Senate

Revised Explanatory Memorandum

Circulated by the authority of the Treasurer, the Hon Wayne Swan MP

Chapter 1 Amounts misappropriated by an employee or agent

Outline of chapter

2.1 Schedule 1 to this Bill amends the Income Tax Assessment Act 1997 (ITAA 1997) to:

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allow a deduction in relation to amounts misappropriated by an employee or agent in respect of a disposal of a depreciating asset under the uniform capital allowances (UCA) regime;

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recognise the amount misappropriated by an employee or agent if a capital gains tax (CGT) event occurs and the amount would have otherwise been taken into account in working out the amount of a capital gain or capital loss; or

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allow a taxpayer to both claim a deduction and recognise the misappropriation as discussed above (in situations where the use of the asset was in part for a taxable purpose and in part for other than a taxable purpose).

Context of amendments

2.2 When a depreciating asset is disposed of, the amount of the proceeds received, or taken to be received, by a taxpayer is included as the termination value in a balancing adjustment calculation under the UCA provisions (Division 40 of the ITAA 1997). When a CGT event occurs to a CGT asset, the amount of the proceeds received, or taken to be received, by a taxpayer is taken into account in working out the amount of a capital gain or capital loss under the CGT provisions. In the case where the asset is used for a partial taxable purpose or other than a taxable purpose then both the UCA and CGT provisions will apply.

2.3 However, under section 25-45 of the ITAA 1997, if the amount (or non-cash benefit) is misappropriated by an employee or agent, it can only be deducted against assessable income to the extent that the amount (or non-cash benefit) was included in the assessable income of the taxpayer.

2.4 The current law does not recognise amounts (or non-cash benefits) that are misappropriated by an employee or agent following the disposal of an asset because the amount is not included in the assessable income of the taxpayer. Rather, the amount is used to calculate the balancing adjustment under the UCA provisions, or a capital gain or loss from a CGT event under the CGT provisions, or a mixture of both.

2.5 There is currently no provision in the tax law that recognises the reality that the taxpayer did not receive the economic benefit from the disposal as a result of the misappropriation.

Uniform capital allowances

2.6 In general, section 40-285 of the ITAA 1997 provides a balancing adjustment calculation as the difference between an asset's termination value and its adjustable value before the balancing adjustment event. Under sections 40-300 and 40-305, the termination value includes amounts or non-cash benefits that the taxpayer either receives, or is entitled to receive, according to the relevant subsection 40-300(2) or 40-305(1).

2.7 Section 25-45 does not give a deduction for amounts (or non-cash benefits) misappropriated by an employee or agent that are included in a balancing adjustment calculation as part of the termination value under the UCA provisions.

2.8 If an employee or agent misappropriates an amount (or a non-cash benefit) following the disposal of an asset that has been accounted for by a balancing adjustment calculation, the misappropriated amount is not included in the assessable income. Since section 25-45 only provides for a deduction for the amount included in the assessable income, it cannot provide a deduction under these circumstances.

2.9 Since amounts (or non-cash benefits) that are misappropriated by an employee or agent must be included in working out the tax consequences of a balancing adjustment event, it is appropriate that provision is also made to recognise the loss when the misappropriation has occurred.

Capital gains tax

2.10 A taxpayer is taken to have received any capital proceeds that their employee or agent has received. Therefore, the modification in subsection 116-45(1) of the ITAA 1997 for non-receipt does not apply to reduce the capital proceeds by the amount that is misappropriated by an employee or agent of the taxpayer.

2.11 Where there has been a misappropriation of the capital proceeds by an employee or agent of the taxpayer, in calculating a capital gain or loss, the taxpayer will:

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have to include all the capital proceeds that they were entitled to receive, regardless of whether or not they actually received all of the proceeds; and

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disregard any later recovery of the capital proceeds for CGT purposes.

2.12 These amendments ensure that the capital proceeds from a CGT event will be reduced if an amount is misappropriated by an employee or agent of the taxpayer. If an amount is later recovered, the original capital gain or loss will be amended to take this receipt into account.

2.13 These amendments also ensure that the termination value of a depreciating asset will be reduced by the amount misappropriated or increased by the amount of the misappropriation that is recouped if CGT event K7 happens to a depreciating asset. This ensures that the correct amount is taxed.

