Beyond the loss - deductibility of fraudulent business losses

Fraud can strike any business – whether through embezzlement, fake invoices, payroll manipulation, or investment scams. Beyond the financial loss, fraud can trigger tax consequences and even personal liability for directors.

This article explores potential tax deductions, capital losses, and ATO risks relating to fraud against your business.

Common types of business fraud

Fraud on a business can encompass many forms including:

• Embezzlement: This occurs when employees or agents steal business funds for personal use.

• Invoice Fraud: This occurs when vendors, employees, or scammers generate invoices for services or products that were not provided, or they overcharge for genuine services, redirecting funds into personal accounts.

• Payroll Fraud: Employees may alter payroll records to obtain compensation they have not earned, such as by recording fictitious hours worked or submitting inaccurate expense reports.

• Misappropriation and investment scams: This includes embezzlement by intermediaries, or fraudsters posing as legitimate brokers or investment platforms.

• Reporting Fraud: This entails deliberately falsifying financial statements or ATO returns to misrepresent the financial position of a business or the tax liabilities owed to employees (such as superannuation) or to the ATO.

Tax deductions and capital losses - what you can claim

When fraud happens to your business, the business may be eligible for deductions or capital losses depending on the nature of the fraud.

In fraud scenarios, a tax deduction may be claimed pursuant to the following provisions of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997):

• Section 25-45 allows deductions for losses due to theft, embezzlement or misappropriation by employees or agents, but only if those funds were included in assessable income;

• Section 8-1 provides a general deduction for any loss incurred in gaining or producing assessable income or from carrying on a business, provided such loss is not capital, private, or domestic in nature.
  
  If the loss is capital in nature, it may not be deductible but could result in a capital loss. 

Where fraud relates to a CGT event (such as the sale of a property where the sale proceeds are stolen), then the related capital proceeds may be reduced under section 116-60 of the ITAA 1997 if the taxpayer’s employee or agent misappropriates all or part of those proceeds, resulting in a capital loss for the taxpayer. If the misappropriated proceeds are later recouped, the capital proceeds are increased by the amount received.

Reimbursements and insurance payouts

If you recover a fraudulent loss (including through insurance), any recouped amounts deducted become assessable income under sections 20-20 and 20-35 of the ITAA 1997.

Practical scenarios and potential tax implications

Below we explore some common fraud scenarios and the criteria which must be satisfied in order to claim a tax deduction or capital loss.

1. Employee theft

Example: A bookkeeper transfers $50,000 from the company’s bank account to their own personal account.

Potential tax consequences:

• If the stolen funds were from assessable income of the company, a deduction under section 25-45 may apply.
• However, if the stolen funds cannot be traced to assessable income amounts (such as if the funds were transferred to the company’s investment account before being stolen), the connection to assessable income may be broken, and the deduction denied under section 25-45 (see for example LEAN v Federal Court of Taxation [2010] FCAFC 1).

2. Fraudulent investment advisors and trading platforms

Example: A taxpayer deposits $200,000 with a broker to invest on the taxpayer's behalf. The taxpayer was advised by the broker that losses of $100,000 have been suffered in respect of the investments. The losses were in fact incurred from fictitious transactions, or from misappropriation of the taxpayer's funds.

Potential tax consequences:

• If the loss resulting from payment to the intermediary cannot be attributed to the taxpayer's assessable income and is capital in nature, a deduction would not be permissible.

• Whether or not the taxpayer is entitled to a capital loss will depend on the circumstances surrounding the transfer of the funds to the broker and the characterisation of the relationship between the taxpayer and the broker.
  
  Where funds are transferred to a fraudulent investment intermediary, such amount transferred may result in a debt or obligation being owed to the transferor by the investment intermediary. When the recovery of funds from the fraudulent investment intermediary is unsuccessful, as no money or other property is received, the debt may be worthless and the capital proceeds reduced to nil, resulting in a capital loss arising.

3. Cryptocurrency scam

Example: A taxpayer transfers crypto assets to an offshore trading platform that turns out to be fraudulent. The taxpayer is not in the business of trading crypto. The taxpayer engaged a specialist crypto recovery organisation to recover the crypto, however, the recovery organisation has advised that the funds have been moved into numerous other locations and are not able to be associated with the owner of the account or recovered.

Potential tax consequences:

• Where the loss incurred is from an initial investment made in order to generate future profits, the loss may be capital in nature resulting in a deduction under section 8-1 not being allowed (see for example paragraph 36 of IT 2228 Income tax: futures transactions).

• If the trading platform can be characterised as an agent for the taxpayer, then the loss incurred on the disposal of crypto may result in a capital loss due to the capital proceeds the business is entitled to receive being reduced by the amount misappropriated.

4. Fake invoices

Example: An employee wrongfully pays a fraudulent invoice of $30,000. The invoice was intercepted and altered fraudulently before being received by the business and accordingly the payment is made to a fraudster. The business’s insurance company confirmed that its insurance policy did not cover a loss due to fraud.

Potential tax consequences:

• A deduction under section 25-45 may not be available as the loss would not be caused by the theft, stealing, embezzlement, larceny, defalcation or misappropriation by the employee (with the employee believing that the invoices were legitimate).

• A deduction for the loss under the general deduction provisions in section 8-1 may be available if the payment was for a profit-making purpose, however, no deduction would be available if the payment was capital in nature.

Liability for incorrect taxation lodgments

Fraud may result in amounts owed to the ATO being incorrectly reported or unpaid. 

For example, a business’ tax agent may alter a business’ Business Activity Statement (BAS) to increase GST refunds and redirect refunds to their own bank account. In such circumstances, the taxpayer may remain liable to the ATO for the fraudulent overpayments made to their agent’s account.

If as a result of fraud, Pay As You Go Withholding (PAYGW), Superannuation Guarantee Charge (SGC) liabilities or Goods and Services Tax (GST) liabilities of a company are reported incorrectly or remain unpaid, then the ATO can seek to recover amounts from the directors of that company by issuing a Director Penalty Notice (DPN).

Author: Stephanie Flegg

Contributing partner: Chris Tsovolos

This publication is intended as a source of information only. No reader should act on any matter without first obtaining professional advice.