High Court of Singapore: AQP v Comptroller of Income Tax [2011] SGHC 229

27 October 2011

This is an appeal concerning the question whether losses caused to a company by a fraudulent director (“the Ex-MD”) are deductible for income tax purposes under section 14(1) of the Income Tax Act (Cap 134, 2008 Rev Ed) (“the Act”).

The appellant is a company listed on the SGX Main Board. The youngest son of the founder of the company, “the Ex-MD”, had entered into a service agreement with the appellant to hold office as Managing Director for three years commencing on 20 October 1995. The service agreement was renewed for a further term of three years from 20 October 1998. At all material times, he also served as a member of the Board of Directors.

On 1 December 1999, the Ex-MD was dismissed as both Director and Managing Director for misappropriation of the company’s funds and was charged and tried in the District Court. In Public Prosecutor v Kwek Chee Tong in DAC 48461/99 (“PP v KCT”), the District Judge (“the DJ”)convicted the Ex-MD of 24 charges of criminal breach of trust under section 409 of the Penal Code (Cap 224) and sentenced him to a term of nine years in prison.

The Ex-MD’s modus operandi was to make out false purchase orders to the appellant’s suppliers for the purchase of bearings, the appellant’s stock in trade. Based on these false purchase orders, several cheques were issued to him or his nominees on his claim that he had advanced money from his personal account to the appellant to make the purchases. He also falsely claimed that he had made loans to the appellant’s customers for their purchases against and he reimbursed himself from the appellant’s funds. In most instances the company’s funds were used to repay the accused’s gambling debts and feed his gambling habit.

After the Ex-MD’s misappropriation came to light, the appellant made provisions for doubtful debts of $12,410,141 inclusive of the Loss in its statutory accounts under “Extraordinary items” for the year ended 31 December 1999. However, no claim for deduction for the Loss was made for the YA 2000.

In 2003, the appellant instituted legal proceedings against the Ex-MD for the amount misappropriated and obtained judgment against him. However, recovery proved fruitless and the Ex-MD was subsequently adjudged bankrupt.

On 15 December 2005, the appellant lodged an “error or mistake” claim for the Loss under section 93A of the Act with the respondent. By a letter dated 1 December 2008, the respondent made a determination that relief could not be granted “as there is no error or mistake within the meaning of section 93A of the Act”.

The appellant then filed a Notice of Appeal to the Income Tax Board of Review (“the Board”) on 5 December 2008. This was followed on 30 December 2008 by the Petition of Appeal seeking an order (among other things) to direct the respondent to grant relief to the appellant under section 93A of the Act and to allow the Loss as a deduction for YA 2000 under section 14(1) of the Act.

The Board referred to the English approach in Curtis (HM Inspector of Taxes) v J & G Oldfield, Limited (1925) 9 TC 319 (“the Curtis test”) and came to the conclusion that the Loss sustained by the appellant was not deductible under section 14(1) of the Act. The appellant’s appeal was therefore dismissed.

The two issues that arose on appeal were:

  • Did the Board err in holding that the Loss incurred by the appellant was not wholly and exclusively incurred by the appellant in its production of income under section 14(1) of the Act?
  • Did the Board err in holding that an erroneous opinion or a grossly negligent error, such as a mistake of law, can constitute an “error or mistake” under section 93A of the Act?

The appellant put forward three main arguments in support of its position that the Loss it has sustained should be deductible, i.e.

  •  The Commonwealth cases support the appellant’s understanding of the Curtis test – i.e. whether the misappropriation occurred in the course of the appellant’s normal income-earning activities and not outside them;
  • The Board’s understanding of the Curtis test – i.e. whether the defalcator was “in a position to do whatever he likes” – is undesirable both legally and on policy grounds;
  • Even if the Board’s understanding of the Curtis test is to be applied, the Ex-MD was not “in a position to do whatever he likes”.

In response, the respondent submitted:

  • The Commonwealth cases have established the proposition that losses arising from embezzlement by a director or partner are not deductible;
  • The appellant’s understanding of the Curtis test should not be adopted lest financial indulgence is seen as being condoned;
  • The Ex-MD of the appellant was not merely an employee but was a person with overriding power or control similar to the defalcating director in Curtis.

The crux of the dispute between the appellant and the respondent is how the Curtis test is to be understood and applied.

Held: The appeal was dismissed. A summary of the decision is as follows:

  1. The correct understanding of the Curtis test was applied by the Income Tax Board of Review.

Most of the Commonwealth cases have understood the Curtis test as drawing the critical distinction, for the purposes of income tax deductibility, between defalcations by a mere employee and defalcations by a person who “in virtue of his position [of power or control was] in a position to do exactly what he likes” (Curtis at 331). This is the approach that has in fact been applied in Singapore (see DR & P v Comptroller of Income Tax (2001) 5 MSTC 293). The Board correctly relied on the finding of fact by the DJ in the conviction of the Ex-MD (PP v KCT at [284]).