Summary of new law

2.14 This Schedule amends the ITAA 1997 to recognise amounts (or non-cash benefits) that are misappropriated by an employee or agent following the disposal of an asset that has been accounted for by either a balancing adjustment calculation as part of the termination value under the UCA provisions, or a CGT event under the CGT provisions, or both.

Uniform capital allowances

2.15 This Schedule amends Division 25 by inserting a provision to allow a deduction for amounts (or non-cash benefits) misappropriated by an employee or agent that are included in the termination value of a depreciating asset under sections 40-300 and 40-305. [ Schedule 1, item 3, section 25-47 of the ITAA 1997 ]

2.16 The amount (or non-cash benefit) will be recognised as a deduction at the time that the misappropriation has occurred. The amount that can be deducted will be reduced in the same way (or by the same proportion) as occurs under section 40-290 for depreciating asset balancing adjustment amounts (ie, a reduction for other than taxable purpose use). [ Schedule 1, item 3, subsection 25-47(4 ) of the ITAA 1997 ]

Capital gains tax

2.17 This Schedule also amends Division 116 by inserting a provision which reduces the capital proceeds from a CGT event by the amount misappropriated by an employee or agent. [ Schedule 1, item 18, section 116-60 of the ITAA 1997 ]

2.18 CGT event K7 happens where a balancing adjustment event happens to a depreciating asset that has been used, or installed ready for use, wholly or partly for non-taxable (generally for private) purposes.

2.19 If CGT event K7 happens to a depreciating asset, the termination value of the depreciating asset is reduced by the misappropriated amount or increased by the amount of the misappropriation that is recouped. [ Schedule 1, item 7, subsections 104-240(3 ) and ( 4 ) and item 8, subsections 104-245(3 ) and ( 4 ) of the ITAA 1997 ]

Comparison of key features of new law and current law

Detailed explanation of new law

Uniform capital allowances

2.20 These amendments allow a deduction for amounts (or non-cash benefits) misappropriated by an employee or agent that are included in the termination value of a depreciating asset under sections 40-300 and 40-305.

2.21 The amount that can be deducted is so much of the amount misappropriated that represents an amount applicable to the taxpayer under item 8 in the table in subsection 40-300(2) or item 1, 3, 4 or 6 of the table in paragraph 40-305(1)(b) in relation to the balancing adjustment event. In particular, these amendments refer precisely to all or part of the amount (or non-cash benefit) that is capable of being misappropriated by an employee or agent. [ Schedule 1, item 3, subsection 25-47(2 ) of the ITAA 1997 ]

2.22 For example, item 8 in the table in subsection 40-300(2) provides that for a balancing adjustment event in relation to a depreciating asset that is lost or destroyed, the termination value is the amount or value received or receivable under an insurance policy or otherwise for the loss or destruction. Similar rules are contained in the table in paragraph 40-305(1)(b).

2.23 These amendments also reduce the deduction for amounts (or non-cash benefits) misappropriated by an employee or agent in the same way (or by the same proportion) as occurs under section 40-290 for depreciating asset balancing adjustment amounts (ie, a reduction for other than taxable purpose use). [ Schedule 1, item 3, subsection 25-47(4 ) of the ITAA 1997 ]

Example 2.1

Linda operates a flower delivery business. She purchased a van she used solely in her business. Linda's agent sold the van on her behalf for $10,000 and misappropriated the proceeds. At that time, in the 2008 year, the adjustable value of the van was $6,000. Under the UCA provisions, Linda would include $4,000 in assessable income (ie, the difference between the van's termination value and its adjustable value before the balancing adjustment event). Under these amendments, Linda is now also able to claim a deduction equal to the amount that was misappropriated - $10,000 (see item 3, section 25-47 of the ITAA 1997).

Example 2.2

Henry is an architect and operates a business from home. He owns a computer which is used 60 per cent in the business. Henry authorises an agent to sell the computer on his behalf and collect the proceeds. The agent sells the computer for $1,500 (its termination value). At that time, in the 2008 year, the adjustable value of the computer is $1,000. The balancing adjustment calculation will use an adjustable value of $1,000 and a termination value of $1,500. Since Henry is taken to receive the amount, $300 (60% of $500) will be included in Henry's assessable income.

