Page 686 - SAIT Compendium 2016 Volume2

IN 80 Income Tax acT: InTeRPReTaTIon noTes IN 80
of some properties on behalf of its clients. One of the clerks employed by the rm had embezzled the clients’ funds, and the taxpayer had incurred expenditure in reimbursing the clients as well as in investigating the embezzlement and in obtaining legal advice. The taxpayer sought to claim a deduction for the expenditure. It was held that the amounts were allowable as they were part of the cost of performing the taxpayer’s business operations. The court re-con rmed that the test established in the Port Elizabeth Electric Tramway Co case* was the appropriate test to apply when determining whether the expenditure and losses arising from the embezzlement, fraud or theft of money was incurred by the taxpayer in the production of the income and noted the following:†
‘All expenses attached to the performance of a business operation bona de performed for the purpose of earning income are deductible whether such expenses are necessary for its performance or attached to it by chance or are bona de incurred for the more ef cient performance of such operation provided they are so closely connected with it that it would be proper, natural or reasonable to regard the expenses as part of the cost of performing the operation.’
In deciding whether the fortuitous expenditure was deductible, the court in the Rendle case was of the opinion that the inquiry must be whether the ‘chance’ of such expenditure or loss being incurred is suf ciently closely connected with the business operation. The focus is thus on the risk of the expenditure or loss being incurred and not on the actual expenditure or loss itself. The court summarised the legal position as follows:‡
‘Before fortuitous expenditure can be deducted, the taxpayer must show that the risk of the mishap which gives rise to the expenditure happening, must be inseparable from or a necessary incident of the carrying on of the particular business.’
The test as formulated above has been con rmed and applied in various other court cases.§ In ITC 952¶ the appellant, a practising attorney, had carried on business in partnership. The appellant’s partner had stolen money from the partnership trust account which the appellant had made good. At issue was whether the amount paid by the appellant was an allowable deduction for income tax purposes. In nding that the amount was not allowable, Fieldsend P stated that –**
‘the essential factor to be determined is whether the dishonest removal of funds was a reasonably incidental risk to the production of assessable income in the locality at the time’.
Although the language used in the Rendle case (‘inseparable from’ and ‘necessary incident of’) differs from that used in ITC 952 (‘reasonably incidental risk’), they are in substance the same test. The assessment which needs to be made is whether in the particular taxpayer’s business the risk of embezzlement, fraud or theft is such a familiar and recognizable hazard so as to be considered inseparable from and inherent in the business.†† In other words, when carrying on that type of business the taxpayer inevitably has to undertake the risk that embezzlement, fraud or theft could occur.
In ITC 1383‡‡ the appellant, a commercial bank, had claimed a deduction for a loss incurred as a result of theft by an employee. The ‘fairly senior’ employee ranked sixth amongst the bank’s senior of cials at its head of ce but only had control over three employees. In allowing the loss as a deduction Hill AJ found that the risk of loss to a bank as a result of theft was an ever-present factor, stating the following:§§
‘The appellant in the present case is a commercial bank which in the ordinary course of its business must necessarily allow the employees to handle large sums of money and however careful it could be expected to be in the selection and supervision of its staff, the risk of theft is an ever-present factor in the administration of its business and must be regarded as inseparable from it.’
Burglary and robbery are likewise inherent risks attached to conducting a business and losses arising therefrom are connected with the trade.¶¶ The removal of the proceeds from cash sales from a business by a sole proprietor is not theft but rather represents an omission of income.
The application of the risk test in the context of embezzlement, fraud or theft committed by senior employees or of cials can be more dif cult. The court cases have tended to nd that such expenditure and losses are not deductible. In Lockie Bros Ltd v CIR*** a manager of the South African branch of a United Kingdom company had stolen a large sum of money from the company and the appellant sought to claim the loss as a deduction for income tax purposes. Mason J found that the loss was not incurred in the production of income because the embezzlement of the funds was not an operation undertaken for the purposes of the business. In ITC 952 above, the court stated that a sound reason for the decision in the Lockie Bros case was –†††
‘that one does not reasonably expect a senior manager or managing director to make away with his employer’s funds, and that such a risk is not reasonably incidental to the trade, as the petty larcenies of servants and the leakages through carelessness or dishonesty to which the revenues of most pro t-earning organizations are exposed’.
Turning to the facts of ITC 952 (that is theft by a partner of the appellant), Fieldsend J held as follows:‡‡‡
‘Applying the law to the facts of the appellant’s case I do not think that it can be said that the defalcations of a partner in an attorney’s rm can be said to be the kind of casualty, mischance or misfortune which is a natural and recognized
* As subsequently modi ed by various Appellate Division decisions.
† At SATC 330.
‡ At SATC 333.
§ ITC 1221 (1974) 36 SATC 233 (R); ITC 1242 (1975) 37 SATC 306 (C); ITC 1268 (1977) 40 SATC 57 (T); ITC 1383
(1978) 46 SATC 90 (T) and ITC 1710 (1999) 63 SATC 403 (C). ¶ (1961) 24 SATC 547 (F).
** At 551.
†† See the Rendle case above at SATC 333.
‡‡ (1978) 46 SATC 90 (T).
§§ At 94/95.
¶¶ ITC 1268 (1977) 40 SATC 57 (T). *** 1922 TPD 42, 32 SATC 150. ††† At SATC 551.
‡‡‡ At 552.
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