Edited version of your written advice

Authorisation Number: 1051334935702

Date of advice: 12 February 2018

Ruling

Subject: Tax treatment of proceeds from illegal activities

Question 1

Are the proceeds of their business included in the assessable income of the Taxpayers in respect of the Y income year pursuant to subsection 6-5(2) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Are the Taxpayers entitled to a deduction pursuant to section 25-45 or section 8-1 of the ITAA 1997 for the Y income year in respect of amounts confiscated and forfeited to the Commonwealth?

Answer

No. However, where the proceeds of the business were included in the assessable income of the Taxpayers for the Y income year, any amounts confiscated and forfeited to the Commonwealth that formed part of the assessable income may be excluded from the assessable income.

This is subject to the amendment and objection provisions set out respectively in section 170 of the Income Tax Assessment Act 1936 (ITAA 1936) and the Taxation Administration Act 1953 (TAA).

Relevant facts and circumstances

The small business Taxpayer Company and Taxpayer Trust (‘Taxpayers’) carried on a business in the Y income year.

The Taxpayers received income regularly from the business.

During the course of the Y income year, the business was found to be an illegal activity and the proceeds from the business were confiscated by the relevant authority on the basis of suspected crime against Commonwealth law, and forfeited to the Commonwealth.

The confiscated funds were included in the assessable income of the Taxpayers in their tax returns for the Y income year.

Further, the Taxpayers claimed a deduction in respect of the confiscated amounts in their tax returns for the Y income year.

Relevant legislative provisions

Income Tax Assessment Act 1997: Subsection 6-5(2):

Income Tax Assessment Act 1997: Section 8-1

Income Tax Assessment Act 1997: Section 25-45

Income Tax Assessment Act 1936: Subsection 51(1):

Reasons for decision

Question 1

Summary

The cash and assets confiscated by the relevant authority represent earnings of the Taxpayers from illegal activities. The Taxpayers systematically engaged in the illegal activities which had the requisites of regularity and organisation of that of a business carried on with a view to profit.

Consequently, in accordance with the Commissioner’s view in Taxation Ruling TR 93/25 and subsequent court decisions, it is considered that income derived by the Taxpayers from carrying on an illegal business is assessable income of the entities for the relevant income years pursuant to section 6-5 of the ITAA 1997.

Detailed reasoning

Income Tax Assessment Act 1997

Assessable income

Are receipts of an illegal business assessable income?

Section 6-5: Income according to ordinary concepts (ordinary income)

(1) Your assessable income includes income according to ordinary concepts, which is called ordinary income

(2) If you are an Australian resident, your assessable income includes the ordinary income you derived directly or indirectly from all sources, whether in or out of Australia, during the income year.

For the purposes of subsection 6-5(1), there is no specific guidance on what is meant by ‘ordinary concepts’. The extensive case law on the topic has identified various factors which may be relevant in determining whether an amount is income according to ordinary concepts.

These include:

● whether the amount has the characteristics of periodicity, recurrence or regularity

● whether it is convertible into money or money's worth

● whether it is associated with business activities or services rendered, as distinct from the mere sale of property, and

● whether it is solicited, as distinct from a windfall.

In the decision of Commissioner of Taxation v La Rosa [2003] FCAFC 125 (5 June 2003); 2003 ATC 4510 (‘the La Rosa case’), the Full Federal Court of Australia (per Carr, Merkel and Hely JJ), considered the assessability of income derived by the taxpayer from carrying on a business of dealing in drugs. They consulted various overseas case law authorities and concluded that in determining whether the proceeds of a business are assessable for income tax, the Income Tax Assessment Act 1936 (ITAA 1936) and the ITAA 1997 do not differentiate between income derived from legal and illegal business activities.

Relevantly, Taxation Ruling TR 93/25 (TR 93/25) sets out the Commissioner’s views on the assessability of proceeds from illegal activities.

The term ‘illegal activities’ is defined at paragraph 2 of TR 93/25 to mean any activity not permitted by law such as drug dealing, insider trading, misappropriation, SP bookmaking etc.

At paragraph 9, TR 93/25 provides that, where a taxpayer systematically engages in an illegal activity and the elements of a business, such as repetition, regularity, view to a profit and organisation are present, the proceeds from the activity have an income character.

In the present circumstances, the Taxpayers carried on a business in the Y income year. The business was found to be an illegal activity and the proceeds from the business were confiscated by the relevant authority on the basis of suspected crime against Commonwealth law, and forfeited to the Commonwealth.

The business carried on by the Taxpayers would constitute an ‘illegal activity’, pursuant to action taken by the relevant authority, for the purposes of the definition of that term in TR 93/25.

The Taxpayers received income regularly from the business subsequently found to be an illegal activity.

It is considered that the Taxpayers systematically engaged in illegal activities which had the requisites of a business such as regularity and organisation with a view to profit.

