Private ruling: Entitlement to a tax deduction as a result of a fraud
Date of advice: 10 May 2019
Published: July 2019
Ruling period: 1 January 2018 to 31 December 2018
Date scheme commenced: October 2018

Ruling: Q1: Are you entitled to claim a tax deduction for funds transferred as a result of fraud under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: No | Q2: Are you entitled to claim a tax deduction for funds transferred as a result of fraud under section 25-45 of the ITAA 1997? | A2: No | Q3: Are you entitled to claim a tax deduction for funds transferred as a result of fraud under section 40-880(2) of the ITAA 1997? | A3: Yes

Relevant facts and circumstances: Background The Taxpayer is an Australia resident private company. Over a period of time the Taxpayer was defrauded of a sum of money. The enforcement authorities were notified and a formal report made. A breach of the Taxpayer’s IT systems occurred, assisting in the fraud. The fraud resulted in payments being made by an employee of the Taxpayer, pursuant to an authority given to them as part of their job description. The funds lost cannot be recovered under the Taxpayer’s insurance policies and it is not economical to pursue recovery of the loss. The funds came from the Taxpayer’s normal operating bank account together with an amount from an overdraft facility. Detailed reasoning Question One Summary The outgoing as a result of misappropriated funds is not deductible under section 8-1 of the ITAA 1997 as the loss or outgoing is of capital or is capital in nature. Detailed reasoning Section 8-1 of the ITAA 1997 Section 8-1 of the ITAA 1997 allows a deduction for any loss or outgoing necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income however you cannot deduct a loss to the extent the amount is an outgoing of capital, private or domestic in nature or a provision prevents it from being deductible. Section 8-5 of the ITAA 1997 provides that an amount may also be deductible under another provision of the Act. Where an amount is deductible as specific deduction under another provision, section 8-10 of the ITAA 1997 requires that you only deduct the amount under that specific provision only. Section 8-1 of the ITAA 1997 states: You can deduct from your assessable income any loss or outgoing to the extent that: (a) it is incurred in gaining or producing your assessable income; or (b) it is necessarily incurred in carrying on a * business for the purpose of gaining or producing your assessable income. However, you cannot deduct a loss or outgoing under this section to the extent that: (a) it is a loss or outgoing of capital, or of a capital nature; or (b) it is a loss or outgoing of a private or domestic nature; or In this case, the relevant elements that need to be satisfied for the amount to be deductible under section 8-1 of the ITAA 1997, are as follows: ● The outgoing is incurred; ● There is the relevant nexus between the loss or outgoing and the carrying on of a business for the purpose of gaining or producing assessable income; ● The outgoing is not of a capital or private or domestic nature. The loss or outgoing is incurred The first requirement is that the loss or outgoing is incurred. A loss or outgoing is incurred where it has been paid or where it has not been paid results in a presently existing pecuniary liability. The money was transferred from the Taxpayer’s operating business bank account with part of the funds being sourced from the business bank overdraft. The outgoing was therefore incurred by the business for the purposes of section 8-1 of the ITAA 1997. Nexus between the loss or outgoing and the carrying on of a business for the purpose of gaining or producing assessable income Expenditure will generally be deductible under subsection 8-1 of the ITAA 1997 if its essential character is that of expenditure that has a sufficient connection with the operations or activities which more directly gain or produce the taxpayer’s assessable income, provided that the expenditure is not of a capital, private or domestic nature. Assessable income in relation to a business includes income according to ordinary concepts which can include ordinary business income or profits from isolated transactions. Whilst assessable income also includes statutory income such as proceeds from capital gains, these are excluded from being deductible under the second limb of section 8-1 of the ITAA 1997. Taxation Ruling Income tax: subsection 51(1) - relevance of subjective purpose, motive or intention in determining the deductibility of losses and outgoings (TR 95/33) provides guidance on when an outgoing is considered to have the requisite connection to the carrying on of a business for the purpose of gaining or producing assessable income. Paragraph 4 of TR 95/33 provides that where the outgoing does not produce any income or the amount is less than the outgoing, it is necessary to consider all the circumstances surrounding the expenditure. Paragraph 11 also considers that there is also need to have regard to the subjective purpose, motive or intention where there is no obvious commercial connection between the outgoing and the carrying on of the taxpayer’s business. Taxation Ruling TR 92/3: whether profits on isolated transactions are income at paragraph 7 provides that it is not