Private ruling: The deductibility of misappropriated funds
Date of advice: 28 September 2016
Published: November 2016
Ruling period: Year ended 30 June 2016 | Year ended 30 June 2017
Date scheme commenced: 1 July 2015

Ruling: Q3: Do the non-commercial losses provisions apply to the loss? | A1: N/A | Q4: Can you vary your PAYG withholding? | A2: No

Relevant facts and circumstances: Following from a conversation with a work colleague you contributed funds during and prior to the relevant period intended to purchase options a company. The investments were made through representatives of what you believed to be an company. Your colleague became aware of the investment opportunity via a phone call. You made a number of enquiries about the overseas company and you believed there was enough information found to give validation to both the overseas company and your transaction. You believed that the investments would be short term and that you would make a profit. You contributed a combined amount of money towards the options and a security bond. You were advised you were a victim of what is believed to be a 'specific scam', whereby it is likely that the trades are fictitious.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 8-1 | Income Tax Assessment Act 1997 section 15-15 | Income Tax Assessment Act 1997 section 25-40 | Income Tax Assessment Act 1997 section 25-45 | Income Tax Assessment Act 1997 section 102-20 | Income Tax Assessment Act 1997 section 104-25 | Income Tax Assessment Act 1997 section 108-5 | Income Tax Assessment Act 1936 section 25A

Reasons for decision: Detailed Reasoning - General deductions: Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) provides for general deductions for expenditure 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. No deduction is allowable to the extent that the expenditure is private, domestic or capital in nature. | Detailed Reasoning - Capital nature of losses due to misappropriation: In Taxation Ruling IT 2228 Income Tax: Futures Transactions (IT 2228) (Partially Withdrawn - withdrawn paragraphs 37 to 43 dealing with 'basis trading') the Commissioner discusses the income tax implications of the various aspects of futures trading. It specifies that losses of a taxpayer's funds due to misappropriation have the character of losses of capital. In paragraph 36 of IT 2228 the Commissioner deals with losses sustained as a result of the fraudulent actions of futures brokers or dealers. While in your case the loss was occasioned by the fraudulent actions of your representative the same principles apply. The Commissioner states: 36. Furthermore, it seems that there may be a number of cases where taxpayers engaged in futures transactions may have incurred losses not from futures contracts themselves but from futures brokers or dealers acting in a fraudulent manner. In managed accounts, for instance, a taxpayer may have deposited $20,000 with a broker to enter into futures contracts on the taxpayer's behalf. The taxpayer may be advised by the broker at a relevant time that losses amounting to $10,000 have been suffered. In fact, the losses will not have been incurred from genuine futures transactions. They may be incurred from fictitious transactions and, in some cases, from misappropriation of the taxpayer's funds. It is difficult to say the losses incurred in these circumstances are losses incurred in carrying on a business or in carrying out a profit-making undertaking or scheme. They have more the character of losses of capital. Claims for deduction for losses incurred in these circumstances should be disallowed. In your case, your losses were incurred from what is believed to be fictitious transactions resulting in your funds being misappropriated and therefore any losses incurred have the character of capital and are not allowable deductions. Any gains made will be assessable as capital gains and any losses made will be regarded as capital losses under Part 3-1 of the ITAA 1997. As the loss is capital in nature you are not entitled to a deduction under section 8-1 of the ITAA 1997. As the amounts invested are considered to be capital and are not allowable as deductions in carrying on a business or carrying out a profit making undertaking or scheme it is not necessary to consider if the amounts are deductible under those provisions, however for your benefit we have included reasoning below as to why the amounts would not be deductible. | Detailed Reasoning - Carrying on a business and capital nature of investments: The term 'isolated transaction', in relation to a non-business taxpayer refers to any transaction entered into by the taxpayer. Taxation Ruling 92/4 Income tax: whether losses on isolated transactions are deductible discusses the circumstances under which losses from isolated transactions are deductible for income tax purposes. A loss from an isolated transaction entered into by a non-business taxpayer is regarded as deductible under section 8-1 of the ITAA 1997 if: (i) the intention or purpose of the taxpayer in entering into the transaction was to make a