Private ruling: Deduction for settlement sum
Date of advice: 13 September 2017
Published: January 2018
Ruling period: Year ending 30 June 2017
Date scheme commenced: 1 July 2016

Ruling: Q1: Are you entitled to a deduction under section 40-880 of the Income Tax Assessment Act 1997 in respect of the settlement sum and associated legal costs? | A1: No.

Relevant facts and circumstances: In 2004 you became a salaried partner in a business and were bound by a partnership agreement. In 2007 you were verbally offered and verbally accepted admission as an equity partner to in the business. This offer was formalised by the statement of admission the next year. You signed a deed to adopt a partnership deed in 2008. As an equity partner you were awarded the units yearly in the Trust of the business. You were made a Director and made a beneficial shareholder of a number of related companies and entities related to the business. You were required to pay amounts for the equity in the business. You retired from the partnership in May 2013 by a letter dated one month later. You commenced working for another business as a consultant. Following your departure from the firm the former partners commenced proceedings against you for: ● Damages for breaches of various clauses of the partnership agreement ● Interest ● Costs ● Compensation for breach of fiduciary duties ● Other various injunctions and declarations You filed a counter claim against your former partners in 2014 In 2016 you entered in to a Deed of Settlement with your former partners that contained the following terms: ● You would pay your former partners an amount in full and final settlement of all claims ● The parties release and forever discharge each other from all claims subject of the proceedings and all claims arising in relation to the former partnership, business and entities related to the business. ● The parties agree to sign orders dismissing the claim and counterclaim with no orders as to costs. You leaving the partnership did not dissolve the partnership.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 40-880

Reasons for decision: Summary: Section 40-880 of the ITAA 1997 is a provision of last resort which allows a deduction over five income years for certain business capital expenditure incurred after 30 June 2005 which is not otherwise taken into account or is denied a deduction by some other provision. Subject to the limitations and exceptions contained in subsections 40-880(3) to 40-880(9) of the ITAA 1997, subsection 40-880(2) of the ITAA 1997 provides that you can deduct, in equal proportions over a period of five income years starting in the year in which you incur it, capital expenditure you incur: (a) in relation to your business; or (b) in relation to a business that used to be carried on; or (c) in relation to a business proposed to be carried on; or (d) to liquidate or deregister a company of which you were a member, to wind up a partnership of which you were a partner or to wind up a trust of which you were a beneficiary, that carried on a business. Taxation Ruling TR 2011/6 sets out the Commissioner's views on the interpretation of the operation of section 40-880 of the ITAA 1997. TR 2011/6 states that the use of the expression 'in relation to' in subsection 40-880(2) of the ITAA 1997 rather than 'in carrying on', which is used in section 8-1 of the ITAA 1997, indicates that Parliament intended there be greater latitude in the connection that needs to exist. The test under the second positive limb of section 8-1 of the ITAA 1997 is therefore a more demanding test requiring a more immediate or direct link between the expenditure and the process of operating the business than a connection that qualifies the expenditure as being 'in relation to' a business. In considering the phrase 'in relation to' contained within subsection 40-880(2) of the ITAA 1997, paragraph 2.25 of the Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No. 1) Bill 2006 states: The provision is concerned with expenditure that has the character of a business expense because it is relevantly related to the business. The phrase 'in relation to' was considered by the High Court in PMT Partners Pty Ltd (In Liquidation) v. Australian National Parks & Wildlife Service (1995) 184 CLR 301. Brennan CJ, Gaudron and McHugh JJ observed, in considering the application of the Commercial Arbitration Act 1985 (NT), at 313: Inevitably, the closeness of the relation required by the expression 'in or in relation to' in s 48 of the Act, indeed, in any instrument - must be ascertained by reference to the nature and purpose of the provision in question and the context in which it appears. It is therefore necessary to consider the legislative context of subsection 40-880(2) of the ITAA 1997 in order to determine whether there is a sufficient and relevant connection between the incurrence of the expenditure and the taxpayer's business. Whether such capital expenditure is incurred 'in relation to' the particular business will turn on the particular facts and circumstances and is a matter of impression and judgement. Determining whether the expenditure has the character of a business expense can be approached by asking what the expenditure is for, in the sense of identifying the need or object that the expenditure serves. If the facts show that the expenditure satisfies the ends of the relevant business then it will have the character of a business expense. In your case, the amount that you paid was in respect of settling your breach of contract and breach of fiduciary duties. The amount was paid to cover a personal wrong you performed to the business. It does not have the character of an expense in relation to the business. At the time of making the payment, you were no longer involved in the business, and the payment was not in relation to an expense of the business. It was personal expenditure and is not deductible under section 40-880 of the ITAA 1997.