Private ruling: Subject:
Date of advice: 4 June 2026
Published: 17 August 2026
Ruling period: Income year ended 30 June 20YY | Income year ending 30 June 20YY

Ruling: Q1: Is the settlement sum paid by company A to company B deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: Yes. | Q2: Are the legal fees incurred by company A in defending proceedings brought by company B deductible under section 8-1 of the ITAA 1997? | A2: Yes.

Relevant facts and circumstances: 1. Company A is an Australian company incorporated in MM 20YY. 2. Company A provides consultancy services. 3. Company A derives assessable income from the provision of its consultancy services to clients. 4. Person Z is the sole director of company A. Company H is the sole shareholder of company A and person Z is both the sole director and shareholder of company H. 5. Person Z was employed by company B until MM 20yy. 6. In 20YY, company B commenced legal proceedings against both company A and person Z. 7. The legal proceedings alleged a breach of person Z's contractual, fiduciary and statutory duties. Specifically, company B alleged that during and after the employment of person Z by company B, person Z breached their contract of employment with company B, including by: • soliciting clients of company B away from company B for the benefit of themself and company A; • using company B's confidential information and intellectual property for the benefit of themself and company A; and • improperly using their position in the employment of company B to gain an advantage for themself and company A and to cause detriment to company B. 8. Person Z denies the alleged misconduct and the proceedings were resolved by a Deed of Agreement and Release executed between company B, person Z and company A (the Deed). Under the terms of the Deed: • company A and person Z were jointly liable to pay the settlement sum to company B; • each party agreed to bear its own legal costs; • confidentiality and non-disparagement obligations were imposed; • company A and person Z agreed not to provide services to specified clients until a specified date; and • mutual releases were given to resolve the proceedings. 9. The amount of the settlement sum was reached by commercial negotiation between the parties as a compromise of contested claims, having regard to the nature and scope of the claims asserted by company B, company A's assessment of litigation risk and uncertainty, expected legal and opportunity costs of ongoing litigation, and the cessation of the dispute and reduction of ongoing operational uncertainty. 10. The settlement sum was paid from company A 's bank account in MM 20YY. 11. In defending the proceedings and negotiating the settlement, company A incurred legal fees. Specifically, the legal fees were charged for work associated with: • analysing and responding to the claims made by company B; • advising company A on its legal position and exposure; • preparing evidence and submissions; • engaging in settlement negotiations and mediation; and • drafting and finalising the Deed. 12. The legal fees were paid from company A 's bank account over the period MM 20YY to MM 20YY. 13. No third-party reimbursement or contribution was received in respect of the settlement sum or the legal fees, and no insurance policy or indemnity covered any part of those outgoings.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 8-1 | Income Tax Assessment Act 1997 subsection 8-1(1) | Income Tax Assessment Act 1997 subsection 8-1(2)

Reasons for decision: Summary: Both the settlement sum paid by company A to company B and the legal fees incurred by company A in defending the proceedings brought by company B are deductible under section 8-1 in the income year incurred. | Detailed Reasoning - Detailed reasoning: Subsection 8-1(1) allows a deduction for a loss or outgoing to the extent that it is incurred in gaining or producing assessable income or is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. However, subsection 8-1(2) excludes any such deduction to the extent the loss or outgoing is of a capital nature, a private or domestic nature, or relates to the gaining or producing of exempt income. Whether an outgoing is deductible depends on its essential character ( Lunney & Hayley v FCT (1958) 100 CLR 478). For a settlement payment to constitute an allowable deduction, it must be shown that it was 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). In determining whether a deduction for a settlement payment is allowable under section 8-1, the nature of the expenditure must also be considered ( Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634). Therefore expenses as a result of legal action are generally deductible if the expenses arise out of the day-to-day activities of the taxpayer's business ( Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113) and the legal action has more than a peripheral connection to the taxpayer's income-producing activities ( Magna Alloys and Research Pty Ltd v. FC of T (1980) 49 FLR 183 ( Magna Alloys )). Similarly, legal expenses/fees are deductible if they are incurred: • in defending or preserving the taxpayer's business income, rather than creating, enlarging or reorganising it ( Magna Alloys ); or • to prevent the diminution of assessable income and have a real connection to the carrying on of a business ( FCT v Day (2008) 236 CLR 163). Expenditure is not deductible where it secures or creates an enduring benefit, alters the structure of the business or is directed to the profit-yielding apparatus itself. Such expenditure is capital or capital in nature ( Associated Newspapers Ltd v FCT (1938) 61 CLR 337). | Detailed Reasoning - Settlement sum: For the settlement sum to constitute an allowable deduction under section 8-1, it must be shown that it was incidental or relevant to the production of company A's assessable income. The settlement sum was paid by company A to resolve litigation brought against it and person Z by company B. The litigation centred on allegations that clients had moved from company B to company A and that company A was generating revenue from them. At the heart of the dispute was company A's ordinary revenue-earning activities; that is, the solicitation and servicing of clients, the use of intellectual property and provision of consultancy services and the earning of fees. These are matters of ordinary, day-to-day business operations. The settlement sum was incurred by company A to resolve a dispute that had arisen in the ordinary course of its consultancy business. It removed the risk of adverse orders that could have restrained or disrupted company A's trading activities and avoided ongoing management distraction associated with protracted litigation. Its essential character is therefore that of an expense which enabled company A to continue its established income-producing activities without the ongoing burden of contested proceedings; and a business expense incurred in the course of carrying on its business for the purpose of producing assessable income. The character of the advantage sought by the settlement sum was not one of an enduring benefit, nor was it incurred to acquire, create or protect a capital asset, or alter the framework within which company A carries on its business. It follows that the settlement sum is as an outgoing incurred in the ordinary course of company A's business, is not of a capital nature and is deductible under section 8-1. | Detailed Reasoning - Legal fees: The legal fees incurred by company A were paid to solicitors engaged to defend the proceedings brought by company B and to negotiate the settlement. As noted, the allegations concerned matters such as client solicitation, the use of intellectual property and the conduct of consultancy services, all of which were central to company A's ongoing business operations. The occasion of the legal fee expenditure is therefore found in the conduct of company A's consultancy business and the fees were incurred to both enable company A to defend the manner in which it carried on its business and preserve its ability to generate income. The essential character of the legal fees (like the settlement sum) is therefore that of a business expense incurred in the course of carrying on company A's consultancy business for the purpose of producing assessable income. The character of the advantage sought by the legal fees were not one of an enduring benefit, nor were they incurred to acquire, create or protect a capital asset, or alter the framework within which company A carries on its business. Accordingly, the legal fees are also an outgoing incurred in the ordinary course of company A's business, are not of a capital nature and are deductible under section 8-1.