August 1, 2019



The provisions of section 28 of Income-tax Act deal with income chargeable to tax under the head “Profits and Gains of Business or Profession” and section 29 indicates that the income referred to in section 28 shall be computed in accordance with the provisions contained in sections 30 to 43D of the Act. The carrying on business is always attendant with risks and sometimes a businessman may have to face what is known as “Embezzlement or Defalcation” made by employees or others connected with business. The loss incurred by a businessman by embezzlement or through defalcation has always been the bone of contention between the Income Tax Department and the assessee.

Section 28(i) vs. Section 37(1)

The question arises about the manner in which this embezzlement/defalcation loss should be claimed. Section 37(1) is a specific provision where deduction is provided for any expenditure laid out or expended wholly and exclusively for the purpose of the business or profession. On the other hand, a general provision has been made in section 28(i) read with section 29 for determination of “profits and gains of any business or profession” carried on by the assessee “in accordance with the provisions contained in sections 30 to 43D”. In arriving at the figure of profits and gains in the commercial sense business expenditure of all types, whether specifically provided for or not, may be deducted under section 28(i) itself {Addl. CIT v. Rustam Jehangir Vakil Mills Ltd. [1976] 103 ITR 298, 310 (Guj.)}. An amount would be deductible under section 28(i) only where it is an expenditure connected with or arising out of trade or is a commercial loss. {CIT v. Mihir Textiles Ltd. [1976] 104 ITR 167 (Guj.)}.
Hence embezzlement/defalcation loss has to be claimed under section 28(i) of the Income-tax Act.
In the following paragraphs a few decisions pertaining to embezzlement loss have been discussed.

Case Laws and Board Circular

Allowability – The first and foremost decision which comes to one’s mind and which has been the forerunner is the decision rendered by the Supreme Court in the case of Badridas Daga v. CIT [1958] 34 ITR 10. The Supreme Court in that case observed that a business especially such as is calculated to yield taxable profits has to be carried on through agents, cashiers, clerks and peons. If employment of agents is incidental to the carrying on of business, it must logically follow that losses which are incidental to such employment are also incidental to the carrying on of the business. Human nature being what it is, it is impossible to rule out the possibility of an employee taking advantage of his position as such employee and misappropriating the funds of his employers, and the loss arising from such misappropriation must be held to arise out of the carrying on of business and to be incidental to it.


(a) The Madras High Court speaking through Rajagopalan J. in the case of Gothamchand Galada v. CIT [1961] 42 ITR 418 made the following observations:

“The test to apply in deciding whether a loss sustained by a businessman, when an employee of his embezzles funds left in the charge of that employee, constitutes a trading loss of the business of the employer, is whether the loss was incidental to the carrying on of that business. Was the employment of the employee in the normal course of that business and was it a normal incident of the conduct of that business? Was the entrustment of the funds of the employer to that employee in the normal course of the conduct of that business? Was the loss caused to the employer by the embezzlement by the employee incidental to that entrustment? These questions have to be answered from the view point of a prudent man of business. If these tests are satisfied then the loss would be a trading loss.”

(b) The Supreme Court in the case of Associated Banking Corporation of India Ltd. v. CIT [1965] 56 ITR 1 observed that it is wrong to say that irrespective of other considerations, as soon as an embezzlement of the employer’s funds takes place, whether the employer is aware or not of the embezzlement, there results a trading loss. So long as there is a reasonable prospect of recovery of the amounts embezzled, trading loss in a commercial sense cannot be deemed to have resulted. Embezzlement of funds by an agent, like a speculative adventure, does not necessarily result in loss immediately when the embezzlement takes place, or the adventure is commenced.

Embezzlement may remain unknown to the principal, and the assets embezzled may be restored by the agent or servant. In such a case in the commercial sense no real loss has occurred. Again it cannot be said that in all cases when the principal obtains knowledge of the embezzlement loss results. The erring servant may be persuaded or compelled by process of law or otherwise to restore wholly or partially his ill-gotten gains. Therefore, so long as a reasonable chance of obtaining restitution exists, loss may not in a commercial sense be said to have resulted.

(c) The Central Board of Direct Taxes in Circular No.35-D (XLVII-20) of 1965, F.No.10/48/65-IT(AI), dated 24-11-1965 after referring to its Circulars No.25 of 1939 and 13 of 1944 and the decision of the Supreme Court in the cases of Badridas Daga v. CIT [1958] 34 ITR 10 and Associated Banking Corporation of India Ltd. v. CIT [1965] 56 ITR 1 clarified the legal position that the loss by embezzlement by employees should be treated as incidental to a business and this loss should be allowed as deduction in the year in which it is discovered.

