When is stolen money tax-deductible?

Latest News from CPA Australia (Robert Richards, solicitor and CPA)

Lean v FC of T (Administrative Appeals Tribunal, 20 June 2008)

Lean was a share trader. In 2001 he met a Mr Heffernan, who claimed he was a Hong Kong-based, experienced share trader and that he produced ‘unprecedented earnings of 20 to 40 per cent a month for select international investors’. Lean formed an association with Heffernan and transferred $4.65 million to him. Most of this sum was misappropriated by Heffernan.

Lean claimed a tax deduction for the misappropriated amount.

So far as is presently relevant, Lean argued that he had incurred a loss, which was deductible as it was incurred in carrying on a business; that it was a loss from a profit-making undertaking or plan; or that it was loss or misappropriation by an agent.

General deductibility

A loss is deductible under the general provisions if it was incurred in gaining or producing assessable income, or was incurred in carrying on a business for the purpose of producing such income. The loss, cannot be of capital, or of a capital nature (section 8-1 of the Income Tax Assessment Act 1997).

The tribunal held that Lean was not entitled to deduct the amount misappropriated by Heffernan under that section. This was because the lost sum was in the nature of a ‘capital contribution’ to a venture between Lean and Heffernan. The sum formed part of an amount that could be resorted to by Heffernan ‘for any of a very wide range of investment activities’.

Loss from a profit-making undertaking or plan

Lean claimed that the sum he paid to Heffernan was part of a profit making undertaking or plan. He argued that, as a consequence, he was entitled to a deduction for that loss, such a deduction being specifically allowed by section 25-40 of the Act (that section allows a deduction for a loss incurred from a profit making undertaking or plan). However, the tribunal rejected that argument. It said: ‘A taxpayer is not entitled to a loss deduction under this section in relation to conduct that involves mere investment in an undertaking conducted by others.’

Section 25-45 of the Act allows a deduction for a loss by ‘theft, stealing, embezzlement, larceny, defalcation or misappropriation’ by an employee or agent (other than one employed solely for private purposes) of any amount returned or returnable by the taxpayer as assessable income. Lean said that the sum misappropriated by Heffernan was a loss of income returned by him as assessable income.

The Tax Office resisted, arguing that the section did not allow a deduction for a loss unless there was ‘identity’ between the loss and the character of the money as income.

It argued that this identity would be lost once the money was appropriated to the taxpayer’s general purposes, as it would inevitably be if it was merely retained in general funds after the year of income.

However, the tribunal refused to adopt such a narrow interpretation. It said that section 25-45 ‘encourages the conclusion that the section is not confined to losses that occur as a result of the “theft” of money that retains its character as income, and has not, at that time, either been applied for any particular purpose or merely held as part of the taxpayer’s general funds’.

This effectively means that one need not worry about the limitations contained within the general deductibility provisions.

However, the tribunal only allowed Lean a deduction of $2,315,157 because he could not show that some of the funds remitted by him to Heffernan were remitted from amounts returned or returnable as assessable income.

It used to be said that if money is stolen before being banked, a deduction would be allowable. If, however, it was stolen after being banked, a deduction would not be allowable. The tribunal’s interpretation of section 25-45 shows this will not necessarily be the case if an agent or employee is the thief.