Private ruling: Income tax - Deductions - Legal expenses
Published: June 2015
Ruling period: 1 July 2013 to 30 June 20AA.
Date scheme commenced: 16 May 2008.

Ruling: Q1: Are the legal fees you incurred in the income years ended 30 June 20XX to 30 June 20YY deductible under section 40-880 of the Income Tax Assessment Act 1997 (ITAA 1997) in the income year ended 30 June 20ZZ? | A1: No. | Q2: If the legal fees are not deductible under section 40-880 of the ITAA 1997, are they included in the cost base or reduced cost base of CGT event C2 in the income year ending 30 June 20AA? | A2: Yes.

Relevant facts and circumstances: You were an investor in a managed investment scheme and are considered to be carrying on a business. You borrowed money to finance your investment into the scheme. A year later, the responsible entity for the management investment scheme went into voluntary administration and later was placed into liquidation. Subsequent to the liquidation, various class actions were commenced. You incurred legal expenses to challenge the validity of the loans and were a party to the multiple class actions that were commenced. You have not previously deducted these legal expenses in any tax return. A Deed of Settlement was entered into in July 20ZZ and approved by the Supreme Court of Victoria in December 20ZZ. As a group member to the class action, you are bound by the Deed of Settlement. Under the terms of the Deed of Settlement, group members (which includes you) acknowledge and admit the validity and enforceability of the loans the subject of the challenge. You did not receive any payment from the settlement.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 8-1 | Income Tax Assessment Act 1997 Subsection 8-1(2) | Income Tax Assessment Act 1997 Section 40-880 | Income Tax Assessment Act 1997 Paragraph 40-880(5)(f) | Income Tax Assessment Act 1997 Section 104-25 | Income Tax Assessment Act 1997 Subsection 110-35(2) | Income Tax Assessment Act 1997 Section 110-55

