ATO ID 2010/91: Legal expenses: misrepresentation
Date of decision: 14 April 2010
Year of income: Year ended 30 June 2006 Year ended 30 June 2007 Year ended 30 June 2008 Year ended 30 June 2009 Year ended 30 June 2010
Business line: Small Business/Individual Taxpayers

Issue
Does paragraph 40-880(5)(f) of the Income Tax Assessment Act 1997 (ITAA 1997) apply to prevent a deduction under section 40-880 of the ITAA 1997 if the expenditure incurred could be used in working out the amount of a capital gain or capital loss for an income year in which the provisions of the Income tax Assessment Act 1936 (ITAA 1936) apply?

Decision
Yes.

Facts
The taxpayer carried on a business. In a year prior to the introduction to the ITAA 1997 they sold the business assets, including the goodwill, which is a CGT asset. The capital gain on disposal of the goodwill was calculated in accordance with subsection 160Z(1) of Part IIIA of the ITAA 1936. The taxpayer included a net capital gain in their assessable income under former subsection 160ZO(1) of the ITAA 1936 for the income year in which the business assets were disposed of. Subsequently, the purchaser of the business commenced legal action against the taxpayer for allegedly misrepresenting the value of the goodwill of the business. The taxpayer incurred legal fees in relation to the legal action. Some of these legal fees were incurred on or after 1 July 2005. The legal fees incurred on or after 1 July 2005 are capital expenditure incurred in relation to a business the taxpayer used to carry on for the purposes of paragraph 40-880(2)(b) of the ITAA 1997. The fees are also incidental costs of the disposal of the goodwill for the purposes of former subsection 160ZH(7) of the ITAA 1936 and form part of the cost base of the goodwill.

Reasons for decision
Summary: Paragraph 40-880(5)(f) of the ITAA 1997 provides that a taxpayer can not deduct anything under section 40-880 for an amount of expenditure you incur to the extent that it could apart form section 40-880 be taken into account in working out the amount of a capital gain or capital loss from a CGT event. If the sale of the business had occurred after the introduction of the ITAA 1997, paragraph 40-880(5)(f) of the ITAA 1997 would have prevented the legal fees from being deducted under section 40-880 as they would have been included in working out a capital gain or loss from a CGT event. The CGT regime in the ITAA 1997 is an event based regime. The now repealed CGT provisions of the ITAA 1936 did not operate on an event based basis but rather on the basis of acquisition and disposal of an asset, to which end certain transactions are 'deemed' to have effected a disposal. However, as the idea behind the now repealed CGT regime in the ITAA 1936 and the CGT provisions of the ITAA 1997 is to bring all capital gains and capital losses to account, most of the deeming provisions to effect a disposal under the repealed ITAA 1936 are substantially mirrored in the ITAA 1997. Paragraph 40-880(5)(f) of the ITAA 1997 will apply to the CGT provisions in the ITAA 1936 which are mirrored in the ITAA 1997. Therefore, even though the legal expenses are included in calculating a capital gain on the disposal of the goodwill under the provisions of the ITAA 1936, this does not prevent paragraph 40-880(5)(f) of the ITAA 1997 from applying.

Legislative references: Income Tax Assessment Act 1997 section 40-880 paragraph 40-880(2)(b) subsection 40-880(5)(f)
Other references: Taxation Determination TD 93/44
Subject references: Capital expenditure CGT cost base Deductions & expenses Legal expenses