solely the subjective intention of the taxpayer that is relevant. Rather, it is the taxpayer’s intention or purpose discerned from an objective consideration of the facts and circumstances. Paragraph 13 of TR 95/33 provides that in the case of a company, the relevant purpose is the corporate purpose. This requires an examination of the purpose, motive or intention of the company’s directors, officers and employees. In Ronpibon Tin NL and Tongkah Compound NL v FC of T (1949) 78 CLR 47 at 57, their honours in respect of which the motive and purpose of making an outgoing is for, concluded that: 'So to say is not, however, to exclude the motive of the taxpayer in making the outgoing as a possibly relevant factor in characterisation for the purposes of the first limb of s. 51(1). At least in a case where the outgoing has been voluntarily incurred, the end which the taxpayer subjectively had in view in incurring it may, depending upon the circumstances of the particular case, constitute an element, and possibly the decisive element, in characterisation of either the whole or part of the outgoing for the purposes of the subsection.' In Magna Alloys & Research Pty Ltd v FC of T 80 ATC 4542 (Magna Alloys) in relation to the subjective intention and objective facts, Deane and Fisher JJ stated: The key to the role of the objective and subjective in such a formulation is, in the case of a voluntary outgoing, to be found in the statement of Fullagar J in FC of T v. Snowden & Willson Pty Ltd ... that "within the limits of reasonable human conduct the man who is carrying on the business must be the judge of what is 'necessary' ". The controlling factor is that, viewed objectively, the outgoing must, in the circumstances, be reasonably capable of being seen as desirable or appropriate from the point of view of the pursuit of the business ends of the business being carried on for the purpose of earning assessable income. Provided it comes within that wide ambit, it will, for the purposes of s.51(1) be necessarily incurred in carrying on that business if those responsible for carrying on the business so saw it.' There are many judicial decisions that have concluded that the outgoings as a result of fraud did not have the requisite connection with carrying on of a business including: ● FC of T v Lean (2010) 75 ATR 213 – the taxpayer transferred funds for investment purposes not for a business purpose and subsequently those funds were misappropriated; ● Case 15/2004 , 2004 ATC 301 – the taxpayer intention was to make a profit from the sale of shares however it was found that the taxpayer was not carrying on the business of a share trader. The funds were misappropriated and were lost; ● C of T (NSW) v Ash (1938) 61 CLR 263, EHL Burgess Pty Ltd v FC of T 88 ATC 4517 and Curtis v J & G Oldfield (1925) 9 T.C. 319 (Oldfield) – where the misappropriation of money were made by employees who were considered proprietors and directed the money for their own purposes and not in the course or furtherance of the ordinary activities of the business; Charles Moore & Co WA v. FCT (1956) 95 CLR 344 (Charles Moore) however involved a case where the business takings were stolen at gun point on the way to taking it to the bank. The High Court found that the banking of the Department store takings were a necessary part of carrying on a business or gaining or producing assessable income and so the loss incurred was deductible as it was necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. In Ash , whilst the case involved a misappropriation of money by the proprietor, Rowlett J provided some guidance in respect of employees and the carrying on of a business. Rowlett J stated at (330-331): I quite think... that if you have a business … in the course of which you have to employ subordinates, and owing to the negligence or the dishonesty of the subordinates some of the receipts of the business do not find their way into the till, or some of the bills are not collected at all, or something of that sort, that may be an expense connected with and arising out of the trade in the most complete sense of the word. In the case of the Taxpayer’s employee, they were the subject of a complex fraud by a person or organisation outside of their employ. The payments were made as part of the employees normal duties and were made after obtaining what was considered to be the usual approvals for making such payments. Therefore there is the required nexus between the outgoing or loss and the carrying on of the Taxpayer’s business under subsection 8-1(1) of the ITAA 1997 The outgoing is not of capital or private or domestic nature. In relation to the issue of determining whether expenditure is of a revenue or capital nature, the decision of the High Court of Australia in Sun Newspapers Ltd v Federal Commissioner of Taxation (1938) 61 CLR 337 (Sun Newspapers) is the leading authority. In Sun Newspapers, Dixon J stated that there are three matters to be considered when deciding whether expenditure incurred is revenue or capital: i) the character of the advantage sought by the outgoing; ii) the manner in which the advantage is to be used, relied upon or enjoyed by the taxpayer; iii) the means adopted to obtain the advantage, such as by recurring payments. The character of the advantage sought provides the best