Knowledge

Are Fraud Losses Tax Deductible?

Rehana MoosaBy Rehana Moosa

As the old saying goes, “There are only two certainties in life – death and taxes.”  While we often discuss fraud detection and prevention, the tax consequences are often overlooked.  Can victims of fraud deduct their losses for tax purposes?

 

Deductibility depends on who committed the fraud, and certain criteria must be met for the losses to be deductible.

 

In Canada, the Canada Revenue Agency (“CRA”) issued a guidance sheet, Folio S3-F9-C1, which discusses the deductibility of losses caused by fraud.

 

Individuals

 

Victims of fraudulent investment schemes can deduct their losses if they did not know the investment was fraudulent.  The losses can be deducted from either business income or capital gains, depending on the nature of the investment.

 

For example, if the loss occurred while the individual was carrying on a business, it can be deducted from business income.  If the loss was the result of an investment made by the taxpayer, the losses can be offset against any capital gains.

 

The CRA applies a “course of conduct” test, which considers a variety of factors, to determine whether the loss resulted from a business versus an investment.  Some of the factors considered include:

 

  • How long the investment was held
  • The frequency of the transactions involving the investment
  • Whether the investment purchases were part of the taxpayer’s normal course of business

 

Businesses

 

For businesses, losses due to theft are generally deductible if two criteria are met:

 

  • The losses are part of the inherent risk of doing business
  • The losses are reasonably related to the business’ normal income earning activities

 

For tax purposes, only out-of-pocket losses can be deducted.  Lost profits or income are not deductible, even if they were caused by fraud. 

 

It is also important to note that taxpayers cannot deduct their losses twice.  For example, a business purchases a piece of equipment and records it as an expense instead of an asset.  If the equipment is later stolen, the business cannot claim a deduction for the resulting loss.  This is because a deduction was already taken when the equipment was purchased and recorded as an expense.  If the loss from the theft of the equipment is deducted, this would result in double counting.

 

Fraud Committed by an Owner

 

If a fraud is committed by a business’ owners, partners, or significant shareholders, the deductibility of any losses is less clear.  Generally, such losses are treated as withdrawals of capital and not deductible. 

 

There are exceptions, however, and the specific circumstances must be assessed to determine whether the losses are deductible. 

 

For example, in the court case Parkland Operations Ltd. v. The Queen (1 CTC 23, 90 DTC 6676 F.C.T.D.), two senior employees misappropriated funds from a company in which they were minority shareholders. 

 

The court determined that the funds were not taken in their capacity as owners of the business, but through deceptive means, and that the funds were wrongfully taken.  The company was then allowed to deduct the resulting losses.

 

Fraud Committed by a Senior Employee

 

Similarly, if a fraud is committed by a senior employee, the deductibility of the losses is evaluated on a case by case basis.  Some factors that are considered include:

 

  • The level of control the employee had over the business.  If the employee behaved like an owner of the business, the CRA may treat the stolen funds as a withdrawal of capital and the losses would not be deductible.
  • The stage of the income earning process in which the funds were stolen.  If funds are stolen after they have already been earned by the company and recorded as profits, the CRA would consider that the losses are not reasonably related to the business’ normal income earning activities.
  • The employee’s percentage ownership in the business.  If funds are misappropriated by the employee in their capacity as a shareholder, the stolen funds are treated as a withdrawal of capital and are not deductible.

 

How Deductible Losses are Calculated

 

In cases where assets such as cash are stolen, the calculation of the deductible loss is fairly straightforward.

 

If a capital asset is stolen (e.g. equipment), the deductible loss is calculated as the proceeds of disposition ($nil in the case of a theft) less the adjusted cost base.  This calculation is the same as the one used when an asset is sold or otherwise disposed.

 

The loss is treated as a capital loss for tax purposes and is deducted from any capital gains earned by the business.

 

Other Factors

 

Losses can be deducted in the year in which the fraud was discovered.  The exception is where claiming the loss in this time period would cause the taxpayer undue financial hardship.  In these cases, the taxpayer can request that the deduction be taken in the years in which the losses occurred.

 

Many businesses have a fidelity / crime insurance policy, which provides coverage for losses caused by employee theft.  If a business files a claim under its insurance policy, any funds recovered must be offset against the losses deducted for tax purposes.  In other words, the business can only claim the net amount of the loss that they have not recovered through their insurance or other means.

 

The same rules apply where an individual or business recovers some of their losses through a restitution order applied against the perpetrator.

 

Prior to recording any deductible for fraud losses, it is best to consult with a tax lawyer or accountant to ensure that the tax treatment is consistent with current rules.

 

Contact us to learn more.   647-426-0146  |  rehana@rmforensics.ca

Communications are intended for informational purposes only and do not constitute legal advice or an opinion on any issue. For permission to republish this content, please contact Rehana Moosa Forensic Accounting Professional Corporation.

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