CAN LOSSES INCURRED DUE TO THEFT OR FRAUD IN BUSINESS BE DEDUCTED FROM PROFIT UNDER INCOME TAX ACT, 1961?

 

By Nirmal Behera

Madhusudan Law College, Cuttack, India

Email- nirmalbhr6@gmail.com

Linkedin- www.linkedin.com/in/nirmal30

 

ABSTRACT-

The objective of this article is to discuss the provisions of the Income Tax Act, 1961 with regards to deduction made in profit, when any loss is incurred by theft or embezzlement in a business or profession. To analyse the different cases with respect to theft and fraud in business of the assessee, and thereby try to understand the pattern, in the circumstances of which the courts have been allowing a deduction, in the profits of any accounting year in which loss due to theft or fraud have been occurred. This article attempts to analyse the relevant sections of the Income Tax Act, especially the section 37 which is directly related to the issue of deductions in profit with respect to trading losses. It discusses the scope of application of the section 37 and has outlined the condition required for the application of the section.

 

 

INTRODUCTION- 

Losses in Businesses due to theft or embezzlement affects small businesses much more than the large ones. In fact many of the business failures are caused due to employee theft. It is highly unfair to impose tax on a profit which is miscomputed and does not count into all kind of losses which has been incurred by the assessee in the due operation of his business. These losses should include the losses regarding any theft, fraud or embezzlement in business for which the assessee has suffered losses. Generally income tax is imposed on the net profit or gain of a financial year of a business. Net profit or gain implies the profit or gain deducting the losses of the financial year for which income tax is assessed. Practically, losses due to theft or embezzlement (fraudulent appropriation of property by one to whom it is entrusted) are technically not losses occurred due to day to day business activities or are not losses due to conventional sense of business, but are accidental, unpredictable and unforeseeable in nature. Section 30 to 43-A of the Income Tax Act, 1961 expressly provides for the tax deduction from the income of any business or profession.

 

SCOPE OF DEDUCTIONS ALLOWED UNDER INCOME TAX ACT, 1961- 

The deductions allowed in the Income Tax Act within the ambit of section 30 to 43-A is limited primarily to the losses in the nature of expenditures only. It means that the relevant sections provides for the deductions in income tax of a business if the losses incurred by the company or firm are in the nature of expenditures on rent, taxes, repairs, insurance for buildings, repairs and of insurance of machinery, plant and furniture, investments, development rebate and allowance, expenditure on scientific research, acquisition of patent rights or copyrights, obtaining licences, expenditure on skill development projects etc. Even section 37 being a residuary section, expressly permits deduction related to the expenditures which are not mentioned within section 30 to 36. However, the explanation under section 37 clarifies, that the expenditure for the purpose of being able to claim for a deduction should not be a capital expenditure. It means that the expenditure should be in the nature of revenue expenditure or trading expenses to be able to claim a deduction under section 37.

 

According to ordinary principle of accounting, for the purpose of assessing income tax, net profit or gain should be calculated by deducting all the losses incurred by the business, only then we can arrive to true profit or gain of a business, that is –

 

[NET PROFIT = TOTAL PROFIT – TOTAL LOSSES].

 

And from that net profit for the purpose of the income tax assessment is determined. This principle was approved by the Supreme Court in Badridas Daga v. C.I.T, 34 I.T.R. 10 : 1958 SC 783, and after that, in many subsequent cases as well. Thus, it is now settled that trading losses may be allowed, to arrive at true figures of the profit or loss in a business income. For that following conditions are to be fulfilled-

1)      The loss should be incidental to the trade or business and not merely connected with the trade,

2)      The loss must be of non-capital nature,

3)      The loss must have been incurred by the assessee in the character of a trader and has fallen on him in that character,

4)      The deduction of the loss is not expressly or by necessary implication prohibited by the Act,

5)      The loss has been incurred in the relevant accounting year.

 

WHETHER LOSSES INCURRED BY THEFT OR EMBEZZELEMENT ARE LOSSES INCIDENTAL TO BUSINESS-

The conditions given above are to be carefully considered, while assessing the losses incidental to a business or a trade. The losses cannot be simply allowed for a deduction because it is closely related to the business or has some connection with the business. The losses should be purely incidental to the operation of the business. In a case of,  C.I.T.  v. Chakka Narayana, (1961) 43 I.T.R. 249 (A.P.) it was the view of the court that, “ a loss should be treated as loss incidental to the business only when the action is in pursuance of which the loss has been incurred to the assessee, is absolutely necessary for the purposes of his business.” In the above case, the assessee was a dealer in cloths and government securities. After selling the government securities worth about Rs. 20,000, he was taking the money to his place of business, but lost it on account of theft. The A.P. High Court held that, “It could not be posited that it was absolutely necessary for the assessee to cash the cheque issued and to carry the money on his person. It is only when it could be posited that it was part of his business to take money with him that it could be said that the loss was incidental to his business.”

 

Later, the Supreme Court had rejected this view of the A.P. High Court in the case of Ramchandar Shivanarayan v. C.I.T., 1978 Tax L.R. 228: A.I.R. 1978 S.C. 278. In this case, the assessee borrowed money for the purpose of purchasing government securities. The money was brought by his employee and handed over to the cashier, but an unknown person committed theft of the money. The A.P. High Court on the basis of judicial precedence held that the loss was not incidental to the business of the assessee. Soon, The Apex Court rejected the opinion and held that the loss was incidental to the carrying on of the business and directly connected to the business operation of the assessee. It was also held in the same case that, “The risk is inherent in the carrying on of the business and is either directly connected with it or incidental to it.” The Supreme Court here acknowledged that, whether or not a loss is incidental to the operation of a business depends on the nature of the operation carried on and also the nature of risk involved in carrying on that business.

