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Ruling

Subject: Income Tax: Deduction - Loss by Theft

Question 1

Is the taxpayer eligible to claim deduction for the loss of theft by an employee that was discovered during the financial year ended 30 June 2xxx under section 25-45 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

This ruling applies for the following period

Financial year ended 30 June 2011

The scheme commenced on

1 July 2010

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.

The taxpayer is a trust which operates a business.

In the particular income year, the taxpayer became aware of embezzlement from the trust fund by a joint employee of the trust.

The embezzlement has been carried on by the employee on several occasions over approximately a twelve month period. The method used by the employee to carry out the theft was through money transfer and withdrawal from the account.

The embezzlement was discovered in the particular income year.

The employee who embezzled the funds was paid a salary for each of the preceding numerous income years and was responsible for the day to day operations of the business and trust.

This employee was also at the time one of X directors and shareholders in the trustee company of the trust.

The trust had no other source of funds entering its accounts other than assessable income, i.e. there were no loans or capital contributed amounts from which the embezzled money could be said to have been taken from,

The trust failed to recover the money from the employee as they lost the money in lifestyle pursuits.

An insurance payment being the limit of liability insurance for Employee Theft was received.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 20-20

Income Tax Assessment Act 1997 section 20-35

Income Tax Assessment Act 1997 section 25-45

Reasons for decision

Summary

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

In this case the trust made a loss of more than $Y million due to embezzlement by the employee in respect of money which has been included in their assessable income and it was discovered during the financial year ended 30 June 2011. Therefore, the trusts are eligible to claim deduction under section 25-45 of the ITAA 1997 for the amount of loss that the trust incurred.

Further, where a deduction has been allowed, or is allowable under section 25-45 of the ITAA1997 in respect of a loss, any amount received as recoupment of the loss, whether by way of insurance, indemnity, recovery or otherwise, is assessable under section 20-20 of the ITAA 1997.

Detailed reasoning

Section 25-45 of the ITAA 1997 provides:

You can deduct a loss in respect of money if:

(a) you discover the loss in the income year; and

(b) the loss was caused by theft, stealing, embezzlement, larceny, defalcation or misappropriation by your employee or 'agent' (other than an individual you employ solely for private purposes); and

(c) the money was included in your assessable income for the income year, or for an earlier income year.

Note: If you receive an amount as recoupment of the loss, the amount may be included in your assessable income: see Subdivision 20-A.

Therefore, for the taxpayers to claim under section 25-45 of the ITAA 1997 to succeed it needs to satisfy each of the following requirements:

(1)  the taxpayer must incur a loss.

(2)  the loss must be in respect of money

(3)  the loss must be discovered in the income year in which the deduction is claimed

(4)  the loss must be caused by theft, stealing, embezzlement, larceny, defalcation or misappropriation

(5) the theft, stealing, embezzlement, larceny, defalcation or misappropriation must be by an employee or agent of the taxpayer

(6) the money must have been included in the taxpayers assessable income for the income year in which the loss is discovered or an earlier year

(1) The taxpayer must incur a loss.

A loss is not the same thing as an outgoing. A loss is a "residual item arrived at after taking into account all relevant debits and credits": EHL Burgess Pty Ltd v FC of T 88 ATC 4517, at 4524. In EHL Burgess's case, where the taxpayer company stripped of its assets (mainly cash) under a "bottom of the harbour" scheme, 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. Similarly, there is no loss if the taxpayer receives the misappropriated money back in full: e.g. Case M9, 80 ATC 66.

In this case the taxpayer incurred a loss as the employee embezzled the money from bank accounts. Also, the trustee has not recovered any amount from the employee because the employee spent the money on lifestyle pursuits.

(2) The loss must be in respect of money.

A loss of cash is covered by section 25-45 of the ITAA 1997. However, 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 should be covered by the section.

The employee of the trust not only transferred money from the trusts but also from related trusts to cover up the embezzlement. The trust incurred a loss as theft of money. It is not an outgoing that is incurred in the course of gaining or producing assessable income.

(3) 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, i.e. there must be an event separate from the knowledge of those person(s): EHL Burgess's case, at pp 4523 to 4524 - there is no substantial difference in the requirement of the old law (considered in that case) that the loss be "ascertained" in the relevant income year and the requirement of the new law that the loss be "discovered" in the relevant income year.

The facts of this ruling indicate that the loss was ascertained in the relevant income year after their bank informed one of the trustees that the amounts were being transferred from the account by the employee.

(4) The loss must be caused by theft, stealing, embezzlement, larceny, defalcation or misappropriation.

These are technical terms which cover a variety of common law and statutory offences dealing with the dishonest appropriation of another person's property. In the absence of any contrary intention, these technical terms must be given their technical meaning: Pemsell v. Special Commissioners of Income Tax (1891) AC 531; (1891) 3 TC 53.

Each State and Territory jurisdiction has different offences. New South Wales, for instance, has retained the common law offence of larceny, which is the wrongful or fraudulent taking of another person's property without the owners' consent, with the intention of permanently depriving the owner of the property. There are also a number of statutory offences, such as stealing, to supplement the offence of larceny (for example, the Crimes Act 1900 (NSW), sections 134 to 138).

In other states, there is generally a single statutory offence of theft or stealing which catches all types of dishonest appropriation of another's property, including the conduct which constitutes larceny in New South Wales (for example, the Crimes Act 1958 (Vic), sections 72 to 73).

