Private ruling: Deductibility of legal expenses
Date of advice: 20 November 2017
Published: April 2018
Ruling period: Year ending 30 June 2017 | Year ending 30 June 2018 | Year ending 30 June 2019
Date scheme commenced: 1 July 2016

Ruling: Q1: Are you entitled to a deduction under section 8-1 on the Income Tax Assessment Act 1997 (ITAA 1997) for legal expenses incurred in the action taken against the directors for a breach of directors duties? | A1: No

Relevant facts and circumstances: You are a shareholder of J Pty Ltd, holding XX% of the shares in the company. The remaining shares in J Pty Ltd are held by the directors in the following proportions: ● XX% held by B ● XX% held by C B set up a new company, G Pty Ltd with different business partners conducting a similar business to J Pty Ltd. G Pty Ltd is trading as R, the trading name of J Pty Ltd. You have commenced action against the two directors of J Pty Ltd and have applied for leave to bring further proceedings against G Pty Ltd for passing off as J Pty Ltd. You have incurred legal expenses and expect to continue to incur expenses for the next 12 – 18 months whilst action is being taken. The expected result from the action taken is for you to be paid the market value of your shares, re-paid any outstanding shareholder loans and compensation and damages as a result of the director’s breaches. If you are successful in your application for leave, you expect to recover losses on behalf of J Pty Ltd due to G Pty Ltd’s use of intellectual property and other breaches.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 8-1

Reasons for decision: Summary: Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income, except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income. In determining whether a deduction for legal expenses is allowable under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered ( Hallstroms Pty Ltd v Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 8 ATD 190). The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses. If the advantage to be gained is of a capital nature, then the expense incurred in gaining the advantage will also be of a capital nature. Outgoings incurred in the preservation of an existing capital asset have been held to be capital in nature ( John Fairfax & Sons Pty Limited v Federal Commissioner of Taxation (1959) 101 CLR 30; (1959) 7 AITR 346; (1959 11 ATD 510). In your case, the advantage sought to be obtained by pursuing the legal action is to preserve your existing equity interest in the company, being the value of your shares in the company and to return the company to the position it was prior to the actions of the directors. The legal expenses are therefore capital in nature. As the legal expenses incurred are capital in nature, a deduction is not allowable under section 8-1 of the ITAA 1997.