Private ruling: Deduction - legal expenses
Date of advice: 6 April 2022
Published: June 2022
Ruling period: Year ended 30 June 20XX
Date scheme commenced: 1 July 20XX

Ruling: Q1: Are the legal fees and the settlement payment expenses deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: Yes

Relevant facts and circumstances: The company carried on a business as a franchisee. The company has derived assessable income by carrying on this business in the relevant income years. The franchisor alleged that the company breached a deed of settlement (the first deed of settlement), which was entered into following a previous alleged breach of the franchise agreement. The company denied the breaches of the first deed of settlement. Legal proceedings were commenced by the franchisor. The franchisor issued a Termination Notice and a Notice of Intention to Acquire Assets to the company. A second settlement was reached, and a second deed of settlement was entered into by the company and the franchisor. Pursuant to the second deed of settlement, the company was required to pay a settlement amount to the franchisor. This amount represented franchise fees and marketing fees. The second deed of settlement provided that the company and the franchisor would cease association at the settlement date. The company incurred legal fees pertaining to the proceedings and the settlement.

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

Reasons for decision: Summary: Yes, the legal fees and settlement payment expenses are deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997). | Detailed Reasoning - Detailed reasoning: Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income or are necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income (positive limbs). However, no deduction is allowed under subsection 8-1(2) of the ITAA 1997 if the outgoings are of a capital nature, a private or domestic nature, or relate to the earning of exempt income (negative limbs). | Detailed Reasoning - Positive Limbs: 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 AITR 236; (1949) 8 ATD 431). Legal expenses are generally deductible under section 8-1 of the ITAA 1997 if the: • expenditure arose out of, or concerned the day-to-day activities of the taxpayer's business ( Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113) • expenditure is not undertaken to alter the organisation or structure of the taxpayer's profit yielding subject ( Foley Brothers Pty Ltd v. FC of T (1965) 13 ATD 562) • legal action has more than a peripheral connection to the taxpayer's income producing activities (Magna Alloys and Research Pty Ltd v. Commissioner of Taxation (1980) 49 FLR 183; (1980) 11 ATR 276; 80 ATC 4542; (1980) 33 ALR 213 ( Magna Alloys Case ); Putnin v. Commissioner of Taxation (1991) 27 FCR 508; 91 ATC 4097; (1991) 21 ATR 1245 ( Putnin's Case) In Herald and Weekly Times , a newspaper publisher was entitled to deduct both legal costs incurred in defending defamation proceedings and the damages payments it made to successful claims because the nature of the taxpayer's business exposed it to risk of such action. In Magna Alloys , legal expenses incurred by a company in defending its directors and managers against conspiracy charges (involving the payment of secret commissions to employees of purchasers of the taxpayer's products) were deductible because the expenses were incurred in defending the manner in which directors and managers performed their duties. As stated in ATO ID 2002/663 Income Tax: Deductions & Expenses: Sum paid in settlement of a harassment and victimisation claim , the treatment of a settlement sum or damages payment will follow the treatment of legal costs incurred in relation to a particular matter for example, if legal expenses incurred in relation to a matter are an allowable deduction under section 8-1 of the ITAA 1997, then any compensation payment or settlement payment made in relation to the matter will also be an allowable deduction. | Detailed Reasoning - Negative Limbs: The nature of the expenditure must also be considered ( Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634, (1946) 3 AITR 436; (1946) 8 ATD 190). The question of whether expenditure is of a capital nature revolves around the character of the advantage sought by the expenditure; whether an enduring benefit is obtained as a result of the outgoing ( Sun Newspapers v FCT (1938) 61 CLR 337 and BP Australia Limited v FCT (1965)112 CLR 386). Where 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 and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 87; (1938) 1 AITR 403 (Sun Newspapers) ). The decision in Sun Newspapers considers expenditure in establishing, replacing and enlarging a business structure is capital expenditure, in contrast to working or operating expenses that are revenue in nature. In the Federal Commissioner of Taxation v. Snowden & Willson Pty Ltd (1958) 99 CLR 431; 11 ATD 463; (1958) 7 AITR 308 ( Snowden ) the taxpayer incurred legal expenses in defending itself against allegations made in Parliament and in front of a Royal Commission against its business