Private ruling: Legal expenses
Date of advice: 16 March 2026
Published: 11 May 2026
Ruling period: 1 July XXXX to 30 June XXXX

Ruling: Q2: Is Entity A entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) with respect to the Settlement Sum under the Settlement Deed (Settlement Sum)? | A1: Yes. Entity A is entitled to a deduction for 100% of the revenue-related portion of the Settlement Sum. In these circumstances, having regard to the nature of the claims and cross-claims, it is reasonable to accept that 90% of the legal expenses are on revenue account and 10% is on capital account. The capital-related portion of the Settlement Sum must be apportioned amongst all vendor entities in proportion to their Asset Sale Agreement (ASA) sale proceeds. | Q3: Is Entity B entitled to a deduction under section 8-1 of the ITAA 1997 with respect to the Settlement Sum? | A2: No. Entity A is entitled to a deduction for 100% of the revenue-related portion of the Settlement Sum. The capital-related portion of the Settlement Sum must be apportioned amongst all vendor entities in proportion to their ASA sale proceeds.

Relevant facts and circumstances: Entity B was incorporated in Australia on XXXX. Individual A and their spouse, Individual B, are the only directors and shareholders of Entity B. Entity B acquired a commercial property which has been leased to Entity A for use by Entity A in carrying on its business. There is no formal lease agreement and lease payments are at less than market value. Entity A was incorporated in Australia on XXXX. It is a wholly owned subsidiary of Entity B. Individual A and Individual B are the only directors of Entity A. Entity A and Entity B are collectively referred to as The Group. Individual A and Individual B controlled Entity E and Entity F and Individual C controlled Entity G, that operated a business (Entity C) prior to XXXX. Entity C operated in the same industry as Entity A Entity C was sold to a third-party purchaser, Entity D under an Asset Sale Agreement (ASA) on XXXX. The completion of the sale occurred on XXXX. Entity E, Entity F and Entity G ceased trading etc. following the sale of Entity C. Legal proceedings Claims Entity D made various claims against Entity A, Entity B, Entity C, Entity E, Entity F, Entity G, Individual A, Individual B, Individual C (Individual A and Individual B's child who worked for Entity D) and Individual D (an unrelated individual who worked for Entity D with Individual C) (collectively, described as the Respondents). The claims against Entity A, Entity B, Entity C, Entity E, Entity F, Entity G includes misrepresentation relating to the sale of Entity C - including continuing to use Entity C's names etc. and the failure to handover Entity C material. The claims against Individual C and Individual D includes Individual C and Individual D working for Entity A and/or The Group contrary to their Entity D employment contracts and their misuse of Entity D material for the benefit of Entity A's business. The claims were denied by the Respondents. Cross-claims Entity A and Entity B made cross-claims against Entity D, and certain employees of Entity D. for breach of copyright and the Australian Consumer Law, contending that as a result of the breach The Group suffered loss and damage. Entity A and Entity B claimed that Entity D and its employees infringed the copyright owned by The Group. From about XXXX, Entity A sought to on sell Entity D equipment. Entity A relied on Entity D's representations in relation to Entity D equipment that was to be supplied to an Entity A customer. - the customer accepted the quote, was invoiced and paid Entity A for the supply of the equipment. Without any notice and with the knowledge that Entity A was to supply the Entity D equipment to the Entity A customer, Entity D did not supply the Entity D equipment to Entity A. Entity A had to carry out work for the customer at its own cost. Settlement The parties to the claims and counter-claims entered into a Settlement Deed to resolve the legal proceedings (i.e. the claims and counter-claims). The Respondents were required to pay Entity D an amount (Settlement Sum) to settle the legal proceedings.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 8-1 | Income Tax Assessment Act 1997 section 40-880 | Income Tax Assessment Act 1997 section 116-50

