The following is a summary of the judgment by Tay Yong Kwang J. It deals with conflicting interpretations of Commonwealth cases as well as legal and policy arguments on the scope of deductibility.
The question before the court is whether losses caused to a company by a fraudulent director ("the Ex-MD") are deductible for income tax purposes under s14(1) of the Income Tax Act ("the Act"). The Ex-MD had misappropriated company funds causing the appellant to incur losses ("the Loss"). The appellant is seeking relief for the Loss under s93A of the Act, which concerns relief in respect of error or mistake.
Previously, the Income Tax Board of Review applied Curtis (HM Inspector of Taxes) v J & G Oldfield, Limited (1925) 9 TC 319 (“the Curtis test”) and concluded that the loss sustained by the appellant was not deductible under s14(1). It held that the Ex-MD was 'in the same position as the managing director in the Curtis case".
The Board also considered whether the appellant’s omission to set off the Loss in YA 2000 could qualify as an “error or mistake” under section 93A(1) of the Act, if the Loss were deductible. The Board held that the omission by the appellant was not “due to oversight” as “it was a decision made after due consideration that the Loss was not an allowable deduction under section 14 of the Act” but agreed with the appellant’s argument that “[i]f the decision was a mistake it was one of law and still a mistake falling within section 93A of the Act”.
Hence, two issues arose on appeal:
Issue A: 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 s14(1)?
The appellant argued that in Curtis, the “real reason” why the loss was not deductible was because the defalcations took place outside the company’s trading or income-earning activities, since the money had already been earned and was simply passed through the company’s books into the pocket of the director. The respondent, however, understood the Curtis test as prohibiting the deduction of losses incurred by a director who was “in a position to do exactly what he likes”.
Tay J agreed with the respondent and held that the correct understanding of the Curtis test, is as follows: Did the defalcator possess an “overriding power or control” in the company (i.e. in a position to do exactly what he likes) and was the defalcation 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. This reasoning was derived from a review of cases from different jurisdictions that considered the Curtis test, with Tay J eventually concluding that the Commonwealth cases are on the whole, in greater support of the "overriding power or control" test.
Tay J also rejected the appellant's argument that such an approach was undesirable both legally and on policy grounds. The Curtis test should be understood as a common law exception developed by the courts to render certain defalcation losses as having sufficient “nexus” with the production of income such that they could be deductible for income tax purposes. The Curtis test seeks to alleviate the hardship of the taxpayer by granting tax-deductibility to certain defalcation losses but it cannot and should not provide a warped incentive for firms to allow certain employees to do as they please and then claim that they had “expected” the losses which result from the employees’ defalcations to be tax deductible.
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 view of 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 a deterrent tool, the Curtis test only makes sense if it is not only descriptive but also prescriptive of commercial practice.
In addition, it was considered that the appellant’s test 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. This is because so long as their employees, especially the high-level ones, “dress up” their defalcations as if they were part of the company’s activities, the losses which they incur would be tax-deductible.
Issue B: 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 s93A of the Act?
The Board 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”.
Tay J held that he agreed with the judge in the Hong Kong case of Extramoney Ltd v Commissioner of Inland Revenue [1997] 2 HKC 38 that errors with regards to the commercial advantage of attributing the said profits to itself are clearly outside the ambit of section 93A(1), which provides only for an “error or mistake in the return or statement made by [the taxpayer]”. It must follow then that genuine mistakes or errors made by the taxpayer in the filling up of the return or statement falls within section 93A(1) and this could have been caused by a genuine mistake of law instead of fact.
On this issue, Tay J agreed with the Board that a genuine mistake of law is still a mistake falling within section 93A of the Act.
