Private ruling: Deductibility of legal fees
Date of advice: 9 March 2016
Published: May 2016
Ruling period: 1 July 2012 to 30 June 2013 | 1 July 2013 to 30 June 2014 | 1 July 2014 to 30 June 2015
Date scheme commenced: 1 July 2012

Ruling: Q1: Are the legal expenses incurred by the Taxpayer in order to recover: • lost revenue due to the misappropriation of patents and intellectual property rightfully your property • salaries paid to ex-employee/director for time spent developing their own business interests in contravention of their service agreement • breach of fiduciary duty as a director • recruitment fees incurred in replacing lost employees poached by the ex-employee in contravention of their service agreement, and • to cease the unauthorised use of your intellectual property deductible in the year they are incurred pursuant to section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: Yes.

Relevant facts and circumstances: You are the head of a consolidated company for income tax purposes. You use proprietary technology developed in house. Individual A was a director, an employee and shareholder of you. Individual A signed a service agreement with you. You commenced legal proceedings against Individual A as a result of breaches you discovered in the service agreement and contractual obligations between Individual A and yourself. In a series of cases, the Court found that Individual A had breached their service agreement, contractual obligations, fiduciary duties and director duties owed to you. You were awarded damages by the Court as a result of their decision being found in your favour. You incurred legal expenses as a result of the legal proceedings.

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

Reasons for decision: Summary: The legislative provision to determine the deductibility of legal expenses is considered under section 8-1 of the ITAA 1997. Section 8-1 of the ITAA 1997 states: | Detailed Reasoning - 8-1(1): You can deduct from your assessable income 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 | Detailed Reasoning - 8-1(2): However, you cannot deduct a loss or outgoing under this section to the extent that: (a) it is a loss or outgoing of capital, or of a capital nature; or (b) it is a loss or outgoing of a private or domestic nature; or (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 this Act prevents you from deducting it. | Detailed Reasoning - 8-1(3): A loss or outgoing that you can deduct under this section is called a general deduction. As a company you are limited to the second limb of the subsection and the expenses must be incurred in carrying on a business for the purpose of gaining or producing your assessable income. They must also not be of a capital, private or domestic nature or incurred in gaining exempt income. Taxation Ruling TR97/7 considers the meaning of the term 'incurred' and the timing of deductions. Paragraph 3 of TR 97/7 states that to qualify for deduction under section 8-1 of the ITAA 1997 a loss or outgoing must have been incurred. In determining whether a deduction for legal expenses is allowed 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) 3 AITR 436; (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 expenses incurred in gaining the advantage will also be of a capital nature. The courts have determined legal expenses to be an allowable deduction if the expenses arise out of the day to day activities of the taxpayer's business (Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 39 ALR 46; (1932) 2 ATD 169). The action out of which the legal expense arises has to have more than a peripheral connection to the taxpayer's income producing activities ( Magna Alloys and Research Pty Ltd v. FC of T (1980) 49 FLR 183; (1980) 11 ATR 276; 80 ATC 4542). Taxation Ruling TR 2000/5 contains the Commissioner's view on the deductibility of costs incurred by employees and employers in preparing and administering employment agreements. Paragraph 4 of TR 2000/5 states that the costs incurred by an employer include the settling of disputes arising out of an existing employment agreement as an allowable deduction under section 8-1 of the ITAA 1997. The following guidelines for determining whether a loss or outgoing is of a capital nature have been set down by the High Court in Sun Newspapers Limited v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 23; (1938) 1 AITR 403: • the expenditure is related to the business structure itself, that is, the establishment, replacement or enlargement of the profit yielding structure rather than the money earning process, • the nature of the advantage has lasting and enduring benefit, or • the payment is 'once and for all' for the future use of the asset or advantage rather than being recurrent and ongoing. The decision of the full court of the Federal Court in FCT v Consolidated Fertilizers (1991) 22 ATR 281 illustrates the extent to which the assignment of an outgoing to capital or revenue accounts depends upon inferences, even impressions, drawn from the facts peculiar to each case. The court held by majority that legal costs incurred in litigation to protect valuable trade secrets in the taxpayer's possession were on revenue account. In Case 43, 9 CTBR, the taxpayer used his patent for the purpose of his business: he granted licences to persons on condition that they purchased from him the machines, etc required for use in connection with the patent invention. A former employee set up a similar business and used the invention, without a licence, and in conjunction with machines similar to those used and sold by the taxpayer. The taxpayer commenced legal proceedings to obtain damages and took action for infringement of the patent. The action was unsuccessful. The Taxation Board of Review held that the expenses incurred in the unsuccessful legal action were deductible. Legal costs undertaken in relation to the protection of patent rights or of confidential information have generally held to be deductible. It is only where the dispute concerns matters directed to the ownership or transfer of the property right itself, then the affair is more likely to be considered one of capital and the costs will not be deductible. In your case, the legal expenses were necessarily incurred in carrying on a business because the breaches of the service agreement and unauthorised use of your intellectual property affected the income and the day to day activities of your business. The legal expenses associated with settling this dispute in the service agreement relate to the operation of your business, rather than the business structure itself. Your legal expenses in relation to the unauthorised use of your intellectual property are not capital in nature as the expenses relate to the operation of your business rather than to the business structure itself. Based on the above information, it is accepted that the legal expenses you incurred in relation to the breaches in the service agreement and the unauthorised use of your intellectual property is relevant to you in gaining your assessable income. As a result, the legal expenses in this matter are an allowable deduction to you in the year they are incurred under section 8-1 of the ITAA 1997.