profit or gain, and (ii) the transaction was entered into, and the loss was made, in the course of carrying out a commercial operation. We acknowledge that your intention with respect to the options was to sell them for a profit in order to make a short term financial gain. However, you did not have a sophisticated method for deciding when to buy and sell the options. You did not have a strategy based on technical analysis or structured trading techniques to maximise profits, nor did you have a contingency plan to limit your trading losses if the price kept falling. You were relying on the information provided to you by someone you believed to be a broker that they could be sold quickly and at higher price than what you had purchased them for. In AC Williams v. Federal Commissioner of Taxation 72 ATC 4157;(1972) 128 CLR 645; (1972) 3 ATR 236, Stephens J. stated a speculator is a person whose purchases were in the nature of individual forays in particular stocks with a view to resale. This view is in contrast with the definition of a share trader as their dealing should be seen as part of a more extensive business of buying and selling shares. However, gains and losses made by both share investors and share speculators are treated as capital gains and capital losses respectively. In respect of a profit-making purpose the facts of your case are similar (had the transactions occurred) to those outlined in example 1 in Taxation Ruling TR 92/3 Income tax: whether profits on isolated transactions are income . This example states: Ms Donovan, a public servant, purchased 10,000 shares in a listed public company at a price of $1 each and sold them 18 months later for $2 each. During that period, the company paid one small dividend. Donovan was not carrying on a business of trading in shares. A significant purpose of Donovan in acquiring the shares was to make a profit from an increase in the value of the shares. The profit made on the sale of the shares is not income. The transaction was merely an investment, not a business operation or commercial transaction. A similar example is also provided in example 2 of Taxation Ruling 92/4 which states: In 1987 Mr Lyon bought 20,000 shares at $1 each in a large public company from an arm's length seller. Mr Lyon was not carrying on a business of trading in shares. He principally bought the shares to derive dividend income although a significant purpose was to benefit from an increase in the value of the shares. In 1992 Mr Lyon sold the 20,000 shares at $0.80 each. Mr Lyon's loss is a capital loss and not deductible under subsection 51(1). If the sale of shares had returned a profit, that profit would not have been income because the transaction was merely an investment, not a business operation or commercial transaction. Although your plan was to hold the options for less time than those shown in both examples the reasoning remains the same. You entered into the scheme to make a profit, the profit could only come from selling the options at an increased value and the entire scheme was contingent on you being able to sell the options for more than you acquired them for. The plan may have involved you having to invest a considerable amount of money, but the plan itself is a simple one. The activities to be undertaken by you involved two steps buying the options and then selling them on a later date. Setting aside the volume of options involved and the way in which the scheme was financed, the mechanics of this scheme is no different to one in which someone purchases a parcel of shares with the intent of making a profit from their sale at a later date. There is a profit making purpose but once the shares are purchased the ability to make a profit is reliant on factors and actions outside of the owner's control. In your case, the transactions relied on you obtaining a capital gain. There was no other way you could have made a profit from this scheme and the nature of the property purchased meant that you could not do anything to the property yourself to increase the value. We do not consider that your options transactions were carried out in a commercial manner. The facts and the nature in which the activity was carried out indicate that your activities would be regarded more as a speculator. In your case, you paid money as a private investor to acquire what you believed to be options. Options are a capital asset and as such, the cost of acquiring them is considered capital in nature, as are any associated losses. An option is an intangible asset. It is also a CGT asset as defined in subsection 108-5(1) of the ITAA 1997. Options are specifically cited as examples of CGT assets (see Note 1 to subsection 108-5(2) of the ITAA 1997). In your case, you were not considered to be carrying on a business of options trading. The funds you provided to the overseas company have the character of a loss or outgoing which is of a capital nature rather than of a revenue nature. The outlay was intended to bring into existence an asset that was to provide enduring benefits. We do not accept that the loss was