AQP v. Comptroller of Income Tax [2013] SGCA 3 concerned a situation that can regrettably arise in the corporate world regularly. The former managing director of the taxpayer company (the Company) was dismissed for misappropriating Company funds. He was convicted of misappropriation in 2001. Although the Company obtained a civil court judgment against the former managing director, it obtained no recovery from him. Some S$12 million was lost (the Loss). The Company made a provision for doubtful debts including the Loss in its accounts for the requisite years but did not claim a deduction for the Loss in its income tax return for the Year of Assessment 2000 (YA 2000).

In 2005, the Company applied to the Comptroller of Income Tax for relief under Section 93A of the Income Tax Act (the Act) on the basis that it made an “error or mistake” within the meaning of that section by not claiming a deduction for the Loss under Section 14(1) of the Act in its income tax return for YA 2000. The Comptroller made a determination that no relief would be granted because no “error or mistake” had occurred.

The central factual issue was whether the former managing director, who was also a substantial shareholder, had complete control over the Company. When the case eventually reached Singapore's highest court, the justices decided that lower tribunals had applied the wrong test. The Company has not been given an opportunity to present evidence on the system of checks and balances it had in place at the time of the misappropriation.

The Decision in the Court of Appeal

The Court of Appeal began by noting that under Section 14(1) of the Act, a defalcation by an employee would not usually be considered an “outgoing” or an “expense” which is wholly and exclusively incurred in the production of income, and hence not deductable.

Nevertheless, after reviewing the law in various other jurisdictions, it concluded that deductions for misappropriations by employees who do not have overriding power or control in their respective organizations should be allowed as such misappropriations are an inevitable commercial reality in any business, and that it would be practically impossible to have appropriate checks and balances to prevent such misappropriations from taking place.

This was distinguished from a situation where the misappropriation was committed by an employee who had overriding power or control over the organization. The Court of Appeal stated that sufficient checks and balances can and should be put in place to prevent such overriding power or control from being abused by these employees. The Court of Appeal would only allow deductions for misappropriations by such employees if there was a sufficient system of checks and balances in place and if the employee still manages to abuse his or her position of overriding power or control. If the Company did not put in place a sufficient system of checks and balances, resulting in the overriding power or control being abused, deductions for such losses will be denied as it could have been prevented.

The law does not require a perfect system of checks and balances for this would put an unfair burden on the organization. What constitutes a sufficient system of checks and balances would vary from case to case depending on the factual matrix.

In finding that the former managing director had been in substantial control, the lower tribunals had applied the test in Curtis (HM Inspector of Taxes) v J & G Oldfield, Limited (1925) 9 TC 319. The tribunals looked at his post and his substantial shareholding, and found sufficient legal or de jure control.

The Court of Appeal disagreed with this approach. It stressed that the question was not whether the post of managing director conferred “overriding power or control” but whether in fact the managing director had overriding power and control. It was important to the Court that substance took priority over form. The de facto power or control of an employee was the real issue, not his or her de jure power.

The Court of Appeal concluded by remitting the proceedings to the lower tribunal for a factual enquiry on, inter alia, whether a sufficient system of checks and balances was in place.

Observations

The case is a useful reminder of the importance of maintaining comprehensive checks and balances in an organization. It also highlights how employee fraud, and the existence (or lack thereof) of checks and balances, may have tax implications. The emphasis by the Court of Appeal as to whether the Company had a system of checks and balances must be taken as an incentive for companies to relook their governance systems.