Edited version of your private ruling

Authorisation Number: 1012424926741

Ruling

Subject: The deductibility of investment losses from fraud

Question 1

Are you entitled to a deduction for the loss of funds that were misappropriated?

Answer

No.

Question 2

Are you entitled to a capital loss for the misappropriated funds?

Answer

Yes.

Question 3

Are you entitled to a deduction for legal fees incurred while attempting to recover misappropriated funds?

Answer

No.

Question 4

Can the legal costs incurred, while attempting to recover misappropriated funds, be included as a part of the cost base for capital gains tax purposes?

Answer

Yes.

This ruling applies for the following periods:

Year ended 30 June 2012

Year ended 30 June 2013

The scheme commences on:

1 July 2011

Relevant facts and circumstances

You were introduced an individual who convinced you to borrow funds to advance to him to 'invest in your future'.

You did not know the individual.

You borrowed a substantial amount of money from a financial institution in your name only, and advanced the funds to the individual to invest in a number of investments.

Despite repeated requests for the return of the capital you invested, you have only had a small portion of the funds returned to you.

You engaged a solicitor who has been unable to locate the individual or other involved parties. They have advised that further investigation by them is unlikely to result in recovery or return of the funds invested.

A substantial period of time has elapsed since you last had any communication with the individual.

You referred the matter to the Australian Securities and Investments Commission (ASIC). However they decided not to investigate your report of misconduct at that point in time, and advised that further legal action was likely to be the main avenue available to you to attempt to get a resolution to the matter.

After numerous and frequent requests, you have never received a share certificate or contract listing you as an interested party to any of the investments with the individual. You have in your possession an incomplete share transfer relating to an unrelated company, and the connection of that document with any of your investments is unclear.

You now believe that you are a victim of fraud by the individual, as he has "duped" you out of your money and there is no prospect of having it returned to you.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 102-20

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Paragraph 108-5(1)(b)

Income Tax Assessment Act 1997 Section 108-20

Income Tax Assessment Act 1997 Section 110-25

Income Tax Assessment Act 1997 Subsection 110-35(2)

Reasons for decision

Summary

Deduction for the loss of funds

Deductibility as a general deduction

The debt is not considered to be incurred in the gaining or producing of your assessable income. Further as the loss relates to contractual rights or capital purchases, the loss is of a capital nature and is therefore not deductible.

Capital Gains Tax consequences

The contractual arrangement with the individual is considered a CGT asset.

As a substantial period of time has passed with non-action from either party, and you are no longer going to pursue the recovery of your funds, it is considered that the contract has been abandoned with the effect that your rights under the contract cease. Therefore a CGT event C2 has occurred, resulting in a capital loss which can be offset against a capital gain made in this or a subsequent financial year.

Legal expenses

Deductibility as a general deduction

The legal fees were incurred by you in your capacity as an investor with the object of recovering invested capital. As such, the legal expenses are of a capital nature and are not deductible.

Capital Gains Tax consequences

The second element of the cost base comprises of incidental costs an entity incurs in relation to a CGT asset, such as costs incurred for the services of a legal adviser. Therefore these costs should be included in the second element of the cost base.

Detailed reasoning

Deductibility as a general deduction

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for expenditure to the extent that it is incurred in the gaining or producing of assessable income, or in the carrying on of a business to gain or produce assessable income. No deduction is allowable to the extent that the expenditure is private, domestic or capital in nature.

The funds that were lost were to be used to purchase capital assets. Therefore the loss of these funds retains its capital nature. As such, no deduction is allowable under section 8-1 of the ITAA 1997.

Capital Gains Tax (CGT) implications

Whilst the loss of your funds are not an allowable deduction under section 8-1 of the ITAA 1997, the amount of the loss may be included in the capital loss calculations.

Section 102-20 of the ITAA 1997 provides that a capital gain or loss can only arise when a capital event occurs in respect of a capital asset.

As a result of you entering into the contractual arrangement with the individual, it is considered that you acquired contractual rights. These contractual rights are CGT assets for the purposes of paragraph 108-5(1)(b) of the ITAA 1997.

Section 104-25 of the ITAA 1997 provides that a CGT event C2 happens if your ownership of a CGT asset ends by the asset being abandoned, surrendered or forfeited.

In DTR Nominees Pty Ltd v. Mona Homes Pty Ltd (1978) 138 CLR 423; [1978] HCA 12 it was recognised that a contract can come to an end merely by being treated as being at an end by the parties. It was held in Fitzgerald v. Masters (1956) 95 CLR 420 at 432 that:

Where an inordinate length of time has been allowed to elapse, during which neither party has attempted to perform, or called on the other to perform, it may be inferred that the contract has been abandoned. What is really inferred in such a case is that the contract has been discharged by agreement, each party being entitled to assume from a long-continued ignoring of the contract on both sides that (in the words of Rowlatt J.) the matter is off altogether.

In your situation, a large amount of time has elapsed since you last had any communication with the individual. In addition, your attempts to contact the individual through your solicitor have been unsuccessful. The individual has made no attempt to perform their part of the contract and you have determined you were the victim of a fraud.

As a substantial period of time has passed with non-action from either party, you have reported your experience to the authorities for investigation of fraud, and you are no longer going to pursue the recovery of your funds because the individual cannot be found, it is considered that the contract has been abandoned with the effect that your rights under the contract cease. Therefore a CGT event C2 in section 104-25 of the ITAA 1997 has occurred, resulting in a capital loss which can be offset against a capital gain made in this or a subsequent financial year.

The cost base for the debt is the amount of the debt (section 110-25 of the ITAA 1997).

Legal expenses

Deductibility as a general deduction

In determining whether a deduction for legal expenses is allowable under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered (Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 3 AITR 436; (1946) 8 ATD 190). The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses. If the advantage to be gained is of a capital nature, then the expenses incurred in gaining the advantage will also be of a capital nature.

Where the legal expenses arise as a consequence of the day to day activities of a business, the object of the expenditure is devoted towards a revenue end and the legal expenses are deductible (Herald & Weekly Times v FC of T 48 CLR 113; 2 ATD 169). Where, however, the expenditure is devoted towards a structural rather than operational purpose, the expenditure is of a capital nature and the expenses are not deductible (Sun Newspapers Ltd v FC of T (1938) 61 CLR 337; 5 ATD 87).

In your case, you incurred legal expenses to attempt to recover money misappropriated by the individual responsible for your investments. As such, the legal expenses are of a capital nature and are not deductible under section 8-1 of the ITAA 1997.

CGT consequences

Whilst the legal expenses are not an allowable deduction under section 8-1 of the ITAA 1997, the legal expenses may be included in the capital loss calculations.

The cost base and reduced cost base of a CGT asset each consist of five elements. The second element of the cost base and reduced cost base each comprise of incidental costs an entity incurs to acquire a CGT asset or that relate to a CGT event. The term 'incidental costs' is defined in subsection 110-35(2) of the ITAA 1997 to include remuneration for the services of a legal adviser.

In your case, you incurred legal expenses in seeking advice to establish your rights in relation to the funds on-lent to the individual, while attempting to recover your initial investment (a capital amount). Therefore these costs should be included in the second element of your cost base. There is no requirement that the calculation of the cost base be limited to expenditure incurred before the time of disposal (CGT Determination Number 23 TD 23).