ATO ID 2002/402: Income tax: Embezzlement/fraud/defalcation by partner - deductibility of expenditure.
Date of decision: 14 March 2002
Year of income: Year ended 30 June 2001
Business line: Small Business/Individual Taxpayers

Issue
Whether expenditure incurred by the partnership in the form of legal fees and investigation fees to ascertain the details and extent of the fraud by a partner is deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Decision
Expenditure incurred by the partnership in the form of legal fees and investigation fees to ascertain the details and extent of the fraud by a partner is not deductible under section 8-1 of the ITAA 1997.

Facts
The partnership provides specialised services through offices in Australia. During a review of the partnership accounts, it was discovered that a partner had been engaged in fraudulent conduct with regard to out of pocket expenses over a number of periods. The partnership engaged forensic accountants to investigate the transactions. A comprehensive review was undertaken of all client ledgers for which the fraudulent partner was responsible or in respect of which he had some involvement during the relevant period. Where client files had been closed and archived, these were re-opened and included as part of the investigation. Legal advice was also sought on the manner in which issues arising from the fraud should be dealt with. The cost of the investigation and legal advice has been included as an expense in the partnership's Profit & Loss Statement for the year in question.

Reasons for decision
Summary: To be deductible under section 8-1 of the ITAA1997 the expense must be incurred in gaining or producing assessable income or necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income and not be capital, private or domestic in nature. In Hallstroms Pty Ltd v. FC of T (1946) 72 CLR 634, Dixon J at 647 stated that 'legal expenses ... take the quality of an outgoing of a capital nature or of an outgoing on account of revenue from the cause or purpose of incurring the expenditure. We are, therefore, remitted to a consideration of the object in view when the legal proceedings were undertaken, or of the situation which impelled the taxpayer to undertake them.' Here, the investigation and legal fees were incurred to determine the exact nature and extent of the fraud. The expenditure also served the purpose of preserving the firm's reputation, both with existing and potential clients. In Ash's case, Latham CJ at 275 expressed the view that although the ultimate purpose of the payments to the defrauded clients may have been to preserve the credit of the taxpayer and so maintain the business as a profit-earning enterprise, this feature did not deprive them of their capital nature. In Smithkline Beecham Laboratories (Australia) Ltd v. FCT (1993) 26 ATR 260 at 265 - 266, Hill J stated that expenditure incurred to preserve or protect a business as such will ordinarily be expenditure of capital. Here, the investigation and legal expenses were incurred to preserve the firm's reputation with existing and potential clients. The expenditure was incurred for the purpose of securing an enduring benefit to the firm, namely its client base, and is therefore capital in nature. Therefore, the purpose of the legal expenditure, being to preserve the reputation of the firm, was primarily a capital expense. The expenses were in large a measure to protect an enduring benefit. In the circumstances the expenditure in relation to both the forensic accountants and the legal expenses for the purpose of meeting the fraud are of a capital nature and therefore non-deductible.

Legislative references: Income Tax Assessment Act 1997 Subsection 8-1(1)
Case references: Hallstroms Pty Ltd v. FC of T 72 CLR 634
Subject references: Losses from fraud, theft & embezzlement