Reasons for decision: Summary: In these circumstances, having regard to the nature of the claims and cross-claims, it is reasonable to accept that 90% of the Settlement Sum (legal expenses) are on revenue account and 10% is on capital account. It is fair and reasonable that 100% of the revenue-related portion of the legal expenses be allocated to Entity A, with no amount allocated to the individuals or other entities (including Entity B). The capital-related portion of the legal expenses must be apportioned amongst all vendor entities in proportion to their ASA sale proceeds. | Detailed Reasoning - Legal expenses: Legal expenses involve expenditure incurred in pursuing or defending legal actions, or meeting legal obligations, whether via self or 'in-house' representation, or external legal representation. Legal expenses include things such as solicitor or counsel fees for legal services, disbursements charged by legal practitioners for out-of-pocket expenses such as photocopying, telephone and travel costs, costs incurred in obtaining expert opinions, court fees, government department fees, legal costs, damages or settlements in respect of legal actions, but not amounts that can be described as fines or penalties. | Detailed Reasoning - Deductibility of legal expenses: You are entitled to a deduction under section 8-1 of the ITAA 1997 for your legal expenses, to the extent your legal expenses are incurred in gaining or producing your assessable income, or necessarily incurred in carrying on your business for the purpose of gaining or producing assessable income. However, you cannot claim your legal expenses to the extent: • they are of a capital, private or domestic nature; • they are incurred in relation to gaining or producing your exempt income or your non-assessable non-exempt income; or • a provision of the Act prevents you from deducting them. To the extent that a legal expense may be deductible under more than one provision, whether for the same income year or different income years, you can only deduct the expense once under the most appropriate provision Apportionment The use of the phrase 'to the extent that' in section 8-1 of the ITAA 1997 contemplates apportionment between the following: • legal expenses incurred in gaining or producing your assessable income of a non-capital nature, or necessarily incurred in carrying on your business for the purpose of gaining or producing assessable income that is ordinary income or statutory income of a non-capital nature); and • legal expenses that are of a capital, private or domestic nature, or incurred in relation to gaining or producing your exempt income or your NANE income, or for which you are entitled to a specific deduction or disallowed a deduction. In determining the extent of your entitlement to deduction for your legal expenses under section 8-1 of the ITAA 1997, you can use any apportionment method that is fair and reasonable in your circumstances. | Detailed Reasoning - Legal expenses that are capital in nature: Interaction between expenses that form part of the cost base of a CGT asset pursuant to section 110-25 of the ITAA 1997 and whether it is blackhole expenditure for the purposes of section 40-880 of the ITAA 1997 Taxation Ruling TR 2011/6 Income tax: business related capital expenditure - section 40-880 of the Income Tax Assessment Act 1997 core issues sets out the Commissioner's view on the operation of the blackhole expenditure regime. In broad terms section 40-880 of the ITAA 1997 allows a deduction over five years for certain business capital expenditure, incurred on or after 1 July 2005, that is not otherwise taken into account or denied deduction by some other provision, and where the business is, was or is proposed to be carried on for a taxable purpose (blackhole expenditure). The expression 'capital expenditure' is also not a defined term. As discussed above, whether expenditure is capital in nature is determined on the facts of each particular case having regard to the principles established by case law. Merely because expenditure fails the positive limbs of section 8-1 of the ITAA 1997 does not necessarily mean that it will be capital expenditure. Relevantly, paragraph 40-880(5)(f) of the ITAA 1997 provides that the taxpayer cannot claim a deduction under section 40-880 for an amount of expenditure they incur to the extent that it could be taken into account in working out the amount of a capital gain or capital loss from a CGT event. Capital proceeds are taken into account in working out a capital gain or capital loss from a capital gains tax (CGT) event. This means that expenditure that modifies capital proceeds would not be deductible blackhole expenditure. Modification to capital proceeds 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. Where a seller pays an amount to settle the purchaser's claims for misrepresentation regarding the sale, and that amount is not deductible to the seller, it is a type of payment that causes a reduction under section 116-50 of the ITAA 1997, in the taxpayer's capital proceeds from the CGT event (see. e.g. ATO Interpretative Decision ATO ID 2006/179 Income Tax Capital Gains Tax: cost base - remuneration paid to a legal adviser ). The use of the expression 'to the extent that' in subsections 40-880(3), 40-880(4) and 40-880(5) of the ITAA 1997 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'. The Commissioner does not consider the absence of the expression 'to the extent that' in subsection 40-880(2) prevents 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. The basis for any such apportionment must be fair and reasonable. | Detailed Reasoning - Joint and several liability: 'Joint and several liability' relates to circumstances where a number of entities are both separately liable or obligated as well as together as a group liable or