In the same year, Henry becomes aware that his agent has misappropriated the sale proceeds. Under the new provisions, Henry can claim a deduction of $900 (60% of $1,500) for the 2008 income year (see item 3, subsection 25-47 of the ITAA 1997).

Example 2.3

Alternatively, following the facts of Example 1.2, if Henry's agent sells the computer for $600, the termination value will be $600, and $240 (60% of $400) will be deductible from Henry's assessable income (as the termination value is less than the adjustable value). If the sale proceeds are misappropriated by his agent, $360 (60% of $600) may be deducted from Henry's assessable income in the year the misappropriation happened.

If a tax return has already been lodged for the 2008 income year and the misappropriation was discovered in a later year of income, then the taxpayer can request an amendment by the Australian Taxation Office (see item 3, subsections 25-47(3) to (5) of the ITAA 1997).

2.24 The items in the tables in subsection 40-300(2) or paragraph 40-305(1)(b) that are excluded from the new section in Division 25 in relation to the balancing adjustment, refer to amounts that are not strictly capable of being misappropriated.

2.25 If a misappropriation is discovered in a later year of income, the taxpayer may request the Commissioner of Taxation to amend their earlier return. An assessment can be amended within four years, starting immediately after the taxpayer discovers the misappropriation. [ Schedule 1, item 3, subsection 25-47(5 ) of the ITAA 1997 ]

2.26 Any subsequent recoupment of the misappropriated amount for a depreciated asset will be required to be included in the taxpayer's assessable income in the income year when it is recouped. [ Schedule 1, item 2, subsection 20-30(1 ) of the ITAA 1997 ]

Example 2.4

Abbie was able to deduct $500 from her assessable income due to misappropriation of funds by her agent. If she is able to subsequently recoup the amount at a later date, this must be included in Abbie's assessable income for the income year in which it was recouped.

Capital gains tax

Misappropriation rule: modification rule

2.27 Division 116 specifies the capital proceeds to be taken into account in working out whether a capital gain or loss has been made.

2.28 Capital proceeds from a CGT event are ordinarily:

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money a taxpayer receives, or is entitled to receive, for the event happening;

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the market value of any property a taxpayer receives, or is entitled to receive, for the event happening; or

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a combination of these.

2.29 Section 116-60 will modify Division 116 to ensure that the capital proceeds from a CGT event are reduced by the amount misappropriated by an employee or agent (whether by theft, embezzlement, larceny or otherwise). [ Schedule 1, item 18, subsections 116-60(1 ) and ( 2 ) of the ITAA 1997 ]

2.30 This rule exists because the general rules treat the taxpayer as having received an amount to which they are entitled to receive even though they did not actually receive the amount. [ Schedule 1, item 18, subsection 116-60(1 ) of the ITAA 1997 ]

Example 2.5

Parvin sold a rental property in the 2007 income year for $500,000. She would include $500,000 as the capital proceeds for the purposes of working out the capital gain in her 2007 tax return.

However, if the purchaser paid $500,000 to Parvin's solicitor and the solicitor misappropriates the amount, under the current law she must still include the full $500,000 as capital proceeds even though those proceeds were not passed on to her by the solicitor.

Under these amendments, the $500,000 would not be included as capital proceeds for the purposes of working out the capital gain.

2.31 However, if the taxpayer later receives an amount as recoupment of all or part of the misappropriated amount, the capital proceeds will be increased by the amount received. [ Schedule 1, item 18, subsection 116-60(3 ) of the ITAA 1997 ]

2.32 Parts 3-1 and 3-3 of the ITAA 1997 will apply to the debt owed to the taxpayer (misappropriated amount) as if it were not a CGT asset. [ Schedule 1, item 18, subsection 116-60(4 ) of the ITAA 1997 ]

Termination value of the depreciating asset and CGT event K7: general case

2.33 A capital gain or loss may arise from a depreciating asset if CGT event K7 happens to the asset. That event can only happen if a balancing adjustment event has happened to the depreciating asset that has been used either wholly or partly for non-taxable (generally for private) purposes.

2.34 To ensure complementary treatment between the UCA rules and the CGT rules, a capital gain or loss under CGT event K7 is calculated on the basis of the depreciating asset's cost and termination value, instead of on the usual CGT basis of cost base and capital proceeds. The gain or loss arises at the same time as any balancing adjustment amount.