Consequently, in accordance with the Commissioner’s view in TR 93/25 and the principles set out in the La Rosa case, income derived by the Taxpayers is assessable income for the Y income year. The fact that the income from the business represented proceeds of illegal activities does not detract from the conclusion that the income is assessable income of the Taxpayers.

Questions 2

Summary

Treatment of Amounts Recovered or Repaid

In accordance with the Commissioner’s view in TR 93/25, the Taxpayers are entitled to amend their income tax returns to exclude the confiscated amounts from their assessable income. This is subject to the amendment and objection provisions set out respectively in section 170 of the ITAA 1936 and the TAA.

General deduction

The amounts confiscated and forfeited to the Commonwealth are not a loss or outgoing incurred in the course of deriving assessable income of the Taxpayers, and therefore would not be treated as a deductible expense under section 8-1 of the ITAA 1997.

Specific deduction

Section 25-45 of the ITAA 1997, which only allows a deduction for a loss incurred by a taxpayer through theft, stealing, embezzlement, larceny, defalcation or misappropriation by an employee or agent of the taxpayer, cannot apply in the present circumstances.

In conclusion, a deduction is not allowable under either section 8-1 or section 25-45 of the ITAA 1997 for moneys confiscated and forfeited to the Commonwealth from the business proceeds of the Taxpayers in respect of the Y income year.

Detailed reasoning

Treatment of Amounts Recovered or Repaid

The Commissioner’s views on the income tax treatment of amounts recovered from the proceeds of illegal activities which have been subject to income taxes are expressed in TR 93/25.

Relevantly, paragraphs 13-15 of TR 93/25 provide:

In circumstances where amounts are recovered or repaid a strict application of the law may lead to the unfair situation where the Commissioner is seeking tax in respect of amounts that have been repaid. The general approach has been to use the objection and amendment provisions in the law, subject to the statutory time limits in those provisions, to exclude the amount repaid from the assessable income of the year in which the proceeds from the illegal activity were taxed.

In the present circumstances, funds confiscated from the proceeds of their business were returned as assessable income of the Taxpayers in the Y income year.

Therefore, the Taxpayers are entitled to amend their income tax returns in respect of the Y income year to exclude the confiscated amounts from their assessable income. Any deductions claimed in the Taxpayers’ income tax returns in respect of the confiscated amounts must be excluded. This is subject to the amendment and objection provisions set out respectively in section 170 of the ITAA 1936 and the TAA.

Deductibility of confiscated amounts

As the confiscated amounts would be excluded from the Taxpayers’ assessable income in the Y income year, the confiscated amounts would not be treated as a deductible expense to the Taxpayers.

Section 8-1 has no application in the present circumstances, as the confiscated amounts are not a loss or outgoing incurred by the Taxpayers.

Section 25-45 of the ITAA 1997, which only allows a deduction for a loss incurred by a taxpayer through theft, stealing, embezzlement, larceny, defalcation or misappropriation by an employee or agent of the taxpayer cannot apply in the present circumstances.

In conclusion, a deduction is not allowable under either section 8-1 or section 25-45 of the ITAA 1997 for moneys confiscated from the business proceeds of the Taxpayers in respect of the Y income year.

Conclusion

Amendments: statutory time limits

The Commissioner's powers to amend an assessment, or further amend an amended assessment of a company and of a trust, are set out in items 2 and 3 of the Table in subsection 170(1) of the ITAA 1936 respectively.

In relation to a company, item 2 of the Table in section 170(1) provides that:

‘The Commissioner may amend an assessment of a company that is a small business entity for the year of income to which the assessment relates within 2 years after the day on which the Commissioner gives notice of the assessment to the company’ (Emphasis added)

Item 2 of the table in subsection 170(1) also sets out five qualifications that preclude the application of that item. The qualifications include circumstances prescribed by items 5 and 6 of the Regulations, i.e., Income Tax Amendment Regulations 2006 (No. 2), which operate in the context of subsection 170(1).

The Commissioner is taken to have given notice of assessment to a company (a full self-assessment taxpayer) in respect of an income year, on the day the company’s return for that income year is lodged: refer section 166A of the ITAA 1936.

In relation to a trust, item 3 of the Table in section 170(1) provides that:

‘The Commissioner may amend an assessment of a person (in the capacity of a trustee of a trust estate) entity for a year of income if the trust is a small business entity for that year. The Commissioner may amend the assessment within 2 years after the day on which he or she gives notice of the assessment to the person’.

Item 3 of the table in subsection 170(1) also sets out four qualifications that preclude the application of that item. The qualifications include circumstances prescribed by items 5 and 6 of the Regulations, i.e., Income Tax Amendment Regulations 2006 (No. 2), which operate in the context of subsection 170(1).

In conclusion, the Taxpayers can request for an amendment to their tax returns for the Y income year if the limitation periods in subsection 170(1) of the ITTA 1936 for that of a company and a trust are satisfied.