ATO ID 2006/179: Capital Gains Tax: cost base - remuneration paid to a legal adviser
Date of decision: 23 May 2006
Year of income: Year ended 30 June 2001
Business line: Private Groups and High Wealth Individuals

Issue
Can the seller of a capital gains tax (CGT) asset include, in the second element of the asset's cost base (subsection 110-25(3) of the Income Tax Assessment Act 1997 (ITAA 1997) and reduced cost base (subsection 110-55(2) of the ITAA 1997), remuneration paid by the seller to a legal adviser as a result of an action for damages brought by the purchaser in connection with the consideration paid for the sale?

Decision
Yes. Remuneration paid to a legal adviser by the seller of a CGT asset as a result of an action for damages brought by the purchaser in connection with the consideration for the sale of a CGT asset are incidental costs that relate to a CGT event (paragraph 110-35(1)(b) of the ITAA 1997) and are included in the second element of the asset's cost base and reduced cost base.

Facts
The taxpayer sold a business for $25,000. Under the contract of sale, the taxpayer received: The taxpayer prepared its income tax assessment for the relevant year of income on the basis that it realised a capital gain of $12,000 from the sale of goodwill based on a cost base of $8,000 and capital proceeds of $20,000. This capital gain was included in the calculation of its net capital gain. Some months after the sale, the purchaser sued the seller for damages on the grounds that the seller had misrepresented the value of the goodwill. The taxpayer engaged the services of a solicitor, as their legal adviser, to assist with the defence of the action. The taxpayer paid the solicitor $22,000 for these services. The taxpayer paid the purchaser $4,000 in full settlement of the purchaser's claims. The taxpayer was not entitled to a deduction for the legal expenses.

Reasons for decision
Summary: The cost base and reduced cost base of a CGT asset each consist of five elements (subsection 110-25(1) and subsection 110-55(1) of the ITAA 1997 respectively). The second element of the cost base and reduced cost base each comprise of incidental costs an entity incurs to acquire a CGT asset or that 'relate to a CGT event' (subsection 110-35(1) of the ITAA 1997). The term 'incidental costs' is defined in section 110-35 of the ITAA 1997. It includes 'remuneration for the services of a ... legal adviser' (subsection 110-35(2) of the ITAA 1997). In this case, CGT event A1 (section 104-10 of the ITAA 1997) happened in relation to the goodwill as a result of its transfer to the purchaser under the contract of sale. The question at issue in this case is whether the legal expenses incurred by the taxpayer can properly be characterised as costs that 'relate' to this CGT event under paragraph 110-35(1)(b) of the ITAA 1997. Subsection 116-50(1) of the ITAA 1997 provides that the capital proceeds from a CGT event are reduced by any part of them repaid by the recipient or any compensation paid by the recipient that can reasonably be regarded as a repayment of them. In the present case, the purchaser sought and received from the taxpayer a payment of a type that caused a reduction, under section 116-50 of the ITAA 1997, in the taxpayer's capital proceeds from the CGT event. It follows that remuneration paid to a legal adviser in connection with this action had a direct relationship with the ascertainment of the amount of capital proceeds from the CGT event and is therefore an incidental cost that relates to the CGT event, which is included in the second element of the asset's cost base and reduced cost base.

Legislative references: Income Tax Assessment Act 1997 section 104-10 subsection 110-25(1) subsection 110-25(3) section 110-35 subsection 110-35(1) paragraph 110-35(1)(b) subsection 110-35(2) subsection 110-55(1) section 110-55(2) section 116-50 subsection 116-50(1)
Subject references: Asset valuation CGT assets CGT capital proceeds CGT capital proceeds modification repaid rule CGT cost base CGT reduced cost base Goodwill Legal expenses Second element of cost Solicitor Tax related expenses