obligated to the specified liability. Consequently, it is a liability or obligation that can be discharged by one of the entities, some of the entities or all of the entities that are jointly and severally liable. The Commissioner considers that it is relevant to consider all of the facts and circumstances surrounding the discharge of a joint and several liability in determining the deductibility of expenses where the manner in which the liability is discharged does not appear to reflect the ratio that would arise from dividing the amount of the common obligation by the number of solvent co-obligors. | Detailed Reasoning - Application in these circumstances: In these circumstances, the legal expenses (i.e Settlement Sum) can be ascribed to 4 broad categories of legal expenses: A. The general misappropriation, misuse etc. of Entity D material. B. Defending employees etc. C. The Entity C sale of business matters D. The Group's cross-claims Category A and Category B legal expenses The Category A and Category B legal expenses can be characterised as expenses incurred by Entity A in the course of carrying on its business and are not capital in nature. Consequently, the legal expenses that relate to Category A and Category B are deductible under section 8-1 of the ITAA 1997. On balance, it is considered that it is reasonable to accept that Entity A was defending its employees' actions. Category C legal expenses In these circumstances, it is considered that the litigation essentially relates to the former owners continuing to utilise the Enity C name etc. for their own gain (i.e. Entity A's gain) rather than the gain of Entity D. The Entity C connection materially relates to forgone profits rather than permanent damage to either Entity D or Entity C's reputation. However, there is some element of capital. Entity D argued that the previous owners of Entity C did not hand over everything they should have handed over when Entity C was sold. Entity D was attempting to secure its rightful capital assets (i.e. Entity C material). To the extent the legal expenses relate to settling Entity D's claims regarding misrepresentations with respect to the sale of Entity C, it is a type of payment that causes a reduction, under section 116-50 of the ITAA 1997, in the taxpayer's capital proceeds from the CGT event (i.e. sale of Entity C). Category D legal expenses The Category D legal expenses relate to The Group's counter-claims. Broadly, The Group sued for breach of copyright -The Group was not arguing a permanent loss to their business merely an unlawful use of its copyright material. The Group sued because Entity D had promised to sell them equipment (which would be on-sold by Entity A). Due to non-delivery of the equipment, Entity A had to refurbish their customer's existing equipment at their own expense (noting that the equipment would have been trading stock). Consequently, the legal expenses that relate to Category D are deductible under section 8-1 of the ITAA 1997. Apportionment In essence there are various actions by Entity C, one of which is on capital account (i.e. trying to secure delivery of Entity C material etc.), and various counter-claims by The Group that are on revenue account. In these circumstances, having regard to the nature of the claims and cross-claims, it is reasonable to accept that 90% of the legal expenses are on revenue account and 10% is on capital account. | Detailed Reasoning - Legal expenses on revenue account: Although certain individuals were respondents to the proceedings, the revenue-related allegations arose solely from the trading activities carried on by Entity A. The individuals did not conduct a business in their own right; their alleged conduct was undertaken in the course of, and for the benefit of, Entity A's business. Entity B has no trading activities, no customer base, and no operational involvement in the subject matter of the claims and counter-claims. Consequently, it is fair and reasonable that 100% of the revenue-related portion of the legal expenses be allocated to Entity A, with no amount allocated to the individuals or other entities (including Entity B). | Detailed Reasoning - Legal expenses on capital account: The 10% capital component must be apportioned amongst all vendor entities in proportion to their ASA sale proceeds.

Does IVA apply to this private ruling?: Part IVA of the Income Tax Assessment Act 1936 contains anti-avoidance rules that can apply in certain circumstances where you or another taxpayer obtains a tax benefit, imputation benefit or diverted profits tax benefit in connection with an arrangement. | If Part IVA applies, the tax benefit or imputation benefit can be cancelled (for example, by disallowing a deduction that was otherwise allowable) or you or another taxpayer could be liable to the diverted profits tax. | We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part. | If you want us to rule on whether Part IVA applies, we will need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply. | For more information on Part IVA, go to our website ato.gov.au/gaar .