guidance as to the nature of the expenditure because it says the most about the essential character of the expenditure itself. The decision of the High Court in G P International Pipecoaters Pty Ltd v Commissioner of Taxation (1990) 170 CLR 124 at 137 emphasised this stating: The character of expenditure is ordinarily determined by reference to the nature of the asset acquired or the liability discharged by the making of the expenditure. For the character of the advantage sought by the making of the expenditure is the chief, if not the critical, factor in determining the character of what is paid: Sun Newspapers Ltd. and Associated Newspapers Ltd v Federal Commissioner of Taxation (1938) 61 CLR 337 at 363… The advantage that the Taxpayer sought in making the payment was an expectation that the payment was being made to acquire or enhance the Taxpayer’s business operations. The funds that the Taxpayer expended in making the payment were from the working capital of the business, and as a consequence the profit yielding structure of the business has been diminished. That is, funds that were available to acquire items that would have had an enduring benefit to the business are no longer available. Accordingly it is considered that there has been a loss of funds that are capital in nature. The Commissioner considers that the character of the outgoing of funds is more properly characterised as capital in nature. Therefore, as the outgoing is capital in nature it is not deductible under section 8-1 of the ITAA 1997. Conclusion While it is considered that the business has incurred a loss while carrying on a business, it is not considered that the loss is revenue in nature and therefore no deduction is available under section 8-1 of the ITAA 1997. Question Two Summary The outgoing is not deductible under section 25-45 of the ITAA 1997 as the loss was not caused by an employee stealing, embezzling or misappropriating the funds for their own use. Detailed reasoning Section 25-45 of the ITAA 1997 allows a deduction in respect of a loss 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. In order for section 25-45 of the ITAA 1997 to apply the cause of the loss must be as a result of the employee stealing, embezzling or misappropriating the funds for their own use. There are a number of elements required to satisfy section 25-45 of the ITAA 1997 in order for the loss of money to be deductible, however the main element is that the act of theft, stealing, embezzlement, larceny, defalcation or misappropriation was made by your employee or agent. The definition of the terms theft, stealing, embezzlement, larceny 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. New South Wales, for instance, has retained the common law offence of larceny, which is the wrongful or fraudulent taking of another person's property without the owners' consent, with the intention of permanently depriving the owner of the property. There are also a number of statutory offences, such as stealing, to supplement the offence of larceny (for example, the Crimes Act 1900 (NSW) , sections 134 to 138). 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 (for example, the Crimes Act 1900 (NSW) section 157). In other jurisdictions, embezzlement falls within the offence of theft or stealing. 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 (for example, the Crimes Act 1900 (NSW) , section 178A). Defalcation is a fraudulent deficiency in money matters. ATO Interpretative Decision 2001/318 Income Tax Deductibility: Theft by a person other than an employee provides that where sales of a business were stolen from a safe and it was unlikely that an employee was involved in the theft, a deduction for the loss is deductible under section 8-1 of the ITAA 1997. In this case, the actions of the employee of the Taxpayer resulted in a fraud of a sum of money, however the circumstances surrounding the transfer could not be described as theft, stealing, embezzlement, larceny, defalcation or misappropriation. These terms require an intent and knowledge on the part of the employee to have transferred the funds without the owner’s consent. There is no evidence to suggest that this requirement was satisfied in this case and therefore the loss of money cannot be deductible under section 25-45 of the ITAA 1997. Conclusion No deduction is available under section 25-45 of the ITAA 1997 for the loss as the fraudulent activity was not loss was not theft, stealing, embezzlement, larceny, defalcation or misappropriation by your employee or agent of your business. Question Three Summary The outgoing as a result of misappropriated funds is deductible under section 40-880 of the ITAA 1997. Section 40-880 allows the business capital expenditure to be deductible over five years. Detailed reasoning Section 40-880 of the ITAA 1997 provides that: 40-880(1) The object of this section is to make certain *business capital expenditure deductible over five years if: (a) the expenditure is not otherwise taken into account; and (b) a deduction is not denied by some other provision; and (c) the business is, was or is proposed to be *carried on for a *taxable purpose. 