(d) Once it is established that loss has been occasioned by embezzlement of an employee the same should be treated as incidental to a business and this loss should be allowed as deduction in the year in which it is discovered and the bifurcation of the same as between what was irretrievably loss and what was possible of recovery is therefore unnecessary as was held in the case of Dinesh Mills Ltd. v. CIT [2002] 254 ITR 673 (Guj.).

Treatment of subsequent recovery of embessled amount

The Allahabad High Court in the case of Harijan Evam Nirbal Varg Avas Nigam Ltd. v. CIT [1998] 229 ITR 776 held that the Tribunal was right in holding that the assessee was entitled to deduction of loss on account of theft, pilferage, etc., as business loss and if any money is subsequently is recovered out of this embezzlement amount the same could be brought to tax under section 41(2) of the Income-tax Act.

Embezzlemnt by employees or strangers

(a) The Bombay High Court in the case of G.G. Dandekar Machine Works Ltd. v. CIT [1993] 202 ITR 161 held that for determining whether any loss from theft, dacoity, embezzlement, etc., is deductible or not, what is material is whether the loss incurred by the theft, dacoity, etc., is incidental to the carrying on a business. It does not make any difference whether such Act is committed by the employees of the assessee or by strangers.

(b) The loss incurred due to defalcation by an employee is an allowable loss. In arriving at the conclusion the High Court of Kerala in the case of Commonwealth Trust (India) Ltd. v. CIT [2000] 242 ITR 593 held that the competency of the employee to disburse the amount has no consequence if the loss had been sustained during the course of business of the assessee. In that case the defalcation was done by a person who was not authorised to deal with disbursement of the amount but as the loss sustained was incidental to business the same was allowed irrespective of the fact whether the employee was competent to deal with cash or not.

Loss of stock in trade, money etc.

(a) The Supreme Court in the case of Ramchandar Shivnarayan v. CIT [1978 ] 111 ITR 263 summed up the law with regard to defalcation and observed at page 271 as follows:

“It is to be remembered that the direct and proximate connection and nexus must be between the business operation and the loss. It goes without saying that a businessman has to keep money either when he gets it as sale proceeds of the stock in trade or for disbursement to meet the business expenses or for purchasing stock in trade and if he loses such money in the ordinary course of business, the loss is a deductible trading loss. It is immaterial whether the money is a part of the stock in trade, such as, of a banking company or a money lender, or is directly connected with the other business operations. The risk is inherent in the carrying on of the business and is either directly connected with it or incidental to it.”

(b) The Income Tax Appellate Tribunal in the case of Shri Ram Hari Ram Jewellers v. Deputy CIT (Asstt.) [1994] 206 ITR 71 (AT) held that if loss by theft is proved then the burden on the assessee gets discharged and the loss is allowable as a deduction. Whatever that is applicable to loss by theft is equally applicable to loss by defalcation.

Loss whether capital or revenue allowable as loss

The Income Tax Appellate Tribunal in the case of B.R. Maheswari & Co. v. Assistant CIT [1993] 203 ITR 1 (AT) held that a fraudulent withdrawal of certain sum by forging signature of one of the partners is allowable as business loss. The Tribunal in that case held that the loss occurred on account of embezzlement or misappropriation must have connection with the business or profession carried on by the assessee irrespective of the fact as to whether the money so lost was of capital or revenue nature. It was also held that when several ways are open under the law for the recovery of the money and if one of the several ways was adopted by the assessee, merely because the way adopted did not bring in results or proved abortive, the claim by the assessee cannot be disallowed.

Conviction of the accused not relevant – The observations made by the Punjab High Court in the case of Punjab Steel Stockholders Syndicate Ltd. v. CIT [1980] 125 ITR 519 are relevant in this respect :

“If an embezzlement is proved by an assessee, the same can be claimed as business loss. Embezzlement is a criminal offence, and if, in a given case, criminal proceedings have been launched, it may be one of the relevant pieces of evidence for proving the loss but the culmination of such proceedings in the conviction of the accused is not necessary to prove the loss. If an assessee is able to place relevant material before the authorities for proving the loss irrespective of the fact whether the accused charged with embezzlement has been convicted or not, the authorities cannot refuse to consider the material on the ground that the conviction of the person accused of embezzlement has not been recorded.
In a given case, even if the person, who is accused of embezzlement, is acquitted, still, if proper evidence is led before the authorities, the authorities are bound to consider the material with a view to find out if the loss is proved or not.

