ATO ID 2001/42: Deductions and expenses: Legal expenses in recovery of misappropriated funds
Date of decision: 20 January 1997
Business line: Small Business/Individual Taxpayers

Issue
Are legal expenses incurred in attempting to recover misappropriated funds deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Decision
No. Legal expenses incurred in attempting to recover misappropriated funds are not deductible under section 8-1 of the ITAA 1997.

Facts
A taxpayer who is an employee of a unit trust pays $50,000 for units in the trust. The person to whom the payment is made (a principal in the business) misappropriates the money; the money is never transferred to the trust. The taxpayer incurs legal expenses in attempting to recover the misappropriated funds.

Reasons for decision
Summary: In determining whether a deduction is allowed under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered ( Hallstroms Pty Ltd v FC of T (1946) 72 CLR 634; 8 ATD 190 per Dixon J). The nature or character of the legal expenses follows the advantage which is sought to be gained by incurring the expenses. Where the legal expenses arise as a consequence of the day to day activities of a business, the object of the expenditure is devoted towards a revenue end and the legal expenses are deductible ( Herald & Weekly Times v FC of T 48 CLR 113; 2 ATD 169). Where, however, the expenditure is devoted towards a structural rather than operational purpose, the expenditure is of a capital nature and the expenses are not deductible ( Sun Newspapers Ltd v FC of T (1938) 61 CLR 337; 5 ATD 87). The taxpayer has incurred legal expenses to recover money misappropriated by a principal of the business. The legal fees were incurred by the taxpayer in his capacity as an investor with the object of recovering invested capital. As such, the legal expenses are of a capital nature and are not deductible under section 8-1 of the ITAA 1997.

Legislative references: Income Tax Assessment Act 1997 section 8-1
Case references: Herald & Weekly Times Ltd v FC of T 48 CLR 113 2 ATD 169
Subject references: Deductions and expenses Legal expenses