BIM37810 - Wholly & exclusively: expense of earning or application of profits?: defalcations by controlling director
Something outside the trade
Losses arising as a result of staff thefts or negligence are
generally allowable. Losses arising as a result of withdrawals by
the business principals (the trader, partners or directors as the
case may be) are not allowable.
In the case of Curtis v J & G Oldfield Ltd [1925] 9TC319,
the managing director of a private company controlled the business
although he did not have a majority shareholding. After his death
an investigation revealed that some £14,000 was due from his
estate to the company. Many private transactions had gone through
the company’s books. The debt was valueless and was written
off by the company who claimed a bad debts deduction.
The Commissioners allowed the deduction but were overturned
by the High Court. Rowlatt J made the following points:
- Relief for bad debts is confined to items which had they been received would have been taxable receipts.
- A trader is taxed on the profits of their trade and not on what they retain at the end of the day.
- Defalcations by subordinate employees are normally deductible for tax purposes.
- Money appropriated by a controlling individual is an application of profits not an expense of earning profits and no deduction is due.
Rowlatt J thought that the Commissioners had allowed themselves
to act under the impression that they were taxing the company on
what the company in a loose way had made and secured. In point of
law the Commissioners were engaged in assessing the profits of the
company's trade, not of the company itself but of the company's
trade. Rowlatt J had to consider whether there was any ground for
supposing that losses of these sums resulting in this bad debt were
losses in the trade. Rowlatt J explained that where, owing to the
negligence or the dishonesty of the subordinates, some of the
receipts of the business do not find their way into the till, or
some of the bills are not collected at all, or something of that
sort, then any loss arising is a loss of the trade and should be
allowed. But the situation in Curtis v J & G Oldfield Ltd was
quite different. It was the managing director who had taken the
money in question. He controlled the company and making away with
the company’s money was something altogether outside the
trade.
Normally you should allow a deduction for defalcations by
subordinate employees. Equally any recoveries (for example, from
the employee or insurer) are taxable.
But you need to satisfy yourself as to the underlying facts
including why, if that is the case, the alleged defalcations have
not been reported to the appropriate authorities and/or no attempt
has been made to secure a recovery, in whole or in part. In
particular, you should carefully examine any claim to deduction
where the trader alleges theft or other wrongdoing but has made no
serious attempt at recovery.
For those who do not have ready access to tax case volumes,
the part of Rowlatt J’s judgement on which the above guidance
is based is set out below, 9TC lower half of page 330 and upper
part of page 331:
When the Rule speaks of a bad debt it means a debt which is a debt that would have come into the balance sheet as a trading debt in the trade that is in question and that it is bad. It does not really mean any bad debt which, when it was a good debt, would not have come in to swell the profits. What the Commissioners have been misled by, in my judgement, quite clearly is this. They have allowed themselves to act under the impression that they were taxing the Company on what the Company in a loose way had made and secured. In point of law they were engaged in assessing the profits of the Company's trade, not of the Company itself but of the Company's trade, and I have to consider whether there is the least ground for supposing that losses of these sums resulting in this bad debt were losses in the trade. I quite think, with Mr. Latter, that if you have a business (which for the purposes of to-day at any rate I will assume) in the course of which you have to employ subordinates, and owing to the negligence or the dishonesty of the subordinates some of the receipts of the business do not find their way into the till, or some of the bills are not collected at all, or something of that sort, that may be an expense connected with and arising out of the trade in the most complete sense of the word. But here that is not this case at all. This gentleman was the Managing Director of the Company, and he was in charge of the whole thing, and all we know is that in the books of the Company which do exist it is found that moneys went through the books into his pocket. I do not see that there is any evidence at all that there was a loss in the trade in that respect. It simply means that the assets of the Company, moneys which the Company had got and which had got home to the Company, got into the control of the Managing Director of the Company, and he took them out. It seems to me that what has happened is that he has made away with receipts of the Company dehors the trade altogether in virtue of his position as Managing Director in the office and being in a position to do exactly what he likes.