40-880(2) You can deduct, in equal proportions over a period of five income years starting in the year in which you incur it, capital expenditure you incur: (a) in relation to your *business; or … (b) in relation to a business that used to be carried on; or (c) in relation to a business proposed to be carried on; or (d) .. 40-880(2A) However, you can deduct the capital expenditure in the income year in which you incur it if: (a) the expenditure is incurred in relation to a business that is proposed to be carried on; and (b) the expenditure is incurred: (i) in obtaining advice or services relating to the proposed structure, or proposed operation of the business; or (ii) in payment to an *Australian government agency of fees, taxes or charges relating to establishing the business or its operating structure; and (c) you are a *small business entity for the income year, or both of the following apply: (i) you are not carrying on a *business in the income year; (ii) you are not *connected with, or an *affiliate of, another entity that carries on a business in the income year and that is not a small business entity for the income year. The operative provision set out in subsection 40-880(2) of the ITAA 1997 requires that the capital expenditure is incurred “in relation to” your business, a business that used to be carried on, or a business proposed to be carried on. Taxation Ruling TR 2011/6 Income tax: business related capital expenditure – section 40-880 of the Income Tax Assessment Act 1997 core issues (TR 2011/6) , sets out the Commissioner’s views on the interpretation of the operation and scope of section 40-880 of the ITAA 1997. In considering the meaning of ‘in relation to’ TR 2011/6 states: 10. The following key concepts apply in relation to the current section 40-880: ... The expenditure must be capital expenditure which is business related. This excludes revenue expenditure and non-business expenditure such as expenditure relating to occupation as an employee or to passive investment. … 76. The legislation does not define the expression 'in relation to' and so it takes its ordinary meaning. The Macquarie Dictionary, 2005, 4th edition, The Macquarie Library Pty Ltd, NSW, defines 'related' as 'associated; connected'. Accordingly, the expenditure and the business need to be associated or connected for the expenditure to be described as being 'in relation to' the business. Although the phrase 'in relation to' uses wide words of connection, the intended width of the relationship between the two connected subjects must be considered against their legislative context. … 78. The legislative context of section 40-880 indicates that the closeness of the association or connection must objectively support the conclusion that the expenditure is a business expense of the particular business. … 79. Whether capital expenditure is truly a business expense turns on the particular facts and circumstances and is a matter of impression and judgement. Determining whether the expenditure has the character of a business expense can be approached by asking what the expenditure is for, in the sense of identifying the need or object that the expenditure serves. If the facts show that the expenditure satisfies the ends of the relevant business then it will have the character of a business expense. In considering the phrase 'in relation to' contained within subsection 40-880(2) of the ITAA 1997, paragraph 2.25 of the Tax Laws Amendment (2006 Measures No. 1) Act 2006 states: The provision is concerned with expenditure that has the character of a business expense because it is relevantly related to the business. The concept used to establish this character or requisite relationship between the expenditure incurred by the taxpayer and the business carried on (current, past or prospective) is 'in relation to'. The connector 'in relation to' allows the appropriate latitude to enable the deductibility of qualifying capital expenditure incurred before the business commences or after it has ceased. Section 40-880 of the ITAA 1997 allows a deduction over five years for certain capital expenditure incurred after 1 July 2005 where a deduction is denied by another provision of the ITAA 1997 and the expenditure is carried on for a taxable purpose. In this case, the capital expenditure is incurred in relation to a business for the purposes of paragraph 40-880(2)(a) of the ITAA 1997 and the deduction is not denied by another provision of the ITAA 1997. Furthermore, the limitations and exceptions in subsection 40-880(3) and subsection 40-880(4) of the ITAA 1997 do not apply as the business is carried on for a taxable purpose. The remaining subsections of 40-880 are also not relevant to the facts and circumstances outlined in this private ruling. Conclusion At the time of making the outgoing there was sufficient evidence to support the view that that the outgoing would result in capital expenditure in relation to the business carried on. As none of the exclusions in section 40-880 of the ITAA 1997, the capital expenditure is deductible under section 40-880(2) of the ITAA 1997. Subsection 40-880(1) of the ITAA 1997 allows the business capital expenditure to be deductible over 5 years.

Relevant legislative provisions: Section 8-1 of the ITAA 1997 | Section 8-5 of the ITAA 1997 | Section 8-10 of the ITAA 1997 | Section 25-45 of the ITAA 1997 | Section 40-880 of the ITAA 1997 | Section 157 Crimes Act 1900 (NSW) | Section 178A Crimes Act 1900 (NSW)