Edited version of your written advice

Authorisation Number: 1012673212754

Ruling

Subject: Business - deductions - misappropriated funds repaid to client

Questions

1. Are you entitled to a deduction for replacing misappropriated funds to a client?

Answer:

Yes.

2. Are you entitled to a deduction for the interest on the loans taken out to replace misappropriated funds to a client?

Answer:

Yes.

This ruling applies for the following periods:

Year ended 30 June 2014

Year ending 30 June 2015

Year ending 30 June 2016

Year ending 30 June 2017

Year ending 30 June 2018

The scheme commences on:

1 July 2013

Relevant facts and circumstances

You operated a business. You employed your spouse in the business.

You and your spouse later separated.

Your ex-spouse continued to work for you until they found employment elsewhere.

Your ex-spouse took most of the clients with them to their new employment, and you maintained the business to keep the small number of clients that remained with you.

A number of years later, it was found that your ex-spouse had been depositing money from a client into an old bank account of the business without your knowledge. Instead of forwarding the client's funds to pay their bills, the funds were misappropriated and used to fund a gambling addiction.

You and your client went to the police with the information. However you decided to avoid police action as you were informed that it would involve freezing all of your assets and it would take three to four years to resolve the issue. This was not a viable option for you.

You opted to repay the misappropriated funds to the client to avoid litigation.

You initially sold off some assets to repay the client. You were not able to raise enough funds to repay the client this way, so you took out a number of loans to fund the balance of the money owed.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for a loss or outgoing 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. However, no deduction is allowable to the extent that the expenditure is private, domestic or capital in nature.

ATO Interpretative Decision ATO ID 2010/207 discusses whether a reimbursement to a trust account for stolen trust monies would be an allowable deduction. In this case, the taxpayer was operating a real estate agency and where a safe containing cash held on trust was stolen.

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) the High Court held that, as the daily banking of takings by a department store was an ordinary part of its income-producing activities, the loss of the takings by armed robbery en route to the bank was deductible as a loss incurred in gaining or producing assessable income. The Court referred to the following statement by Rich J in Commissioner of Taxation (NSW) v. Ash (1938) 61 CLR 263 at 277; (1938) 5 ATD 76; (1938) 1 AITR 447:

There is no difficulty in understanding the view that involuntary outgoings and unforeseen or unavoidable losses should be allowed as deductions when they represent that kind of casualty, mischance or misfortune which is a natural or recognized incident of a particular trade or business the profits of which are in question. These are characteristic incidents of the systematic exercise of a trade or the pursuit of a vocation.

The Court in Charles Moore held (at CLR 351) that the loss was not on capital account: 'we are here dealing with a loss incurred in an operation of business concerned with the regular inflow of revenue, not with a loss of or concerning part of the "profit yielding subject".'

The use of a trust by the real estate agency to hold monies belonging to clients is an ordinary part of the business operations of a real estate business. Whilst the monies were not the property of the real estate agency, their loss by theft required the real estate agency to make good the loss, in keeping with its obligations to clients under the trust. Such a reimbursement to the trust was 'a natural or recognized incident' of the real estate business and constituted a loss incurred in gaining or producing its assessable income or, alternatively, necessarily incurred in carrying on a business for the purpose of gaining or producing its assessable income.

For the same reasons as given by the Court in Charles Moore, the loss of the trust monies was not a loss of capital or of a capital nature to the real estate agency.

The loss to the taxpayer represented by the reimbursement to the trust was therefore deductible under section 8-1 of the ITAA 1997.

In your case, we can liken your situation to that contained in ATO ID 2010/207. The money that was taken from your business account was being held to pay the client's bills. It was not your money, but you were required to replace the funds in keeping with your obligations to the client.

Therefore, you will be entitled to a deduction for the money you repaid to the client to replace their lost funds, in the year in which you made the repayment.

You will also be entitled to a deduction for the interest on the loans you took out to repay the client, to the extent that the loans were used for this purpose. That is, if the loans were not solely used to repay the client, then you will be required to apportion the interest accordingly.