ATO Interpretative Decision

ATO ID 2002/347 (Withdrawn)

Income Tax

• This ATO ID is withdrawn as it is a straight interpretation of the law, a reference to these types of deductions has been included on the ' Other operating expenses' for businesses page (QC33867).
  This document has changed over time. View its history.

Issue

Is a loss incurred by a partnership through fraud by a partner deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Decision

No, a loss incurred by a partnership through 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 one of the partners had been engaged in fraudulent conduct with regard to out of pocket expenses over a number of accounting periods.

Reasons for Decision

In Ash v. Federal Commissioner of Taxation (1938) 61 CLR 263; (1938) 5 ATD 76 (Ash) a solicitor sought to deduct an instalment paid under a covenant to make good misappropriation by his former partner of moneys belonging to clients of the firm. The fraudulent partner had procured clients to make overpayments to him in respect of various outgoings, such as counsels' fees, payments under contracts of sale, and stamp duties. The High Court of Australia held that the payment was not deductible. The liability to repay was of a capital nature as the risk of dishonesty by a partner is not an inherent risk in carrying on the partnership business.

The court in Ash drew distinctions between the defalcations by a partner and those of an employee. Latham CJ stated at CLR 273 - 274:

... purloinings by office boys and thefts by shop employees should, prima facie, be allowed as deductions. They may be shown to be incidental to, and perhaps inevitable in, the operations which produce income.

But the case is different when income is actually received and then misapplied by the proprietor of a business or person in the position of such a proprietor, as, for example, the manager of a company.

Similarly, Rich J stated at 277:

The defalcations of a partner appear to me to stand in a different position from the petty larcenies of servants and the leakages through carelessness or dishonesty to which the revenues of most profit-earning organisations are exposed ...

There is no difficulty in understanding the view that involuntary outgoings and unforeseen or unavoidable losses should be allowed as deductions when they represent that kind of casualty, mischance or misfortune which is a natural or recognised incident of a particular trade or business, the profits of which are in question.

In his judgment, Dixon J held that where a person in the position of a proprietor of a business defrauds its clients the resulting liability cannot be considered an outgoing of the business, much less an outgoing on revenue account. At 283 his Honour stated:

In my opinion the loss inflicted upon the taxpayer by his fraudulent partner takes no place in the subsequent carrying on of his practice. It was simply a loss or depletion of his general resources as a result of his undertaking the risk of such a liability when by entering into a partnership each partner armed the other with an authority under which he might impose liabilities upon him.

In Ash the fraud by a partner was considered to be a business risk. The loss was a loss of capital and the expenditure made for the purpose of meeting or retrieving the loss was a capital expenditure: see Latham CJ's comments at 275.

Accordingly, the loss caused by the fraudulent partner does not represent the 'kind of casualty, mischance or misfortune which is a natural or recognised incident' of a professional partnership: see Ash per Rich J at 277. The defalcations by a partner are in a different class from theft by employees. The risk that a partner will abuse their position and make fraudulent out of pocket expense claims is not a natural or recognised incident of conducting business through a partnership.

Amendment History

Year of income:  Year ended 30 June 2001

Legislative References:
Income Tax Assessment Act 1997
   Subsection 8-1(2)

Case References:
Ash v. Federal Commissioner of Taxation
   (1938) 61 CLR 263
   (1938) 5 ATD 76

Keywords
Losses from fraud, theft & embezzlement

Business Line:  Small Business

Date of publication:  28 March 2002

ISSN: 1445-2782