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The Federal Court (Stone J) has upheld the Commissioner's appeal from the decision of the AAT, which held that a taxpayer was entitled to a deduction under s 25-45 ITAA 1997 for half the amount of $4,630,314, misappropriated by a person who represented himself as a securities trader and investment fund manager in Hong Kong, on the basis that half the amount of money misappropriated was sourced out of the taxpayer's share of profits derived by him on the sale, in unrelated transactions, of US shares.

Section 25-45 requires, amongst other things, that "the money was included in your assessable income for the income year, or for an earlier income year".

The Commissioner argued that the money itself, being the capital proceeds referable to a capital gain, had not itself been included in assessable income but had merely been taken into account in calculating a net capital gain. This was rejected by her Honour. She said, at para 44:

"The Commissioner's submissions on this point must be rejected. If certain money has been included in the taxpayer's assessable income and if, pursuant to the 1997 Act (which is applicable in this case) the money was properly so included, then to my mind whether it was derived as "income" per se or as a "capital gain" is not relevant. Section 25-45 does not require that the money be acquired as income but only that it be included in assessable income. Assessable income is defined in s 995-1 as having the meaning given by a number of sections including s 6-15 (1) which provides that all assessable income is either statutory income or ordinary income. Section 25-45 does not prescribe the basis of inclusion in assessable income. It makes no distinction between money characterised as ordinary income pursuant to s 6-5 or statutory income pursuant to s 6-10."

The Commissioner then argued that the money, as well as having been included in the taxpayer's assessable income must, at the time of the misappropriation, have retained its character as income. This is necessary, so the Commissioner said, in order for the loss suffered by the taxpayer to be able to be described as being in respect of money that was included in the taxpayer's assessable income. Once the money can no longer be characterised as income then, the Commissioner submitted, it cannot be money that was included in assessable income. The Commissioner argued that, in this case, once the taxpayer directed the proceeds of the share sale to be transferred to Hong Kong for investment in the stock market the money lost its character as income and became part of the capital of the taxpayer.

On this point, her Honour upheld the Commissioner's appeal. She said, at para 49:

"...once money received as income is deployed by the taxpayer, personally or by way of an agent, for expenditure or investment, the characterisation as income is no longer appropriate and the loss cannot be said to have been incurred in respect of the money included in assessable income."

Her Honour then said, at para 51:

"In summary, s 25-45 requires, inter alia, that the money in respect of which the loss has been suffered be money which is included in the taxpayer's assessable income. It is necessary therefore that the latter must be traceable to the former but that is not sufficient. The characterisation must remain the same. The respondent [taxpayer] submits that this is an additional element not to be found in the words of the section and is an impermissible gloss on those words. I do not accept that submission. The requirement that the money in respect of which the loss is suffered be money that was included in a taxpayer's assessable income demands the same characterisation."

FCT v Lean [2009] FCA 490 (Federal Court, Stone J, 14 May 2009).

For a copy of the decision, go here.

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