 

WHETHER A LOSS DUE TO THEFT OR EMBEZZLEMENT IS OF NON-CAPITAL NATURE-

A loss which is not a revenue loss is basically a capital loss. A revenue loss may be defined as a loss which is not merely connected with the trade or the business but also incidental to it (I.T.R., 1958). A loss of stock-in-trade or a loss incurred in the course of business and incidental to it is a revenue loss. Also, even if stock-in-trade is lost in the transit or by negligence or fraud of employees, or is destroyed by fire, it is a revenue loss (A.I.R., 1963). In some case, the theft committed by an employee after the office hours is not treated as revenue loss (I.T.R., 1962). But fortunately the present trend of courts is to consider the thefts and embezzlements regardless of it being in office hours or not, as revenue loss (N.Z.R., 1961). There is no such fixed test to determine or distinguish the revenue loss from capital loss, and therefore nature of the loss to be determined on the facts of each case (I.T.R., 1968).

 

WHETHER THE DEDUCTION OF THE LOSS DUE TO THEFT OR EMBEZZLEMENT IS EXPRESSLY PROHIBITED BY THE ACT- 

A trading loss is allowed to be deducted on the principle of commercial accounting. If any kind of deduction is expressly barred or prohibited by the Income Tax Act, it cannot be allowed. Section 37 of the IT Act prohibits deduction for the expenditure by the assessee for any purpose which is an offence or which is prohibited by law. The deduction related to the expenditure on corporate social responsibility referred to in section 135 of the Companies Act, 2013 is also not allowed. No allowance should be accepted, on the expenditure related to any advertisement in any souvenir, brochure, tract, pamphlet or the like published by a political party. Thus, apart from above expressed prohibitions in section 37 regarding deduction from the expenditure or loss incurred in trading, nothing more can be conferred.

 

WHETHER LOSS DUE TO THEFT OR EMBEZZLEMENT CAN POSSIBLY BE INCURRED BY THE ASSESSEE BEING IN THE CHARACTER OF A TRADER- 

In the case of C.I.T. v. K.T.M.S. Mahmood, 1969, the assessee was a dealer in semi-precious stones. He had purchased total of 750 watches for Rs. 33,125. One day while he was carrying them in a bag to home, was forcibly removed from his possession by two police constables. Only 489 watches were recovered by the constables after a complaint filed by the assessee. These watches he was able to sell in the next year and the relevant profit was brought to tax. The loss was about Rs. 13,271/- due to theft watches. It was contended by the income-tax officer that the watches did not form part of the assessee’s stock-in-trade (since the assessee was dealing in semi-precious stones) and the theft did not occur in his business premises or during business hours and therefore declined to allow it as a business loss. It was held that all the same business loss should be allowed as a deduction in the computation of the profits and gains of business under section 10(1). The assessee was engaged in dealing in semi-precious stones, did not mean that at the same time he could not pursue the business of dealing in watches. The quantity of watches the assessee purchased, itself shows that it should have been for trading purposes (I.T.R., 1969).

 

THE LOSS MUST BE IN THE RELEVANT ACCOUNTING YEAR-

It means a loss incurred before the commencement of the accounting year will not be allowed in assessing the profits and gains of the year. In the case of C.I.T. v. Chitnavis, it was observed by Lord Russel that “one may not arrive at true profits and gains of a year, if the loss deducted occurred before the commencement of the accounting year.” The profits and losses of a year is a self-contained period of time, with respect to which, profits earned or losses sustained before its commencement is immaterial (A.I.R., 1932).

 

CONCLUSION-

It is not settled as to when a loss due to theft or embezzlement may be allowed to be deducted, under the head of profits or gains of a business, though there are some conditions outlined by some cases in the past. More precisely it really depends on different facts of the case, circumstances of the assessee while trading, the nature of the business and relation of the loss occurred with the operation of the business. As the law is evolving and the courts are more acknowledging the problems in system of assessing profits and losses of businesses, and loopholes in the methods of assessing them, it has been observed through precedents of cases that the courts are more inclined to allow any deduction of losses in business even if it is due to theft or embezzlement of an employee or an outsider. Though such courtesy limits to the condition, of the loss being occurred in the accounting year and not before that, and that the loss must be an incidental loss to the business of the assessee.

 

 

 

 

 

 

 

Bibliography

A.I.R. 1963. Annamalai Chettiar v. C.I.T. s.l. : MADRAS HIGH COURT, 1963.

—. 1932. C.I.T. v. Chitnavis. s.l. : P.C., 1932.

I.T.R. 1958. Badridas Daga v. C.I.T. s.l. : Supreme Court, 1958.

—. 1969. C.I.T. v. K.T.M.S. Mahmood. s.l. : Madras High Court, 1969.

—. 1968. C.I.T. v. National Finance Ltd. s.l. : Supreme Court, 1968.

—. 1962. Salem Gujai Sri Krishna Bank Ltd. v. C.I.T. s.l. : Madras, 1962.

N.Z.R. 1961. Gold Bank Service Ltd. v. Commr. I.T.R. s.l. : Supreme Court, 1961.