Private ruling: Deductibility of Legal Expenses
Date of advice: 20 September 2016
Published: November 2016
Ruling period: Year ending 30 June 20XX | Year ending 30 June 20XX
Date scheme commenced: 01 July 20XX

Ruling: Q1: Are you entitled to claim a deduction for legal fees incurred to defend against legal action against costs to rectify defective building work? | A1: Yes

Relevant facts and circumstances: You were a sole trader. You ceased trading as a sole trader. A claimant is taking action for defective work. You have incurred significant legal fees this financial year defending the claim.

Relevant legislative provisions: Income Tax Assessment Act 1997 (ITAA 1997)

Reasons for decision: Summary: Section 8-1 of the Income Tax Assessment Act 1997 (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. Taxation Ruling TR 2004/4 provides the Commissioner's view on the deductibility of interest where the income-producing asset has been disposed of and the taxpayer is still liable for the balance of the loan. In this situation, a nexus will continue to exist between the interest outgoings and the relevant income earning activities at least until the end of the period during which the interest cannot be avoided. Whilst TR 2004/4 specifically discusses interest on a loan used in an income-producing activity, the principle can be used in relation to other business expenses. That is, if an expense is incurred after a business has ceased and a nexus exists between the expense and the normal income producing activities of the former business then the expense will be deductible. In your case, you were a sole trader and have incurred legal expenses defending a defective workmanship claim. Similarly, in FCT v. Rowe (1995) 60 FCR 9995; 95 ATC 4691; (1995) 31 ATR 392, the court accepted that legal expenses incurred in defending the manner in which a taxpayer performed his employment duties were allowable. The activities which produced the taxpayer's income were what exposed them to the liability against which they were defending themselves. In the High Court decision in Federal Commissioner of Taxation v. Day [2008] HCA 53; (2008) 70 ATR 14; 2008 ATC 20-064 ( Day's case), Mr Day was charged with breaching the standards of conduct and failing to fulfil his duty as an officer. It was found that the requisite connection with his assessable income was present and that he was exposed to the charges by reason of his office. The common thread throughout these cases is that the conduct or activity giving rise to the charges was transparently and intrinsically part of the day to day activities by which each party earned their assessable income. In your case, legal expenses relate to the day-to-day activities of your business, a nexus exists between expenses and the income earning activities. This nexus is not broken due to the business having ceased. Therefore, you are entitled to claim a deduction for legal expenses to defend the action for defective workmanship.