be available under this section as it was not in respect of money included in your assessable income.

As there is no entitlement to a deduction under this provision, we will also examine if you are entitled to a deduction under section 25-35 (bad debts) or section 8-1 (general deduction provision) of the ITAA 1997.

Deduction as a bad debt

Section 25-35 of the ITAA 1997 entitled a taxpayer to deduct a debt that is written off as bad in an income year if:

· it was included in the taxpayer's assessable income for the income year or an earlier income year, or

· it was in respect of money that you lent in the ordinary course of your business lending money.

Similar to section 25-45 of the ITAA 1997, as discussed above, a requirement to obtain a deduction for a bad debt is that the debt formed part of your assessable income in the current or an earlier income year.

Again, Lean's case will apply to your situation in respect of both the trading account and the unsecured deposit notes. Whilst the funds in the trading account were characterised as assessable income when they were deposited, the purchase of securities, the unsecured deposit notes and other investments removed that character.

The second paragraph of section 25-35 of the ITAA 1997 does not apply as you were not in the business of lending money.

No deduction is allowable under section 25-35 of the ITAA 1997 for the funds misappropriated from your trading account or invested in unsecured deposit notes.

Deduction under general provisions

Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income or a provision of the taxation legislation excludes it.

In Charles Moore & Co (WA) Pty Ltd v. Federal Commissioner of Taxation (1956) 95 CLR 344; (1956) 11 ATD 147; (1956) 6 AITR 379 (Charles Moore Case) the High Court suggested that three questions determine the deductibility of losses caused by dishonesty under section 8-1 of the ITAA 1997:

Is the 'occasion of the loss' found in the income earning activities or business operations of the taxpayer?

Is the nature or character of the loss of that 'kind of casualty, mischance or misfortune which is a natural or recognised incident' of the income earning activities or business operations? This was a reference to the comments of Rich J in Commissioner of Taxation v. Ash (1938) 61 CLR 263; 5 ATD 76; (1938) 1 AITR 447 (Ash's Case).

Is the loss one of capital, or of a private, domestic or capital nature?

In the Charles Moore Case, the previous day's takings of the taxpayer's department store were stolen at gunpoint from two employees while on their way to the bank. The High Court allowed a deduction for the loss on the grounds that the act of banking takings was an integral part of the taxpayer's business activities and the risk of robbery was inherent to the act of banking.

In Ash's Case, Chief Justice Latham stated:

... purloinings by office boys and thefts by shop employees should, prima facie, be allowed as deductions. They may be shown to be incidental to, and perhaps inevitable in, the operations which produce income.

But the case is different when income is actually received and then misapplied by the proprietor of a business or a person in the position of such a proprietor, as, for example, the manager of a company.

Application to your trading account

In your situation, the misappropriation of the funds can be found in your income earning activities as you earn your income partly through the investment of the employer contributions received by you.

Misappropriation of investment funds by an investment adviser can be seen as a natural risk to any entity who entrusts a third party to invest funds on their behalf.

The funds in your bank account were not private or domestic in nature.

The Macquarie Dictionary, 2001, rev. 3^rd edn, The Macquarie Library Pty Ltd, NSW includes in the definition of 'capital':

· the wealth, whether in money, property, owned or employed in business by an individual, firm, etc

· an accumulated stock of wealth, and

· any form of wealth employed or capable of being employed in the production of more wealth.

Using the ordinary meaning of 'capital' the funds held in your transaction account would be considered to be capital, in that, they are an accumulated stock of wealth and can be used to produce more wealth. The account is a revenue producing capital asset.

As discussed before, the Commissioner considers the funds in the trading account no longer possess the character of assessable income. Instead, they have become capital in nature as they were used to produce additional wealth in the form of interest, dividends and gains on the sale of securities.

Since the funds are considered capital in nature, no deduction is allowable for their misappropriation under section 8-1 of the ITAA 1997.

Application to the funds used to acquire unsecured credit notes in a company which has entered administration

You acquired unsecured deposit notes issued by Entity C. As they have entered administration you do not expect to be repaid the principal amount.

As discussed above, the funds used to purchase the unsecured deposit notes are an item of capital and you did not make the loan in the course of carrying out a business of making loans. Therefore, no deduction is allowable under section 8-1 of the ITAA 1997.