Page 687 - SAIT Compendium 2016 Volume2

IN 80 Income Tax acT: InTeRPReTaTIon noTes IN 80
incident of the business. If a distinction is to be drawn between ordinary servants, and managers or managing directors, for which there appears to be authority, it seems to me that, a fortiori,* a partner is in quite a different position to an ordinary servant. For this reason alone it seems to me that the appeal in this case cannot be allowed.’
In ITC 1383, the commercial bank case referred to above, Hill AJ, referred to overseas court cases and authors when discussing the proposition that if a loss is occasioned by a theft committed by an employee it may be deductible, but if it is committed by a proprietor (including a partner, managing director or someone with the powers to represent his employer at that level) a deduction would not be permitted. He noted that in his view the position would be the same in South Africa under the Act. The loss was held to be deductible. On the facts of the case it was clear that the employee’s ‘fairly senior position’ was not similar to that of proprietorship.
SARS recognises that times have changed since the Lockie Bros and ITC 952 cases and that embezzlement, fraud and theft by senior managers has become more prevalent. A loss arising as a result of embezzlement, fraud or theft by a senior employee will therefore not automatically be denied as a deduction. However, there may still be circumstances in which the risk of embezzlement, fraud or theft by a senior manager is not inherent in the particular business, for example, the theft of a company’s cash by a director who is also the sole shareholder of the company. Each case must be considered on its merits having regard to its particular facts. Facts which will be relevant in most cases include, for example, the nature of the business, who perpetrated or is suspected to have perpetrated the embezzlement, fraud or theft, the perpetrator’s relationship to the taxpayer and the method used to perpetrate the embezzlement, fraud or theft.
In ITC 1661† the appellants were two dentists who practised in partnership. They appointed a rm of auditors to perform certain management and accounting functions which included the making out of and signing of cheques on behalf of the partnership. One of the auditors’ employees and possibly one of the auditors had stolen money and falsi ed signatures on cheques or used cheques for their own purposes. At issue was whether the losses could be claimed as a deduction under section 11(a). The court appeared to hold the view that in order to be ‘in the production of income’ the expenditure or loss had to either be 1) a pre-requisite to earning the income (that is, without the expenditure or loss the income could not have arisen) or 2) if it was not a pre-requisite to earning the income, then the activity giving rise to the expenditure or loss had to be an inherent risk in the taxpayer’s business which gave rise to income. Based on the facts of the case it was held that the losses were not allowable because, rst, the theft by the independent contractor occurred after the income was earned and could not therefore have been a pre-requisite to earning it and secondly, there was no evidence to prove that theft by an independent contractor was an inherent risk of the practice of dentistry.
In relation to the rst basis, with respect, in the context of embezzlement, fraud and theft, the stealing of money can never be a prerequisite to earning income, the stealing of money will nearly always occur after the income has been earned and a pre-requisite test is therefore inappropriate.‡ As stated earlier, the relevant test is whether in the taxpayer’s business, assuming it is a business which gives rise to income, the risk of embezzlement, fraud or theft that occurred is such a familiar and recognizable hazard so as to be considered inseparable from and inherent in the business. The fact that the income was earned before the loss occurred is not a bar to the deduction of the loss.
In relation to the second basis, it is unclear whether the court was saying that a deduction was simply not available because the theft was perpetrated by an independent contractor. It is submitted that this would be an incorrect approach to follow§ and that the correct test, which is in line with case authorities discussed earlier in this Note and ITC 1661 itself, is to consider whether on the facts the risk of the loss was an inherent risk in the taxpayer’s business. This test must be applied on a case-by-case basis and, depending on the facts, could lead to the conclusion that the theft by an independent contractor was incurred in the production of income. In a number of instances it will not matter whether the theft was perpetrated by an employee or independent contractor. For example, if an employee or independent contractor, who is also the sole shareholder of the company, perpetrated a theft, the loss is unlikely to be considered an inherent risk in the business. However, if an unrelated employee or independent contractor perpetrated the embezzlement, fraud or theft, the loss is more likely to be considered an inherent risk in the business.
In ITC 1661 the court said there was no evidence to support the submission that in that particular case the theft by an independent contractor was an inherent risk of the practice of dentistry. The outcome of ITC 1661 may have been different if the taxpayer had succeeded in adducing evidence to show that the risk of loss was inherent in the business, for example, by presenting appropriate crime or insurance statistics which supported the case.
In considering whether the loss is a risk which is inherent in a taxpayer’s business it is necessary to consider the general business environment as well as the industry and type of business in which the taxpayer operates. Taking a wider look than just the taxpayer’s business allows one to assess whether what occurred was an inherent risk or something in the nature of gross negligence¶ which is unlikely to be an inherent risk.
(d) Not of a capital nature
* For a still stronger reason.
† (1998) 61 SATC 353 (G).
‡ In other contexts it is submitted that the pre-requisite test is also inappropriate. The relevant enquiry is whether the
expenditure was incurred for the purpose of earning income (see, for example, Port Elizabeth Electric Tramway Co. v CIR 1936 CPD 241, 8 SATC 13; Sub-Nigel Ltd v CIR 1948 (4) SA 588 (A), 15 SATC 381; CIR v Drakensberg Garden Hotel (Pty) Ltd 1960 (2) SA 475 (A), 23 SATC 251; and CIR v Allied Building Society 1963 (4) SA 1 (A), 25 SATC 343).
§ Support for the view that losses arising as a result of the actions of an independent contractor can qualify for a deduction if all the other requirements of section 11(a) read with section 23 are met, can be found in other court cases, for example, see X v COT 1960 (2) SA 682 (SR), 23 SATC 297 and COT v Rendle 1965 (1) SA 59 (SRAD), 26 SATC 326 (obiter).
¶ See Joffe & Co (Pty) Ltd v CIR 1946 AD 157, 13 SATC 354. In that case damages arising out of negligence were held not to be deductible as based on the facts there was nothing to suggest that the negligence which had occurred was a necessary concomitant of the taxpayer’s trading operations or that the expenditure was bona de occurred for the purposes of trade.
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