Are expenses and losses incurred as a result of embezzlement tax-deductable?

Abstract

The study analyses whether taxpayers may deduct for tax purposes losses and expenses which they incur as a result of embezzlement activities. Whilst the SCA finally got the chance and held that income which is illegally obtained by a taxpayer as a result of illegal activities indeed forms part of the taxpayer s gross income, the SCA is still to get the chance to pronounce whether taxpayers should be allowed to deduct expenses and losses which are incurred as a result of embezzlement activities which may be perpetrated by shareholders, partners, senior managers, junior employees and people unrelated to the taxpayers. The study utilises legislation, cases and commentary from South Africa and other jurisdictions. For a deduction to be allowed for losses and expenditure which are incurred as a result of embezzlement, it must be established that losses and expenditure which the taxpayer incurs as a result of embezzlement are sufficiently close to the taxpayer s production of income as held by the court in CoT v Rendle.1 As required by section 11(a) of the Act, embezzlement losses and expenditure which are incurred in the production of income may be allowed for deduction. For a deduction to be allowed, the risk of incurring the loss or the expenditure must be inherent to the business enterprise of the taxpayer. The study concludes by proffering recommendations which our courts can consider when they get an opportunity to pronounce on whether losses and expenditure which taxpayers incur as a result of embezzlement activities come before our courts again. The study recommends that losses and expenditure which are incurred by taxpayers as a result of embezzlement activities by partners and shareholders in a firm should not be allowed for deduction, and that they should rather be treated as drawings by those partners or shareholders. The study recommends that losses and expenditure which are incurred as a result of embezzlement activities by senior managers in a firm may be allowed if the senior managers did not occupy a position which is akin to that of a shareholder of the company. The study recommends, in line with the decision in Rendle2 that losses and expenditure which are incurred as a result of embezzlement activities by people unrelated to the company should be allowed for deduction. The study also recommends that losses and expenses incurred as a result of embezzlement by junior employees should be allowed for deduction. Finally, the study recommends that as embezzlement activities are secretive and may take long to be detected, the Act must be interpreted flexibly so that taxpayers are not restricted to claiming embezzlement losses and expenditure in the years in which the embezzlement activities occur, as taxpayers may be disadvantaged if they discover embezzlement after some period. Taxpayers should be allowed to claim for tax deductions in the year which they discover the embezzlement losses, even though the losses might have been incurred in prior years. This is the approach which was advanced in the United States cases in Alison v United States3 and United States v Stevenson-Chislett Inc4 and also the approach which is used by the United States Treasury.