Court of Appeal – AQP v Comptroller of Income Tax – [2013] SGCA 3

3 February 2013

Income Tax – deduction

The Appellant’s ex-Managing Director (“Ex-MD”) misappropriated company funds and was dismissed in Dec 1999. The Appellant made a provision for doubtful debt for the loss arising from the misappropriation for the year ended 31 December 1999, but did not claim a tax deduction in that Year of Assessment. A judgement was obtained against the Ex-MD in 2003 but the latter was subsequently declared a bankrupt rendering the loss irrecoverable. In December 2005, the Appellant applied to the Comptroller of Income Tax for relief under s 93A of the Income Tax Act on the basis that it had made an “error or mistake” within the meaning of that section by not claiming a deduction for the Loss under s 14(1) of the Act in its Year of Assessment 2000 income tax return. The application was denied.

The Comptroller’s decision that the Loss did not qualify for a deduction under s 14(1) was upheld by the Income Tax Board of Review as well as the High Court. In arriving at this decision, both the Board and the High Court looked at the “overriding power and control” test, which asks whether the defalcator possessed an “overriding power or control” in the company (ie in a position to do exactly what he likes) and whether the defalcation was committed in the exercise of such “power or control”. If so, the losses which result from such defalcations are not deductible for income tax purposes.

The Appellant then appealed to the Court of Appeal with the sole issue being whether the High Court judge had erred in holding that the loss did not qualify for deduction under s 14(1) of the Act.

A plain reading of s14 (1) would suggest that employee defalcations would not usually be considered as an “outgoing” or “expense” which is “wholly and exclusively incurred…in the production of income”.

Case law, however, indicates a different approach when addressing employee defalcations, and courts (across jurisdictions) have, in fact, allowed deductions in so far as defalcations by employees who do not have overriding power or control in their respective organisations are concerned (eg a cashier taking funds from an employer’s till). This is based on the fact that such defalcations are an inevitable fact of commercial life in general and the conducting of the business concerned in particular. Put simply, the granting of such deductions is premised on commercial reality.

The situation is radically different where defalcations are effected by employees who have overriding power or control in their respective organisations. Checks and balances can, and ought to, be in place to prevent such overriding power or control from being abused by the employee concerned, hence resulting in the defalcations perpetrated by that employee.

If a sufficient system of checks and balances has been put in place by the taxpayer and defalcations nevertheless occur as a result of an employee still managing to abuse his or her position of overriding power and control, the court would generally permit a deduction for such defalcations under s 14. Conversely, if the taxpayer does not put in place a sufficient set of checks and balances with the result that overriding power or control is abused by the employee concerned, then it is logical, fair as well as commonsensical, for the taxpayer to be refused a deduction for such defalcations under s 14.

The onus of demonstrating to the relevant tax authorities that the employee concerned was not placed in a position of overriding power or control or that, if he or she had been so placed, that a sufficient system of checks and balances had indeed been instituted, notwithstanding the fact defalcations had still been effected by the employee concerned, lies on the taxpayer concerned.

The High Court had, when disallowing the deduction, relied on the criminal proceedings against the Ex-MD to conclude that the Ex-MD was in a position of overriding power and control. The Appellant, however, was not a party to the criminal proceedings and therefore did not have the opportunity, inter alia, to proffer evidence as to whether or not it had, in fact, instituted a proper system of checks and balances. It had also not been given the opportunity to challenge the findings of the court in the criminal proceedings that the Ex-MD did possess overriding power or control in the first place.

The Court of Appeal therefore held that it would be just and fair for the proceedings to be remitted to the Board in order for the necessary evidence to be adduced with regard to whether the Ex-MD was in a position of overriding power or control for the purposes of the present (civil) proceedings and, if so, whether a sufficient system of checks and balances had been put in place by the Appellant on the facts of this particular case. The Board should then proceed to render a decision in accordance with the “overriding power or control” test.

The above judgement was delivered on 16 January 2013.