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HMRC internal manual

Business Income Manual

Wholly and exclusively: expense of earning or application of profits?: defalcations by controlling director

S34 Income Tax (Trading and Other Income) Act 2005, S54 Corporation Tax Act 2009

Something outside the trade

Losses arising as a result of staff thefts or negligence are generally allowable. Losses arising as a result of withdrawals by the business principals (the trader, partners or directors as the case may be) are not allowable.

In the case of Curtis v J & G Oldfield Ltd [1925] 9 TC 319, the managing director of a private company controlled the business although he did not have a majority shareholding. After his death, an investigation revealed that some £14,000 was due from his estate to the company. Many private transactions had gone through the company’s books. The debt was valueless and was written off by the company who claimed a bad debts deduction.

The Commissioners allowed the deduction but were overturned by the High Court. Rowlatt J made the following points:

  • relief for bad debts is confined to items which had they been received would have been taxable receipts
  • a trader is taxed on the profits of the trade and not on what they retain at the end of the day
  • defalcations by subordinate employees are normally deductible for tax purposes
  • money appropriated by a controlling individual is an application of profits not an expense of earning profits and no deduction is due

Rowlatt J thought that the Commissioners had allowed themselves to act under the impression that they were taxing the company on what the company in a loose way had made and secured. In point of law, the Commissioners were engaged in assessing the profits of the company’s trade, not of the company itself. Rowlatt J had to consider whether there was any ground for supposing that losses of these sums resulting in this bad debt were losses in the trade. Rowlatt J explained that where, owing to the negligence or the dishonesty of the subordinates, some of the receipts of the business do not find their way into the till, or some of the bills are not collected at all, or something of that sort, then any loss arising is a loss of the trade and should be allowed. But the situation in Curtis v J & G Oldfield Ltd was quite different. It was the managing director who had taken the money in question. He controlled the company and making away with the company’s money was something altogether outside the trade.

Normally you should allow a deduction for defalcations by subordinate employees. Equally any recoveries (for example, from the employee or insurer) are taxable.

But you need to satisfy yourself as to the underlying facts including why, if that is the case, the alleged defalcations have not been reported to the appropriate authorities and/or no attempt has been made to secure a recovery, in whole or in part. In particular, you should carefully examine any claim to deduction where the trader alleges theft or other wrongdoing but has made no serious attempt at recovery.

The part of Rowlatt J’s judgment on which the above guidance is based is set out below:

`When the Rule speaks of a bad debt it means a debt which is a debt that would have come into the balance sheet as a trading debt in the trade that is in question and that it is bad. It does not really mean any bad debt which, when it was a good debt, would not have come in to swell the profits. What the Commissioners have been misled by, in my judgement, quite clearly is this. They have allowed themselves to act under the impression that they were taxing the Company on what the Company in a loose way had made and secured. In point of law they were engaged in assessing the profits of the Company’s trade, not of the Company itself but of the Company’s trade, and I have to consider whether there is the least ground for supposing that losses of these sums resulting in this bad debt were losses in the trade. I quite think, with Mr Latter, that if you have a business (which for the purposes of to-day at any rate I will assume) in the course of which you have to employ subordinates, and owing to the negligence or the dishonesty of the subordinates some of the receipts of the business do not find their way into the till, or some of the bills are not collected at all, or something of that sort, that may be an expense connected with and arising out of the trade in the most complete sense of the word. But here that is not this case at all. This gentleman was the Managing Director of the Company, and he was in charge of the whole thing, and all we know is that in the books of the Company which do exist it is found that moneys went through the books into his pocket. I do not see that there is any evidence at all that there was a loss in the trade in that respect. It simply means that the assets of the Company, moneys which the Company had got and which had got home to the Company, got into the control of the Managing Director of the Company, and he took them out. It seems to me that what has happened is that he has made away with receipts of the Company dehors the trade altogether in virtue of his position as Managing Director in the office and being in a position to do exactly what he likes.’