  • There is clear evidence that the Ex-MD did possess an overriding power or control such that he could do exactly what he liked. The “total trust reposed in the Ex-MD” by the appellant gave the Ex-MD overriding power or control as he “need not have to tell anyone about …the usage of the appellant’s funds”.
  • The defalcations were also committed by the Ex-MD in the exercise of his overriding power or control.
  • The blatant way in which the monies were siphoned from the company, some in the form of cash cheques, others as company cheques, made out directly in the names of or given to, junket operators, or individuals with no trade dealings with the appellant.
  • Therefore, because the Ex-MD did possess an overriding power or control in the company and the defalcations were in fact committed in the exercise of such power or control, the High Court dismissed the appeal and upheld the Board’s decision. The Loss due to the Ex-MD’s defalcations does not qualify for deduction under section 14(1) of the Act.

2.    The deductibility of losses resulting from defalcations is a common law exception.

Neither section 14(1) nor section 15(1)(b) of the Act explicitly addresses the issue of whether losses which result from defalcations should be deductible. The general requirement that there must be a “nexus” between the alleged expense and the production of income also does not explain how and why defalcation losses ought to be treated as having a “nexus” with the production of income. Strictly speaking, and as actualised in the South African courts, one could maintain that all losses which result from defalcations should not be deductible since there is no connection at all between a defalcation and the production of income.

3. The need to deter companies from leaving the powers of their directors and shareholders unchecked.

The distinction between losses resulting from the defalcations of lower echelon employees and those who possess an “overriding power or control” in the firm are justified on two policy grounds. First, the distinction drawn by the Curtis test as understood by the Board is as an extension of sympathy to large firms in their inability to keep all their employees, especially those of the lower echelon, in check. Second, and more importantly, it functions as a form of deterrence to firms that do not provide adequate checks on employees who possess such “overriding power or control” that they are able to incur great financial and social damage. As the respondent correctly submitted, deductions should not be given in the latter scenario to avoid condoning financial indulgence.

4.   The Curtis test only makes sense if it is not only descriptive but also prescriptive of commercial practice.

This prescription is none other than the recognition that it is a highly dangerous and irresponsible practice for companies to leave the power of their directors or shareholders unchecked. For that reason, the Court held that the fact that “[the appellant’s] business was successful in granting the Ex-MD overriding power or control is irrelevant in the light of the prescriptive force of the Curtis test. The non-deductibility of such defalcation losses is the risk a company like the appellant must be made to undertake if it intentionally chooses, whether for commercial reasons or otherwise, to leave the power of certain directors or shareholders unchecked.”

5.   According to the appellant’s understanding of the Curtis test, the court should simply ask whether “the loss arose in the course of  the company’s normal trading activities”.

In application, this means that as long as the fraudulent transactions, for example, arose out of dealings with suppliers or customers, such defalcations must be deductible since “dealings with suppliers or customers” are part of the company’s normal trading activities which may have undesirable consequences. The effect of such a test may be to encourage firms to turn a blind eye towards the power or control wielded by their employees.

6. The test of whether the defalcator was “in a position to do exactly what he likes” should be a test of the factual arrangements within the company.

While it would be rare to find listed companies like the appellant legally giving its directors unbridled power, the Curtis test should be applied to pierce through such legal facades and penalise companies which did give its directors unjustified overriding power or control.

7. The definition of “mistake” in section 93A(1) of the Act was further explained.

  • The appellant first argued that it had omitted to claim the deduction earlier “due to an oversight”. This was rejected by the Board as the Board found that the appellant’s decision was better characterised as one “made after due consideration that the Loss was not an allowable deduction under section 14 of the Act”.
  • Nonetheless, the Board was of the opinion that “[i]f the decision [by the appellant] was a mistake it was one of law and still a mistake falling within section 93A of the Act”.
  • In its conclusion, the Board also held that it did not find favour with the respondent’s argument that “error or mistake under section 93A of the Act does not include an erroneous opinion or grossly negligent error, but ‘must be genuinely due to ignorance or inadvertence’”.
  • The High Court agreed with the Board’s decision that an “error of mistake” under section 93A(1) should not be confined to merely “ignorance or inadvertence” and should be wide enough to cover genuine mistakes of law. However there is an important caveat to the general rule established above that a genuine mistake of law can entitle a taxpayer to relief which is found in section 93A(3) of the Act.
  • It would appear from section 93A(3) that even if the taxpayer was operating under a genuine mistake of law, the taxpayer would not be entitled to relief if the Comptroller, at the material time, was also operating under the same mistake. While not canvassed by the respondent, the respondent could have easily proven that the “practice of the Comptroller generally prevailing” in YA 2000 was to deem losses caused by the defalcations of directors non-deductible under the Act. It follows that the appellant would not have been able to obtain relief because of section 93A(3) as well. Both parties, however did not submit on this point.

To view the full text judgement, please click here.

The above decision was delivered on 17 October 2011.

Source: Supreme Court of Singapore