Edited version of private advice

Authorisation Number: 1052160316718

Date of advice: 5 September 2023

Ruling

Subject: Entitlement to a tax deduction as a result of a fraud

Question 1

Is the company entitled to a deduction under section as a result of fraud under section 25-45 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Is the company entitled to claim a tax deduction for funds transferred as a result of fraud under section 40-880(2) of the ITAA 1997?

Answer

Not necessary to answer.

This ruling applies for the following period:

1 July 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

The Company is a small business entity with an aggregated turnover of less than $2 million.

The directors and shareholders of the Company are husband (director A) and wife (director B). Both directors manage the day-to-day operations of the business.

The Company maintains its own business bank accounts. Business income is deposited into the Company's bank accounts. The two directors have access to these bank accounts.

When director B was on maternity leave and was effectively removed from the day-to-day management of the business, director A became solely responsible for managing the business operations, including approval of all payments.

During this time, the business funds had been misappropriated by director A to support his gambling habit. Funds in the business bank account were transferred by director A to his personal account and recorded them as payments towards business expenses.

Director A has also used the personal funds invested in term deposit by him and director B to fund his gambling activity.

Director A continued to misappropriate the Company funds undetected for some years until their tax advisor contacted director B regarding the Company's tax related debts. Director B later found out about director A's gambling habit who admitted to the misappropriation of the Company funds over the last few years.

Once exposed for the fraud, director A had sought guidance and help to address their issues. Due to the nature of the incident, the enforcement authorities were not notified on the matter.

Director A was requested to pay back the debt, but due to his gambling addiction this was not possible. The personal savings of the family were reduced to nil as they were also utilised by director A for his gambling activity.

The funds lost due to the fraud committed by director A cannot be recovered under the Company's insurance policies. A third party and family members provided temporary funding to maintain cashflow in the business and to meet all employee and tax commitments.

Director A is still currently connected with the operations and management of the business however, his access and permissions were reduced to two signatories after the gambling issues were identified.

Director B has full control of company records and bank accounts, with the director subject to fraud having limited to nil access. Any functions performed by the fraudulent director is heavily scrutinised by the other director, and appropriate internal controls now exist.

The director/shareholder is still currently connected with the operations and management of the business but is closely monitored by fellow directors.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 25-45.

Income Tax Assessment Act 1997 section 40-880.

Reasons for decision

Is the company entitled to a deduction under section as a result of fraud under section 25-45 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Summary

The outgoing is deductible under section 25-45 of the ITAA 1997 as the loss was caused by an employee who misappropriated the funds which were include in the Company's taxable income for his own use.

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.

To be able to claim a deduction under section 25-45 of the ITAA 1997, the following requirements need to be satisfied:

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 Company incurred a loss as director A, who is also an employee, misappropriated funds from the business bank accounts. In addition, the Company has not recovered any amount from the director because director A has gambled away the money.

(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.

In this case, director A who was responsible for managing the business operations and has access to the Company's bank accounts, transferred money from the Company's business account to his personal bank account to fund his gambling habit.

(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 case indicate that the loss was ascertained in the relevant income year after the tax agent advised director B of the Company's debts and only then that director B found out about director A's gambling habit and the misappropriation of Company funds carried out by director A.

(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. In some states, including Victoria, there is generally a single statutory offence of theft or stealing which catches all types of dishonest appropriation of another's property (including money).

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.

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.

The cause of the loss is due to the misappropriation of funds carried out by director A for almost four income years.

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

A loss is not deductible, however, 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. 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.

In this case, director A who was also an employee of the Company misappropriated the Company business funds by transferring them to his own personal bank account to support his gambling habit. The Company was unable to recover the amounts under the insurance policy, nor the director was able to repay the amounts taken.

(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.

In this case, income from the business activities was deposited in the Company's bank accounts. The income received by the Company created cash availability from which the misappropriated funds were taken. Accordingly, the money was included in the Company's assessable income for the previous income years.

Based on the above analysis, the Company made a loss due to the misappropriation by the employee for his personal use and was discovered during the income year ended 30 June 2021. Therefore, the Company is entitled to claim deduction for the amount of loss under section 25-45 of the ITAA 1997.

Assessable recoupment

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 Company 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 recoupment is received before the income year of a deduction, the assessable recoupment is treated as having been received in the deduction year under subsection 25-35(3) of the ITAA 1997.