methodology, in particular the pricing methods used by the taxpayer. The taxpayer incurred legal expenses in defending its reputation against the allegations. The court found that the legal expenses were deductible under the general deduction provisions as they were incurred in defending the way in which the taxpayer carried out its business for the purpose of producing assessable income. In the case of Foley Bros Pty Ltd v FC of T (1965) 13 ATD 474 at 563 (Foley Bros), the taxpayer company entered into a 20-year agreement containing an undertaking not to reduce the scope or extent of its trading activities. It breached this undertaking when financial difficulties forced it to undergo a major rationalisation and reorganisation of its activities. The other party to the agreement commenced legal proceedings. The proceedings were settled on the basis that the taxpayer pay a certain sum in return for the agreement being rescinded, thereby leaving the taxpayer free to carry out its reorganisation. In the end, six of its seven branches and almost all the capital assets were disposed of, the taxpayer had withdrawn from one of its major businesses and its turnover had fallen by 80%. Deductions for the settlement sum and associated legal expenses were disallowed as capital expenditure. The Full High Court took the view that the freedom acquired to carry out the reorganisation was an enduring advantage and not merely a freedom to make day-to-day decisions in the course of carrying on income-producing activities. | Detailed Reasoning - Application to your circumstances: The legal fees were incurred by the company to defend against an alleged breach of the first deed of settlement in legal proceedings brought by the franchisor. Legal fees were also incurred to ultimately come to a settlement, the terms of which are represented in by the second deed of settlement. The first deed of settlement provided for the extension of the franchise agreement. Together, the first deed of settlement and franchise agreement regulated the operation of the company's business. The alleged breach of the first deed of settlement is related to the way the company was operating their business and the day-to-day activities of the business. Thus, the legal fees incurred to defend against the alleged breach had more than a peripheral connection to the company's income producing activities. The legal fees are incidental and relevant to the production of the company's income. The settlement amount represents amounts that would ordinarily be deductible under section 8-1 of the ITAA 1997 and will remain deductible as such. It is considered that the legal fees and the settlement payment were necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income, satisfying the positive limb of section 8-1 of the ITAA 1997. The legal fees and settlement payment are not of a capital nature. The character of the advantage sought by incurring the expenditure was not related to the establishment, replacement or enlargement of the taxpayer's profit-yielding structure. We consider the primary purpose for incurring the legal fees was to respond to allegations of breach made by the franchisor and defend the legal action taken to enforce the terms of the first deed of settlement an obtain orders for the franchisor's relief. As discussed above, it is considered that the breach was in relation to the day-to-day operation of the company's business. Furthermore, this case can be distinguished from Foley Bros, where a legal action was brought due to alleged breaches of an agreement. The breaches were in relation to the taxpayer's profit-yielding structure because the taxpayer was closing down and selling branches of the business. In that case the damages paid secured for the taxpayer the freedom and enduring advantage in respect of a capital matter. However, in the current case, whilst it is recognised that the expenses incurred for the legal fees and the settlement payment may be associated with long-term benefits such as freedom from the terms of the franchise agreement, the first deed of settlement, and the potential of future legal action, we do not consider these benefits to be capital in nature. The settlement payment secured for the company the freedom to make day to day decisions in the course of carrying on income producing activities. Therefore, it is considered that the legal fees and settlement payment are not capital or of a capital nature. It is also accepted that the legal expenses and settlement payment were not private or domestic in nature or incurred in gaining of producing exempt or non-assessable non-exempt income. | Detailed Reasoning - Conclusion: The legal expenses and settlement payment the company incurred in defending and settling the legal action is considered to have been necessarily incurred in carrying on a business for the purpose of gaining or producing its assessable income. Given that the company's legal expenses have arisen from its actions in operating its day-to-day business to produce assessable income, the expenses are revenue in nature and deductible under section 8-1 of the ITAA 1997.