made in the course of carrying out a commercial operation. Additionally, we consider that, as the activity was fraudulent and fictitious, there was not a bona fide commercial operation. The fact that the funds were fraudulently misappropriated by the overseas company does not change the nature of the loss. | Detailed Reasoning - Profit making undertaking or plan: A loss arising from the carrying on or carrying out of a profit-making undertaking or plan is deductible under section 25-40 of the ITAA 1997 if, had there been a profit rather than a loss, the profit would have been assessable under section 15-15 of the ITAA 1997. Section 15-15 of the ITAA 1997 states: (1) Your assessable income includes profit arising from the carrying on or carrying out of a profit-making undertaking or plan. (2) This section does not apply to a profit that: (a) is assessable as ordinary income under section 6-5; or (b) arises in respect of the sale of property acquired on or after 20 September 1985. Additionally, subsection 25-40(2) of the ITAA 1997 states: you cannot deduct a loss under subsection 25-40(1) if the loss arises in respect of the sale of property acquired on or after 20 September 1985. Property is not defined in the ITAA 1997 and consequently takes its ordinary meaning. The Macquarie Dictionary defines property as: that which one owns; the possession or possessions of a particular owner ownership; right of possession, enjoyment, or disposal of anything. Therefore property refers to the objects of ownership and to the proprietary rights over those objects. Property in the sense of objects of ownership may be classified as: (a) real property land and things affixed to land; (b) personal property all property other than real property. Subsection 25-40(3) of the ITAA 1997 states you can deduct a loss under subsection (1) insofar as it arises in respect of property, only if: (a) you notified the Commissioner that you acquired the property for the purpose of profit-making by sale or for the carrying on or carrying out of any profit-making undertaking or plan(however described); or (b) the Commissioner is satisfied that you acquired the property for either of those purposes. Subsection 25-40(2) of the ITAA 1997 specifically denies a deduction in respect of the sale of property acquired on or after 20 September 1985. The application of section 25-40 of the ITAA 1997 in respect of loss on the sale of shares acquired with a profit making intention on or after 20 September 1985 was addressed in ATO Interpretative Decision ATO ID 2002/951 Income Tax: Loss on sale of shares - acquired with a profit making intention on or after 20 September 1985 (ATO ID 2002/951) (ATO ID withdrawn on 11 August 2016 because it merely reinstated the operation of subsection 25-40(2) of the ITAA 1997, and did so where the preconditions in subsection 25-40(1) had not been clearly established). ATO ID 2002/951 came to the conclusion that the taxpayer was not entitled to a deduction under section 25-40 of the ITAA 1997 for a loss on the sale of shares acquired on or after 20 September 1985. The facts in the ATO ID were: The taxpayer acquired shares with the intention of making a profit on the resale of those shares. The shares were acquired on or after 20 September 1985. The shares were not acquired with the intention of long term holding for capital appreciation or to derive assessable income as dividends or bonus share issues. The taxpayer made a net loss from buying and selling shares. The taxpayer is not in a business of share trading. The facts are similar to those in your case (had the purchase of the options occurred) and therefore the reasoning behind the decision is also applicable here. These reasons were: Subsection 25-40(1) of the ITAA 1997 allows a deduction for a loss arising from the carrying out of a profit-making undertaking if any profit from that undertaking would have been included in the taxpayer's assessable income by section 15-15 of the ITAA 1997. However, subsection 25-40(2) of the ITAA 1997 provides that a loss from a profit-making undertaking is not an allowable deduction if the loss arises in respect of the sale of property acquired on or after 20 September 1985. The term 'property' encompasses not only physical assets but also intangible assets such as shares and securities. As the shares constitute property acquired by the taxpayer on or after 20 September 1985, the loss on the sale of the shares is not an allowable deduction under section 25-40 of the ITAA 1997. As the options constitute property that was acquired (if at all) by you after 20 September 1985 the loss that may arise is not an allowable deduction under section 25-40. Additionally as noted above in IT 2228 it is difficult to say that losses that may be incurred from fictitious transactions and misappropriation of the taxpayer's funds were incurred in carrying on a business or carrying out a profit-making undertaking or scheme. They have the character of capital. | Detailed Reasoning - Section 25A of the Income Tax Assessment Act 1936: Section 25A of the Income Tax