Reasons for decision: Summary: Are the legal fees you incurred in the income years ended 30 June 20XX to 30 June 20YY deductible under section 40-880 of the Income Tax Assessment Act 1997 (ITAA 1997) in the income year ended 30 June 20ZZ? Section 40-880 of the ITAA 1997 provides a deduction for business capital expenditure. It is a provision of last resort such that a deduction is not available under section 40-880 of the ITAA 1997 if the expenditure is otherwise available under some other provision (paragraph 40-880(1)(a) of the ITAA 1997). Therefore, the first issue to address is whether the expenditure is deductible under the general deduction provision of section 8-1 of the ITAA 1997. | Detailed Reasoning - Deductibility under section 8-1 of the ITAA 1997: Subsection 8-1(1) provides that: ' 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. ' Subsection 8-1(2) provides that: '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. For legal expenses to constitute an allowable deduction, it must be shown that they were incidental or relevant to the production of the taxpayer's assessable income (Ronpibon Tin NL & Tong Kah Compound NL v Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 4 AITR236; (1949) 8 ATD 431). The courts, on a number of occasions, 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. With regards to the second limb, the High Court in John Fairfax & Sons Pty Ltd v Federal Commissioner of Taxation (1959) 101 CLR 30; (1959) 11 ATD 510 said that an outlay must be part of the cost of trading operations to produce income, that is, it must have the character of a working expense. 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] HCA 34; (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. Your legal expenses were incurred for the purposes of challenging the validity of the loan agreement you entered into to fund your investment into the scheme. Our view is that such expenditure relating to loans is capital in nature as the advantage sought relates to an enduring advantage which is to have the liability to repay the loan extinguished. These amounts are capital and not deductible under section 8-1 of the ITAA 1997. The legal expenses may still be deductible as business capital expenditure under section 40-880 of the ITAA 1997. | Detailed Reasoning - Deductibility under 40-880: The object of section 40-880 of the ITAA 1997 is to make certain business capital expenditure deductible over 5 years if: (a) the expenditure is not otherwise taken into account; and (b) the deduction is not denied by some other provision; and (c) the business is, was or is proposed to be carried on for a taxable purpose . Subsection 40-880(2) of the ITAA 1997 allows you to deduct, in equal proportions over a period of 5 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. Section 40-880of the ITAA 1997 also contains limitations and exceptions to the claiming of the deduction. It is accepted that you carried on a business. As mentioned above, we regard the legal expenses incurred for the purposes of challenging the validity of the loans to be capital expenditure. Therefore, we accept that the legal expenses you incurred are business capital expenditure which may be deductible under section 40-880 of the ITAA 1997. Subsection 40-880(2) imposes a requirement that the expenditure be incurred 'in relation' to your current business, or a business that used to be carried on or a business proposed to be carried on. For capital expenditure to be 'in relation to' a business there must be sufficient and relevant connection between the expenditure and the business (see paragraph 15 of TR 2011/6). Paragraph 2.40 of the Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No.1) Bill 2006 states: Eligibility for deduction is a once only up-front test established as at the time when the expenditure is incurred. (emphasis added) Therefore eligibility for the deduction is determined at the time when the expenditure is incurred by the taxpayer. Similarly the questions of whether the taxpayer is carrying on a current business, former business or future business and whether that expenditure is 'in relation' to that business are all determined at the time the expenditure is incurred. Based on the financing of your investment, we accept that the legal fees were sufficiently connected to the business so were 'in relation to' the business you carried on at the time or the business you used to carry on. Therefore, you satisfy the conditions in subsection 40-880(2) of the ITAA 1997 and the expense is deductible unless it is specifically excluded by one of the limitations or exceptions in section 40-880 of the ITAA 1997. Relevant to your circumstances is the exception under paragraph 40-880(5)(f) of the ITAA 1997. | Detailed Reasoning - The exception under paragraph 40-880(5)(f): Paragraph 40-880(5)(f) of the ITAA 1997 denies a deduction under section 40-880 of the ITAA 1997 for expenditure to the extent that 'it could, apart from this section, be taken into account in working out the amount of a capital gain or capital loss from a CGT event.' Settlement of the multiple class actions against the group which managed the scheme was approved by the Victorian Supreme Court in December 20ZZ. As you were a Group Member of one of the Group Proceedings the Deed of Settlement dated in July 20ZZ applies to you. As part of the settlement, Group Members acknowledged and admitted the validity and enforceability of the loans and agreed not to bring future claims with respect to the loan. Under section 104-25 of the ITAA 1997, CGT event C2 happens if your ownership of an intangible CGT asset ends by the asset: (a) being redeemed or cancelled; or (b) being released, discharged or satisfied; or (c) expiring; or (d) being abandoned, surrendered or forfeited; or (e) if the asset is an option - being exercised; or (f) if the asset is a convertible interest - being converted. Up until the settlement was reached, you had ownership of an intangible CGT asset being the right to dispute the enforceability of the loan you entered into to finance your investment. However, once this dispute was settled, this right ended by virtue of the right being abandoned, surrendered or forfeited in accordance with the terms of the Deed of Settlement (clauses 4.1.4, 4.1.10 and 4.1.12) Under subsection 104-25(2) of the ITAA 1997, CGT event C2 happens when you enter into the contract that results in the asset ending. This occurred on the date the Deed of Settlement was entered into in July 20ZZ. As explained in our answer to Question 2 below, the legal expenses can be taken into account in working out the amount of the capital gain or capital loss from CGT event C2. Therefore, the exception in paragraph 40-880(5)(f) of the ITAA 1997 applies and you cannot deduct the legal expenses under section 40-880 of the ITAA 1997. | Detailed Reasoning - Subsection 35-10(2A) of the ITAA 1997: We note that subsection 35-10(2A) of the ITAA 1997 denies a deduction for an amount under section 40-880 of the ITAA 1997 in relation to a business activity you used to carry on if you are an individual unless you satisfied one of the tests set out in section 35-30 (assessable income test), section 35-35 (profits test), section 35-40 (real property test) and section 35-45 (other assets test), or the Commissioner has exercised the discretion set out in section 35-55 for the business activity or the exception in subsection 35-10(4) applies. Since the legal expenses are not deductible under section 40-880 of the ITAA1997, there is no need to consider subsection 35-10(2A) of the ITAA 1997, which is only relevant if the expenditure under section 40-880 is deductible. | Detailed Reasoning - Question 2: If the legal fees are not deductible under section 40-880 of the ITAA 1997, are they included in the cost base or reduced cost base of CGT event C2 in the income year ending 30 June 20AA? As mentioned, your right to dispute the enforceability of the loan ended in accordance with the Deed of Settlement entered into in July 20ZZ, giving rise to CGT event C2 in the year ending 30 June 20AA. Under subsection 104-25(3) of the ITAA 1997, you make a capital gain if the capital proceeds from the ending are more than the asset's cost base. You make a capital loss if those capital proceeds are less than the asset's reduced cost base. Any proceeds you receive from the settlement will be included as capital proceeds. The asset's cost base and reduced cost base includes amounts you incurred in connection with the right to dispute the enforceability of the loans. The legal expenses you incurred are incidental costs incurred in relation to the dispute and are specifically included as part of the second element of the cost base/reduced cost base under subsection 110-25(3) of the ITAA 1997. Since you did not receive any proceeds from the settlement, you will make a capital loss in the year ending 30 June 20AA, being the amount by which the reduced cost base exceeds those nil proceeds. The reduced cost base of a CGT asset consists of 5 elements and does not include indexation of those elements (subsection 110-55(1) of the ITAA 1997). Except for the third element, all of the elements of the reduced cost base of a CGT asset are the same as those for the cost base (subsection 110-55(2) of the ITAA 1997). Therefore, the legal expenses will form part of the reduced cost base of your CGT event C2 for the year ending 30 June 20AA.