2.35 If the use was wholly for taxable purposes, CGT event K7 does not apply, but there will be a balancing adjustment under the UCA system.

2.36 If the use was not wholly for taxable purposes, there will be a capital gain or loss under CGT event K7 based on the difference between the depreciating asset's termination value and its cost. In such a case, there will be no balancing adjustment.

2.37 If there is mixed use (eg, partly taxable and partly non-taxable), there may be both a balancing adjustment and a capital gain or loss. That capital gain or loss will be based on the difference between the termination value and the cost, apportioned to reflect the taxable component of the decline in value.

2.38 Section 104-240 is used to work out the capital gain or loss for CGT event K7 in general cases. A taxpayer makes a capital gain from CGT event K7 if the termination value of the depreciating asset exceeds its cost. The capital gain is worked out from the formula in subsection 104-240(1).

2.39 Conversely a taxpayer makes a capital loss from CGT event K7 if the cost of the depreciating asset exceeds its termination value. The capital loss is worked out from the formula in subsection 104-240(2).

2.40 The amendments to section 104-240 ensure that if CGT event K7 happens to a depreciating asset, the termination value of the asset will be reduced by the amount misappropriated by the employee or agent and conversely, the termination value of the depreciating asset is increased by any amount received as recoupment of the amount misappropriated.

Example 2.6

Following from the facts in Examples 1.2 and 1.3, given that Henry bought the computer for $1,200 in the 2007 income year and sold the computer at a termination value of $1,500 in the 2008 income year, he makes a capital gain of $120 in relation to his 40 per cent private use under CGT event K7 (($1,500 - $1,200) × 40%).

If his agent subsequently misappropriates the sale proceeds, the termination value would be reduced to zero and a capital loss of $480 now arises under CGT event K7 (($0 - $1,200) × 40%) in the 2008 income year.

Should Henry recoup 100 per cent of the misappropriated amount in a later income year, under these amendments the termination value of the computer is increased by the recovered misappropriated amount of $600 ($1,500 × 40%) applicable to his private use.

In the later year of income Henry's tax assessment for the 2008 income year (of a $480 capital loss) will need to be amended to give effect to a $120 capital gain (see item 7, subsections 104-240(3) and (4) of the ITAA 1997).

Termination value of the depreciating asset and CGT event K7: pooled assets

2.41 When a balancing adjustment event happens in relation to a depreciating asset in a low-value pool, the taxable use portion of the depreciating asset's termination value is taken into account in working out the pool's closing balance for the income year.

2.42 Section 104-245 deals with the calculation of a capital gain or loss from a balancing adjustment event occurring for a depreciating asset that was allocated to a low-value pool under Subdivision 40-E.

2.43 A taxpayer makes a capital gain from CGT event K7 if the termination value of the pooled asset exceeds its cost. The capital gain is worked out from the formula in subsection 104-245(1).

2.44 Conversely, a taxpayer makes a capital loss from CGT event K7 if the cost of the depreciating asset exceeds its termination value. The capital loss is worked out from the formula in subsection 104-245(2).

2.45 The amendments to section 104-245 ensure that if CGT event K7 happens to a pooled depreciating asset, the termination value of the depreciating asset will be reduced by the amount misappropriated by the employee or agent and conversely, the termination value of the depreciating asset is increased by any amount received as recoupment of the amount misappropriated. [ Schedule 1, item 8, subsections 104-245(3 ) and ( 4 ) of the ITAA 1997 ]

Amendment of assessments

2.46 If the taxpayer discovers the misappropriation or receives an amount as recoupment after lodging their income tax return for the income year the taxpayer may request the Commissioner of Taxation to amend their earlier return. An assessment can be amended within four years, starting immediately after the taxpayer discovers the misappropriation or receives the amount as recoupment. [ Schedule 1, items 7, 8 and 18, subsections 104-240(5 ), 104-245(5 ) and 116-60(5 ) of the ITAA 1997 ]

Application and transitional provisions

2.47 These amendments commence when this Bill receives Royal Assent.

2.48 These amendments apply to amounts misappropriated in the 2007-08 and later income years. [ Schedule 1, item 19 ]

Consequential amendments

2.49 There are tables, notes, subsections and references that are inserted, or changed because of the application of the new misappropriation provisions. [ Schedule 1, items 1, 2, 4 to 6 and 9 to 17 of the ITAA 1997 ]