Assessment Act 1936 (ITAA 1936) operates to include certain profits as assessable income. Subsection 25A(1A) of the ITAA 1936 states that the section does not apply in respect of the sale of property acquired on or after 1985. Therefore for the reasons discussed above if the acquisitions/s made are considered to be property acquired after 1985 and this section does not apply. | Detailed Reasoning - Deductions for loss by theft, stealing, embezzlement, larceny, defalcation or misappropriation: 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. The requirement that the income has been included in the taxpayer's assessable income was discussed at EHL Burgess Pty Ltd v Federal Commissioner of Taxation (1988) 88 ATC 5417; (1988) 18 ATR 1407 ( EHL Burgess ): ...income which has been or is to be included in the 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 s71 deduction [the predecessor to section 25-45 of the ITAA 1997]. The requirement that the income has been included in the taxpayer's assessable income was also discussed in the more recent case of Lean v FCT (2010) 75 ATR 213: (1) In order to satisfy s 25-45, the money that was misappropriated must be capable of being characterised as the same money that was included in the taxpayer's assessable income. It must be possible to identify misappropriated money with the money included in the taxpayer's assessable income. (2) The act of a taxpayer in applying money of the taxpayer towards expenses or investment is sufficient to break the necessary connection between money included in the taxpayer's assessable income and a subsequent misappropriation. By applying the money towards expenses or investment the taxpayer has received the benefit of the money that was assessable income. (3) Where the money that was included in the assessable income of a taxpayer has left the taxpayer's hands, there can be no relevant misappropriation of, or in respect of, that money. ATO ID 2003/1029 Deduction: Losses from misappropriation of money by an investment broker details a situation where a share investor engaged a broker to act for them in the purchase of shares. The taxpayer was not in the business of share trading. The taxpayer paid an amount of money to the broker for the shares, via a private line of credit into which their employment income was deposited and used in a manner similar to a normal bank account. The shares were never purchased on the taxpayer's behalf and the broker could not be contacted or brought to account. The loss was irrecoverable. In these circumstances the taxpayer could not satisfy the requirement that the money lost had been included in their assessable income for the income year or an earlier income year and therefore the amount was not deductible under section 25-45 of the ITAA 1997. In the taxpayer's case it was found: Whether or not the taxpayer had at some point returned as assessable income the employment income they deposited into their line of credit facility, it is considered that the character of that money was irretrievably altered because of its assimilation into the taxpayer's general finances. The money was no longer that of 'assessable income' but rather was simply part of the current balance of funds available to, or owing by, the taxpayer under their line of credit. The specific sum of money paid to the broker for the shares cannot be identified as an amount which had been returned by the taxpayer as assessable income. In your case, when the money in your account was transferred to an agent for expenditure on investments, it lost the character of 'amounts included in assessable income'. Therefore you are not entitled to a deduction under section 25-45 of the ITAA 1997 for the loss of money misappropriated by the overseas company because the lost amount was not included in your assessable income. | Detailed Reasoning - Capital gains tax (CGT): Section 102-20 of the ITAA 1997 provides that you make a capital gain or loss if a CGT event happens. The gain or loss is made at the time of the CGT event and can only be made in respect of a CGT asset. Section 108-5 of the ITAA 1997 states that a CGT asset is: (a) any kind of property; or (b) a legal or equitable right that is not property. Note 1: Examples of CGT assets are: • land and buildings; • shares in a company and units in a unit trust; • options; • debts owed to you; • a right to enforce a contractual obligation; • foreign currency. You make a capital gain if the capital proceeds are more than the cost base of your CGT asset. You make a capital loss if the reduced cost base of your CGT asset is greater than the capital proceeds received for the asset. If your total capital losses for an income year are more than your total capital gains, the difference is your net capital loss for the year. A net capital loss cannot be deducted from income, but can be carried forward to reduce assessable gains made in future years. There is no time limit on how long you can carry forward a net capital loss. Potential applicable CGT assets in your case are options and a right to sue for a loss. In your