Private ruling: Income tax: deductions: defrauded funds
Date of advice: 30 April 2019
Published: June 2019
Ruling period: Year ending 30 June 2018
Date scheme commenced: 1 December 2017

Ruling: Q1: Is the loss of unrecovered defrauded funds deductible under section 25-45 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: No. | Q2: Is the loss of unrecovered defrauded funds deductible under section 8-1 of the ITAA 1997? | A2: No. | Q3: Are the legal expenses incurred in recovering the defrauded funds deductible under section 8-1 of the ITAA 1997? | A3: No. | Q4: Are the legal expenses incurred in recovering the defrauded funds deductible under section 40-880 of the ITAA 1997? | A4: No.

Relevant facts and circumstances: This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling. You do not operate a business. You hold several investments including investment properties. You engaged Company A to undertake accounting and financial management services, including access to bank accounts for the payment of expenses. In 20xx, Company A received an email from a person pretending to be you requesting a payment of $xxx. The payment was for investment related purposes. Company A made this payment. As at 20xx, you have incurred a loss. You have taken legal action against Company A for reimbursement of the funds and have incurred legal expenses in doing so.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 8-1 | Income Tax Assessment Act 1997 section 25-45 | Income Tax Assessment Act 1997 section 40-880 | Income Tax Assessment Act 1997 section 995-1

Reasons for decision: Summary: You are not entitled to a deduction for the loss of unrecovered defrauded funds under section 25-45 of the ITAA 1997. | Detailed Reasoning - Detailed reasoning: Section 25-45 of the ITAA 1997 provides a specific deduction for a loss incurred by a taxpayer through theft, stealing, embezzlement, larceny, defalcation or misappropriation by an employee or an agent of the taxpayer. The loss must be in respect of money which has been included in the taxpayer’s assessable income and must be discovered in the income year in which the deduction is claimed. All of the requirements of this section must be satisfied; it is not sufficient to satisfy just one. The section was previously contained in section 71 of the Income Tax Assessment Act 1936 and was considered in the matter of EHL Burgess Pty Ltd v FC of T 88 ATC 4517. The Court stated that the misappropriation be the act of the person, including an agent. The Court also considered the amendments made in 1963 and found that the misappropriation must be committed by an employee or agent of the taxpayer. In your case, there is nothing to suggest that Company A were complicit in the fraud; the fraud was visited upon them. Company A paid out on the fraudulent invoices presented to them. On this basis, no deduction is allowable under section 25-45 of the ITAA 1997. | Summary: You are not entitled to a deduction for the loss of unrecovered defrauded funds under section 8-1 of the ITAA 1997. | Detailed Reasoning - Detailed reasoning: Section 8-1 of the ITAA 1997, allows a taxpayer to make certain general deductions from assessable income for losses or outgoings that were either incurred ‘in gaining or producing … assessable income’ or ‘necessarily incurred in carrying on a business’ for the purpose of producing assessable income, unless these expenses are of a capital, private or domestic nature. Some misappropriation losses may satisfy one or other of these criteria and be deductible. If a misappropriation loss has been incurred ‘in the course of’ an activity that forms part of the conduct involved in ‘gaining or producing assessable income’ it is available as a general deduction: Charles Moore & Co (WA) Pty Ltd v Federal Commissioner of Taxation (1956) 95 CLR 344 at 349-350. In the matter of Case V24 (1988) 19 ATR 3117, no deduction was allowed for funds which were misappropriated by a solicitor. The taxpayer had provided money to the solicitor to purchase a quantity of gold bullion. The bullion was supposedly to be immediately on sold for a profit, but the entire proposal was fraudulent. Although the solicitor repaid a substantial part of the stolen money, the taxpayer claimed a deduction for the unrecovered balance. The deduction claim was disallowed on the basis that the misappropriated money was capital and could not, therefore, qualify as a deductible loss incurred in gaining or producing assessable income. In the matter of Lean v FC of T [2010] 75 ATR 213, no deduction was allowed for funds which were misappropriated by a securities trader. The taxpayer had provided money to the trader for a wide range of possible investment activities. In making their decision, the Full Federal Court only considered whether a deduction was allowable under section 25-45 of the ITAA 1997. However, the AAT had previously considered whether, in the alternative, the deduction was allowable under section 8-1 of the ITAA 1997. The deduction claim was disallowed on the basis that the misappropriated money was capital and could not, therefore, qualify as a deductible loss necessarily incurred in carrying on a business. In your case, the misappropriated payments were for investment related expenses. In usual circumstances, these expenses would be of a capital nature. The fact that the funds were misappropriated does not change the character of the expenses. On this basis, you are not entitled to a deduction under section 8-1 of the ITAA 1997. | Summary: You are not entitled to a deduction for legal expenses under section 8-1 of the ITAA 1997. | Detailed Reasoning - Detailed reasoning: Section 8-1 of the ITAA 1997, allows a taxpayer to make certain general deductions from assessable income for losses or outgoings that were either (i) incurred ‘in gaining or producing … assessable income’ or (ii) ‘necessarily incurred in carrying on a business’ for the purpose of producing assessable income, unless these expenses are of a capital, private or domestic nature. In determining whether a deduction for legal expenses is allowed 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. In your case, the legal expenses are to recover misappropriated payments that were found to be of a capital nature. Therefore, the legal expenses would also be considered to be of a capital nature. On this basis, you are not entitled to a deduction under section 8-1 of the ITAA 1997. | Summary: You are not entitled to a deduction for legal expenses under section 40-880 of the ITAA 1997. | Detailed Reasoning - Detailed reasoning: Section 40-880 of the ITAA 1997 allows a deduction for certain business capital expenditure over a five year period. Paragraph 40-880(2) of the ITAA 1997 confirms the capital expenditure must be incurred in relation to your business. Subsection 995-1(1) defines business to include ‘any profession, trade, employment, vocation or calling, but does not include occupation as an employee’. Taxation Ruling TR 2011/6 Income tax: business related capital expenditure – section 40-880 of the Income Tax Assessment Act 1997 core issues confirms that ‘the nature and scope of a business for the purposes of the section (40-880 of the ITAA 1997) is a question of fact in each case’. You are involved in investment activities and are not in business. Although the legal expenses are of a capital nature, they are not business related capital expenditure. On this basis, you are not entitled to a deduction under section 40-880 of the ITAA 1997.