Embezzlement, which is a statutory offence, involves the unlawful appropriation by a clerk or servant of any property received by him/her for, or on account of, their employer (for example, the Crimes Act 1900 (NSW) section 157). In other jurisdictions, embezzlement falls within the offence of theft or stealing.

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: EHL Burgess's case at p 4521. 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 nor embezzlement (for example, the Crimes Act 1900 (NSW), section 178A). Defalcation is a fraudulent deficiency in money matters.

The cause of the loss is due to the embezzlement of funds by the employee for the previous X income years. The employee who held a particular role of a business manager and was paid a salary of $X per annum.

(5) The theft, stealing, embezzlement, larceny, defalcation or misappropriation must be by an employee or agent of the taxpayer.

A loss is not deductible, if caused by an individual employed solely for private purposes (e.g. housekeeper or nanny). If the employee concerned is employed only partly for private purposes, the loss may be deductible.

"Employee" is not defined in the ITAA 1997 and therefore should have its ordinary meaning - the term is not synonymous with the term "PAYE earner" (as defined in section 995-1 of the ITAA 1997). Whether a person is an employee (as opposed to an independent contractor) is a question of fact.

"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 determined in accordance with the general principles of agency law.

An independent contractor is clearly not an employee for the purposes of section 25-45 of the ITAA 1997 and therefore any loss caused by theft, stealing, etc, by an independent contractor will only be covered by the section if, in the particular circumstances, the independent contractor is an agent of the taxpayer.

A loss caused by the board of directors of a company acting as the mind and will of the company is not a loss resulting from the actions of an employee or agent and is therefore not deductible under section 25-45 of the ITAA 1997. This was established by EHL Burgess's case, where the Full Federal Court considered a transaction whereby a company's assets were transferred to another company under a "bottom of the harbour" scheme. The scheme involved the appointment of new directors to carry out the transaction. The Court rejected the allegation that the new directors had fraudulently taken or misappropriated the assets of the company and held that the company was not entitled to a deduction under section 71 of the ITAA 1936. The Court noted (at p 4253) that the section "distinguishes between events that constitute acts of a taxpayer company by reason of being events in which the directors and/or shareholders join, and a misappropriation which is merely that of an employee or agent of the company".

A misappropriation by an individual director, who is an employee or agent of the company, and who is not acting as the mind and will of the company, may fall within the terms of section 25-45 of the ITAA 1997.

Section 25-45 of the ITAA 1997 does not require that an employee or agent of the taxpayer be convicted of an offence (of theft, stealing, embezzlement, larceny, defalcation or misappropriation) before the taxpayer can claim a deduction for the particular loss. However, such a conviction will effectively substantiate the deduction to be allowed.

The facts indicate that the employee/director of the trust embezzled funds from the bank accounts and transferred funds from one account to other to cover up the situation.

(6) 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 EHL Burgess's case, it was contended that as the transfer of the company's assets under the "bottom of the harbour" scheme was a misappropriation of the whole of the assets of the company, it must have comprehended a misappropriation of the income that had been derived and was included in the company's assessable income. The Full Federal Court rejected this contention as there was no evidence which traced the funds alleged to have been misappropriated back to income that had been derived by the company and had been, or was to be, included in its assessable income.

The Court said (at p 4524) that there must be a "tracing of moneys so that what has been misappropriated can be identified with that which has been or is included in the assessable income". The Court continued:

If income, when received, has been used to pay off the taxpayer's debts and so has left the taxpayer's hands, there can be no misappropriation of or in respect of that money. The benefits arising from the reduction in the liabilities of the taxpayer cannot be the subject of a relevant misappropriation. Likewise, income which has been or is to be included in assessable income of a taxpayer, but has been dealt with in such a way that it has become mingled generally in the finances of the taxpayer and can no longer be traced or identified as income of that description, cannot be the subject of a sec 71 deduction.

The facts indicate that the trust had no other source of funds entering its accounts other than assessable income, i.e. there were no loans or capital contributed amounts from which the embezzled money could be said to have been taken from,

The related trust sold an asset and was assessed on the capital gain made. In all other years it recovered and was assessed on its rental income from its properties.

The proceeds from the sale of the asset created the cash availability from which the embezzled funds were taken.

Accordingly, the money was included in the trusts' assessable income for the previous income years.

The above analysis conforms that the trust made a loss on embezzlement by the employee during the relevant financial year. Therefore, the trust is eligible to claim deduction for the amount of loss that each trust incurred.

Assessable recoupment

Further, where a deduction has been allowed, or is allowable under section 25-45 of the ITAA 1997 in respect of a loss, any amount received as recoupment of the loss, whether by way of insurance, indemnity, recovery or otherwise, is assessable under section 20-20 of the ITAA 1997.

The assessable recoupment is included in the assessable income of the trusts in the year of receipts to the extent it does not exceed the loss or outgoing under section 20-35 of the ITAA 1997. Where the recoupment is received before the income year of a deduction, the assessable recoupment is treated as having been received in the deduction year, subsection 25-35(3) of the ITAA 1997.

In this case the facts indicate that the trust received an insurance claim the payment is considered as assessable recoupment and is assessable to the trust for the subsequent income year.

Does Part IVA, or any other anti-avoidance provision, apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA, go to our website www.ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: Part IVA: the general anti-avoidance rule for income tax.