case it does not appear that your CGT asset is options as you likely never acquired them. You were advised that the transactions you were involved in were part of an "specific" scam and therefore the actual existence of the financial products appear to be fraudulent. If an investment in company options has been embezzled, you do not hold ownership of the options. As a result of entering into the arrangement with the overseas company, it is considered that you acquired contractual rights. Therefore the relevant CGT asset will be the right to sue the overseas company (to seek compensation for your financial loss). | Detailed Reasoning - CGT event C2 - cancellation, surrender and similar endings: CGT event C2 in section 104-25 of the ITAA 1997 happens if your ownership of an intangible CGT asset ends in certain ways, including because the asset expires or is redeemed, cancelled, released, discharged, satisfied, abandoned, surrendered or forfeited. The time of the event is when you enter into the contract that results in the asset ending. If there is no contract, the event happens when the asset ends (subsection 104-25(2) of the ITAA 1997). A right to sue is an example of an intangible CGT asset. ATO ID 2001/799 Income tax: Capital gains tax: capital losses: rights in relation to non-resident company outlines a situation where a taxpayer invested money in securities in a non-resident company and sent the funds overseas. The taxpayer did not receive share certificates for their investment. The overseas company has been under investigation by overseas authorities. The taxpayer has not been able to contact the company or the securities firm and the taxpayer suspects their investment may have been embezzled and that they do not own any shares. Capital gain event C2 will occur once the right to sue has ended. In the ATO ID case the C2 event had not yet occurred. In your case, as there is an ongoing investigation it would appear that you may not be able to establish that any of these actions have occurred in relation to your right to sue, and therefore CGT event C2 may not have occurred at this time. Therefore you do not appear to have made a capital loss to date. The timing of the event would be evidenced by your actions subsequent to your last correspondence from the other parties to the arrangement. | Detailed Reasoning - Conclusion: You are not entitled to claim a deduction or loss under sections 8-1, 25-40 or 25-45 of the ITAA 1997 or section 25A of the ITAA 1936. You are not entitled to a deduction under section 8-1 of the ITAA 1997 for the losses you sustained that relate directly to the investment of your funds in your alleged purchase of your options because those losses are capital in nature and were not necessarily incurred in carrying on a business. Losses of a taxpayer's funds due to misappropriation have the character of losses of capital. You are not entitled to a deduction under section 25-40 of the ITAA 1997 as the options were property that was acquired (if at all) by you after 20 September 1985. The loss that may arise is not an allowable deduction under section 25-40. Additionally losses that may be incurred from fictitious transactions and misappropriation of the taxpayer's funds have the character of capital. You are not entitled to a deduction under section 25-45 of the ITAA 1997 for the loss of money misappropriated by the overseas company because the lost amount was not included in your assessable income. You are not entitled to a deduction under subsection 25A(1A) of the ITAA 1936 states that section 25A does not apply in respect of the sale of property acquired on or after 1985. As noted above for the denial of the deduction under section 25-40 of the ITAA 1997. The relevant CGT asset will be the right to sue. Capital gain event C2 will occur once the right to sue has ended. You are not entitled to deduct a capital loss against income but can use it to reduce your capital gains for the income year in which the loss happened. If the result is a net capital loss for the year, you are entitled to carry that forward to reduce assessable gains made in future years. | Detailed Reasoning - Question 2: Not applicable. As discussed above, losses of a taxpayer's funds due to misappropriation have the character of losses of capital. Therefore the loss will be covered by the CGT provisions. | Detailed Reasoning - Question 3: Not applicable. As discussed above, you were not carrying on a business options trading. | Detailed Reasoning - Question 4: Not applicable as no losses have been incurred that would reduce your taxable income. Further information on varying your PAYG W is available at: https://www.ato.gov.au/Individuals/Working/In-detail/PAYG-withholding/PAYG-withholding---varying-your-PAYG-withholding/

Question 1: Can you claim a deduction under sections 8-1, 25-40 or 25-45 of the Income Tax Assessment Act 1997 or section 25A of the Income Tax Assessment Act 1936 in relation to your investment in options that resulted in your funds being misappropriated? | Are any losses incurred Australian or foreign losses?