It is not necessary for the assessee to prove that the embezzlement was done by a particular employee. If the loss by way of embezzlement is proved, the assessee is entitled to claim set off. If the loss is not known, and it comes to be known during a particular assessment year, the adjustment can be claimed in the assessment year when it came to be known.”

Writing off embezzlement amount/defalcation loss in books of account 

(a) Normally defalcation loss is found out a few years after its occurrence and so it may not be possible for the assessee to write off in the year to which the loss pertained to. Sometimes the loss may be found out only at the time of audit after accounts have been adopted by the shareholders in the Annual General Meeting. In such a situation the loss could be claimed only in the computation statement. It is to be noted that like bad debts there is no stipulation that embezzled amount or defalcation loss should be written off in books of accounts. In order to claim a bad debt the same has to be written off in books of accounts as per the provisions of section 36(1)(vii) but no such stipulation is laid down in Income-tax Act in order to claim defalcation loss under section 28(i). The difference between a bad debt and defalcation loss has been brought out very well by the Ahmedabad Bench of the Income Tax Appellate Tribunal in the case of ITO v. A.G. Gas Agency [1991] 38 ITD 589. The relevant portion of the order of the Tribunal at paragraph 16 is reproduced below:

“A loss occasioned from embezzlement must stand at a footing different from the loss resulted from a debt rendered irrecoverable for the purposes of application of the provisions of section 36(2)(i)(b). The distinction between the two is fine but real. For the allowance of the former what is required is that is must be established that the trading loss of that nature has been suffered by the assessee. Once that fact is established the question of allowance thereof in a particular assessment year would arise. And that question now stands answered by the circular of the CBDT which requires the IT authorities to treat loss by embezzlement by employees as incidental to business and to allow the same as deduction in the year in which it is discovered. In issuing this circular the CBDT has taken into consideration the Supreme Court decisions in the cases of Badridas Daga v. CIT [1958] 34 ITR 10 and Associated Banking Corporation of India Ltd. (supra). The fulfilment of requirement of writing off the same in books of account is thus not a condition precedent for allowance of such a loss, as held by the Supreme Court in the later decision. For the allowance of the later i.e. bad debt, the writing off of the concerned debt in the books of account is a condition precedent for its allowability, as held by the Gujarat High Court in Vithaldas H. Dhanjibhai Bardanwala’s case (supra).”

(b) In the case of Shri Ram Hari Ram Jewellers v. Deputy CIT [1994] 206 ITR 71 (AT) huge losses to the tune of Rs.36 lakh arising as a result of theft was claimed only in the statement of income (computation statement) and the appeal was allowed by the Tribunal taking note of the fact that the loss has been claimed only in the computation statement.

No nexus between the employee and the assessee – So long as there is no nexus between the man who indulged in fraud and the management the Income Tax Authorities cannot disallow the defalcation loss as was held in the case of George Maijo & Co. v. CIT [2002] 125 Taxman 783 (Mad.). In that case the loss was caused due to fraud by a foreign seller in encashing the letter of credit to which the assessee was not a party. The High Court ultimately held that the loss incurred was incidental to business and allowable as business loss in the relevant previous year notwithstanding pendency of litigation. But if the defalcation took place under the direct nose of the management the loss will not be allowable as was held by the Kerala High Court in the case of Yoosuf Sagar Abdulla and Sons (P) Ltd. v. CIT [1990] 185 ITR 371.


So if adequate precautions are taken by the management as well as the professional advisor in making proper claim at the right time there is no reason why embezzlement/defalcation loss could not be allowed by the Assessing Officer himself. The assessee who has already suffered loss by way of embezzlement/ defalcation could at least have some solace if facts are presented properly at the assessment stage itself and the assessment is made by the Assessing Officer accepting the defalcation loss. Even if, by chance, the Assessing Officer disallows the claim it will be easier for the assessee or his representative to agitate the matter properly before the Appellate Forums if proper facts and records have been submitted at the assessment stage itself. But while following the decisions given by the Supreme Court and various High Courts “Note of Caution” advocated by the Supreme Court in the case of CIT v. Sun Engineering Works Pvt. Ltd. [1992] 198 ITR 297 has to be kept in mind. The Supreme Court observed (head note of ITR) as follows:

It is neither desirable nor permissible to pick out a word or a sentence from the judgment of the Supreme Court divorced from the context of the question under consideration and treat it to be the complete law declared by the court. The judgement must be read as a whole and the observations from the judgement have to be considered in the light of the questions which were before the court. A decision of the Supreme Court takes its colour from the questions involved in the case in which it is rendered and, while applying the decision to a later case, courts must carefully try to ascertain the true principle laid down by the decision.

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