Private ruling: Deduction of legal expenses and settlement costs
Date of advice: 30 June 2017
Published: October 2017
Ruling period: Year ended 30 June 2016 | Year ended 30 June 2017
Date scheme commenced: 1 July 2015

Ruling: Q1: Are the portion of legal expenses incurred by you in defending a breach of contract claim bought against your director, and listing you as defendant, deductible? | A1: Yes | Q2: Are the portion of settlement costs incurred by you in complying with the deed of settlement between you, your director and your director’s former employer deductible? | A2: Yes

Relevant facts and circumstances: You (company A) are a small business working in the XYZ industry. You had completed some short contracts an unrelated entity (company B) and your director was offered a job with them, which they accepted and entered into an employment contract for. Your director still undertook freelance work through you for your existing clients while employed with company B. Your director resigned from company B and performed a handover with written documents and team meetings to discuss on hand projects. Company B alleged through their lawyers that your director deleted items from their email account with them in order to disrupt their business and claimed damages due to breach of contract. Your director engaged barristers to refute the claims. Company B filed a claim against your director, as first defendant, and you, as second defendant, in the court for alleged damages and loss. You and your director filed a defence in the court denying any breach of duty of fidelity and good faith. A pre-trial hearing saw a trial booked. A deed of settlement was negotiated between Company B, you and your director with you and/or your director to pay an amount to Company B as full and final settlement of the proceedings.

Relevant legislative provisions: Section 8-1 of the Income Tax Assessment Act 1997

Reasons for decision: Summary: Section 8-1 of the Income Tax Assessment Act 1997 allows a deduction for a loss or outgoing to the extent that it is 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 except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income. To claim a deduction from assessable income under section 8-1 of the ITAA 1997, the expense must fulfil one of the positive limbs of that provision. That is the loss or outgoing must be incurred in gaining or producing assessable income or that it must be necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. In relation to the second positive limb in paragraph 8-1(1)(b) of the ITAA 1997, it was held in Ronpibon Tin that a loss or outgoing will be “necessarily incurred in carrying on” a business if it is “clearly appropriate” or “adapted” for the carrying on of the business. Restating the test another way, the loss or outgoing will be “necessarily incurred” if it is “reasonably capable of being seen as desirable or appropriate from the point of view of the pursuit of the business ends of the business” ( Ronpibon Tin NL v. Federal Commissioner of Taxation (1949) 78 CLR 47). Consideration must be given to the situation which impelled the taxpayer to incur the expenses. For example, if legal expenses are incurred to defend the day to day business activities of the taxpayer, then they are more likely to be deductible. This is discussed by Pincus J in his single judge decision which stated; … as a factor tending to support deductibility, that the expenditure was of a defensive kind, rather than made to acquire an asset ( F.C. of T. v. Consolidated Fertilizers Ltd. 91 ATC 4677 at 4688; (1991) 22 ATR 281 at 293). In your case, the payment of the settlement sum and legal costs were expenditure incurred in the defence of proceedings against the company, as listed as a defendant, for receipt of benefit from the actions undertaken by the company director. The cost is therefore revenue in nature as the expense and accordingly, the legal expenses the company incurred and the settlement sum the company paid, have the requisite connection to being necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income and you are entitled to a deduction for these expenses under section 8-1(1)(b) of the ITAA 1997.