The distinction between business expenditure and business loss is best described in the words of Finlay J who pointed out that an expenditure is something which the trader pays out from his own pocket whereas a loss is something which comes upon him as extra.

Cases frequently arise in respect of loss caused by embezzlement of funds through the dishonesty of employees or agents. An important case on this point is that of the Supreme Court in Badridas Daga vs CIT (34 ITR 10).

In that case, the assessee was the sole proprietor of the firm and carried on business as money lenders, dealers in shares, etc. The assessee himself was residing in one place and carried on business in differentplaces through agents. The agent of his firm in Mumbai held the power of attorney which conferred wide powers of management on him including the authority to operate bank accounts.

He withdrew from the firm's accounts sums aggregating to over Rs 2 lakh and applied them in satisfaction of his personal debts in speculative transactions. A small amount was recovered by the assessee under a decree passed against the agent and the balance amount was written-off as a loss.

The Supreme Court observed as follows: "These being the governing principles, in deciding whether loss resulting from embezzlement by an employee in a business is admissible as a deduction under Section 10(1). What has to be considered is whether it arises out of the carrying on of the business and is incidental to it. Viewing the question as a businessman would, it seems difficult to maintain that it does not. A business especially such as is calculated to yield taxable profits has to be carried on through agents, cashiers, clerks and peons.Salary and remuneration paid to them are admissible under Section 10(2)(xv) as expenses incurred for the purpose of the business. If employment of agents is incidental to 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."

The Supreme Court laid down the principle that when a claim is made for a deduction in respect of which there is no specific provision under Sections 30 to 37 of the Act, its admissibility will depend on trading principles and whether such loss can be said to arise out of the carrying on of the business and whether it can be said to be incidental to the business. If that is established, the deduction must be allowed provided there is no prohibition, express or implied, against it.

It was, however, pointed out that if employment of agents is incidental to the carrying on of the business, it must logically follow that losses which are incidental to such employment are also incidentalto the carrying on of the business.

Another case on this point is that of Sassoon J David & Co vs CIT (98 ITR 50). In this case, the assessee-company was a dealer in shares and securities and was acting as an agent for a textile company and an insurance company. It also did business in cotton yarn. Twenty-five per cent of its capital was held by Sir David and 75 per cent by a trust of which Sir David was the sole beneficiary. Sir Ezra joined the company and became a Director together with Sir David who was residing out of India at all material times.

Under a general power of attorney, executed by the company in favour of Sir Ezra, the latter was authorised to manage the company's business, to transact in monies which would come to his hands as an agent of the company, to withdraw the amounts standing to the credit of the company in banks and to invest the same in the name and for the benefit of the company. Sir Ezra withdrew a sum of Rs 27.5 lakh from the company's accounts and utilised the amount for hisprivate ends.

He was later adjudicated an insolvent and the properties which he had purchased were recovered and Rs 18.5 lakh were received as dividend by the company from the court. The balance amount of Rs 9 lakh was written-off by the company and claimed as a business loss from the taxable profits.

The Bombay high court held that the employment of the agent by the company was incidental to the carrying on of its business in India. When the amount was withdrawn by the agent and misappropriated for his own personal ends, the loss to the company arose out of the carrying on of its business and, therefore, in view of the decision of the Supreme Court in Badridas Daga's case, it was deductible.

The department contended that the aforesaid decision did not apply because it related to the case of a banking business. The Bombay high court pointed out that, in that case, the Supreme Court had expressly approved the three cases, none of which related to the banking business. The Bombay high court pointed outthat, in that case, the Supreme Court had expressly approved the three cases, none of which related to the banking business. Those cases were Venkatachalapathy Iyer vs CIT (20 ITR 363); and Lord's Dairy Farm Ltd vs CIT (27 ITR 700).

In Venkatachalapathy Iyer's case, the assessee were a firm of merchants engaged in the business of selling yarn. The accountant of the firm entered all the transactions in the cash book but while striking the balance at the end of each day, he used to short-total the receipts and over-total the disbursements. It was held by the Madras high court that the amount misappropriated by him was deductible under Section 28.

In Lord's Dairy Farm Ltd's case, the assessee was a limited company whose business was that of dairy farming. The cashier of the company, whose duty was to withdraw the money's from the company's account in the bank, defalcated various amounts. It was held by the Bombay high court that, as it was necessary for the assessee to employ the cashier and to depute tohim the duty of withdrawing monies from the bank, the loss directly arose from the necessity of deputing that duty to the cashier and was, therefore, a trading loss.

In CIT vs Nainital Bank Ltd (55 ITR 707, 715), the Supreme Court called attention to the fact that the three aforesaid decisions were specifically approved in Badridas Daga's case. In Nainital Bank's case, the bank had kept large amounts in its premises in the usual course of its business.

One evening, dacoits carried away the cash from the safe and the question which arose for consideration was whether the loss could be deducted under Section 28 of the Act. It was held by the Supreme Court that in order that a loss could be deducted, it was necessary that it should be incurred for carrying out the operation of the business and be incidental to that operation:

"Whether loss is incidental to the operation of a business is a question of fact to be decided on the facts of each case, having regard to the nature of the operations carried on andthe nature of the risk involved in carrying them out".

Applying this test, the loss incurred by the bank due to the dacoity was held to be incidental to the carrying on of the business of banking.

Recently, the Karnataka high court held that the loss must be allowed as a deduction in the year in which the embezzlement is discovered. In Tadalam G Dwarakanath & Co vs CIT (239 ITR 831), the Karnataka high court rejected the view of the commissioner of income-tax that the embezzlement which related to an earlier year could not be claimed in the subsequent year. The petitioner was made aware of the audit report of the loss in the assessment year 1986-87 and it was on the said amount becoming irrecoverable that the loss was claimed. The order passed by the commissioner of income-tax was not valid.

The Karnataka high court, therefore, held that the loss should be deemed to have occurred in the year in which the embezzlement was detected. In coming to this conclusion, the high court relied on the decision inthe case of Associated Banking Corporation of India Ltd vs CIT (56 ITR 1) in which the Supreme Court held that the loss by embezzlement should be deemed to have occurred when the assessee came to know about the embezzlement and realised that the amounts embezzled could not be recovered.

To sum up, any loss incurred by a businessman in his character as a trader would be allowable as a deduction under Section 28 of the Act, even if the loss was incidental to the running of the business.

The author is a Supreme Court advocate