Private ruling: Deductibility of expenses
Published: April 2014
Ruling period: Year ended 30 June 2013
Date scheme commenced: The scheme has commenced.

Ruling: Q1: Will expenditure on legal fees incurred by Trust A in defending ownership of a business be deductible under section 40-880 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: Yes. Expenditure on legal fees incurred by the taxpayer to the extent that it relates to defending the ownership of a business will be deductible under section 40-880 of the ITAA 1997.

Relevant facts and circumstances: The business was initially owned and operated by Company A. The directors of Company A were Director A, Director B and Director C. Each Director owned one third shares in Company A. Directors B and C resigned. From that point, the business was operated solely by Director A through Company A without involvement from the former directors. Due to financial problems, Director A and Company A ceased operating the business. Subsequently, Director B independently began operating the business through Trust A. Trust A assumed the existing debts of the business, which were re-paid over time. Director A and Company A subsequently contested ownership rights of the business and Trust A's right to run the business. After protracted legal proceedings it was determined that the business was beneficially owned by Company A. As a consequence, Trust A was required to hand over all operations and assets of the business to Company A. Trust A incurred legal costs over several years in defending ownership of the business.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 8-1 | Income Tax Assessment Act 1997 subsection 40-25(7) | Income Tax Assessment Act 1997 section 40-880 | Income Tax Assessment Act 1997 section 995-1

Reasons for decision: Summary: Subsection 8-1(1) of the ITAA 1997 allows a deduction for any loss or outgoing to the extent that: (a) it is incurred in gaining or producing your assessable income; or (b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income. However, subsection 8-1(2) of the ITAA 1997 provides that a loss or outgoing is not deductible to the extent that: (a) it is a loss or outgoing of capital, or of a capital nature; (b) it is a loss or outgoing of a private or domestic nature; (c) it is incurred in relation to gaining or producing your exempt income or your non-assessable non-exempt income; or (d) a provision of [the ITAA 1997 or the ITAA 1936] prevents you from deducting it. In determining whether a deduction 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; (1946) 3 AITR 436 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 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. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 2 ATD 169). However, where the expenditure is devoted towards a structural rather than an operational purpose, the expenditure is of a capital nature and the expenses are not deductible ( Sun Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 87; (1938) 1 AITR 403). In these circumstances, the legal expenses incurred by Trust A defending ownership of the business are considered to be a loss or outgoing of capital, or of a capital nature and are therefore not deductible under section 8-1 of the ITAA 1997. | Detailed Reasoning - Section 40-880: The object of section 40-880 of the ITAA 1997 is to make certain business capital expenditure deductible over five years if the expenditure is not deductible under another part of the Act; and another provision of the Act does not deny a section 40-880 of the ITAA 1997 deduction; and the expenditure relates to a business which is, was or is proposed to be carried on for a taxable purpose. A key element within section 40-880 of the ITAA 1997 is the concept of "taxable purpose" which is relevantly defined in subsection 40-25(7) of the ITAA 1997 to mean "the purpose of producing assessable income". Section 995-1 of the ITAA 1997 further provides that something is done for a taxable purpose if it is done for the purpose of gaining or producing assessable income or in carrying on a business for the purpose of gaining or producing assessable income. Subsection 40-880(2) of the ITAA 1997 outlines four situations where a deduction is available. Relevantly, it is considered that either paragraph 40-880(2)(a) of the ITAA 1997, which refers to capital expenditure in relation to a taxpayer's existing business; or paragraph 40-880(2)(b) which refers to capital expenditure incurred in relation to a business that used to be carried on, may apply to Trust A's circumstances. Director B independently began operating the business through Trust A at a point in time subsequent to Director A and Company A ceasing to operate the business. Trust A assumed the existing debts of the business, which were re-paid over time. The Commissioner considers that Trust A qualifies for a deduction under paragraph 40-880(2)(a) of the ITAA 1997 as the capital expenditure is in respect of Trust A's existing business in the relevant years. Paragraph 23 of Taxation Ruling 2011/6: Income Tax: Business Related Capital Expenditure - section 40-880 of the Income Tax Assessment Act 1997 core issues (TR 2011/6) describes the process of allowing a deduction under section 40-880 of the ITAA 1997 as a multistep process. Firstly, to determine initial entitlement under subsection 40-880(2) of the ITAA 1997. Secondly, to determine if the deduction is limited to any extent by either subsection 40-880(3) of the ITAA 1997 or 40-880(4) of the ITAA 1997 and whether or not any exception applies under subsections 40-880(5) to (9) of the ITAA 1997. Paragraph 24 of TR 2001/6 24 states: The use of the expression 'to the extent that' in subsections 40-880(3), 40-880(4) and 40-880(5) indicates that an apportionment may be required when applying those subsections. In contrast, subsection 40-880(2) does not contain the expression 'to the extent that'. However, in the Commissioner's view the absence of the expression 'to the extent that' in subsection 40-880(2) does not prevent an apportionment of expenditure on a single thing or service which serves more than one purpose or object. This is equally so whether the thing or service serves distinct and separate purposes or objects, or whether the thing or service serves two or more purposes or objects indifferently. Paragraph 25 of TR 2011/6 states the basis for any such apportionment must be fair and reasonable . Refer paragraphs 135 to 150 of TR 2011/6 for further guidelines the appropriate apportionment of expenses. In determining that paragraph 40-880(2)(a) of the ITAA 1997 applies to Trust A's facts and circumstances, the deduction is limited under subsection 40-880(3) of the ITAA 1997 to the extent that Trust A carries on a business for a taxable purpose. Trust A returned the income from the business in its tax returns. Therefore, the Commissioner accepts that Trust A carried on the business for a taxable purpose. In these circumstances, the exceptions listed in subsections 40-880(5) to (9) of the ITAA 1997 are not relevant. There is no indication that there is any impediment which prevents Trust A satisfying section 40-880 of the ITAA 1997. For the purposes of paragraph 40-880(1)(a) of the ITAA 1997, a deduction is not available under subsection 8-1(2) of the ITAA 1997 as it is capital, or capital in nature. For the purposes of paragraph 40-880(1)(b) of the ITAA 1997, a deduction is not denied by some other provision within the Income Tax Assessment Acts . Under paragraph 40-880(1)(c) of the ITAA 1997, Trust A conducts its business for a taxable purpose. Consequently, the Commissioner considers that Trust A qualifies for a deduction under paragraph 40-880(2)(a) of the ITAA 1997. Accordingly, Trust A may deduct legal expenses to the extent that they are incurred defending ownership of the business, in equal proportions over a period of 5 income years starting in the relevant year(s) in which expenditure was incurred.