Private ruling: Deductions under section 8-1
Published: July 2012
Ruling period: 1 July 2011 to 30 June 2012
Date scheme commenced: 200X

Ruling: Q1: Can a deduction be claimed under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for civil penalties imposed by the Australian Government? | A1: No | Q2: Can a deduction be claimed under section 8-1 of the ITAA 1997 for legal expenses incurred in the defence of the imposition of civil penalties imposed by the Australian Government? | A2: Yes

Relevant facts and circumstances: This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling. The Company is in business. As an incident of carrying on normal business activities the Company breached the law. The Federal Court ruled that the Company should pay civil penalties In defending the Company against the imposition of the civil penalties the Company incurred legal fees. The business continues to be conducted.

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

Reasons for decision: Summary: Penalties imposed under an Australian law are not deductible. | Detailed Reasoning - Detailed reasoning: Section 8-1 of the ITAA 1997 allows a deduction from your assessable income any loss or outgoing to the extent that it is incurred in the production of your assessable income or necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. However subsection 8-1(2) of the ITAA 1997 states that you cannot deduct a loss or outgoing under this section to the extent that another provision of the Act prevents you from deducting it. Section 26-5 of the ITAA 1997 states that you cannot deduct under this Act an amount (however described) payable by way of penalty under an Australian law, or an amount ordered by a court to be paid on the conviction of an entity for an offence against an Australian law. The Federal Court ruled that the Company should pay civil penalties. Because the penalties were ordered by a court as the result of breaches of Australian law a deduction for the penalties is specifically excluded by the provisions of section 26-5 of the ITAA 1997. Although it could be determined that the penalties were necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income they are not allowed to be deducted in terms of subsection 8-1(2) of the ITAA 1997. | Summary: A deduction for legal expenses is allowable under section 8-1 of the ITAA 1997 because the expense was necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income and no exclusions apply. | Detailed Reasoning - Detailed reasoning: Section 8-1 of the ITAA 1997 provides that a loss or an outgoing is an allowable deduction if it is incurred in producing assessable income or in carrying on a business for the production of assessable income unless that loss or outgoing is not deductible in terms of subsection 8-1(2) of the ITAA 1997. For legal expenses to constitute an allowable deduction, it must be shown that they arose as a consequence of the day-to-day activities of the business and are incidental or relevant to the production of the taxpayer's assessable income. As clarified in the case No. 3 Board of Review Case B31 , 70 ATC 148 the character of legal expenses is not determined by the success or failure of the legal action. A leading case on the question of legal expenses is The Herald and Weekly Times v Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 2 ATD 169 ( Herald and Weekly Times ), in which the proprietor of an evening newspaper claimed legal expenses in connection with libels the newspaper had published. The Full High Court allowed the deduction, as publishing the newspaper was both the source of income and cause of the liability and secondly, the risk of libel was a regular and almost unavoidable incident or inherent risk of publishing. Another relevant case is Federal Commissioner of Taxation v. Snowden and Willson Pty Ltd (1958) 99 CLR 431; (1958) 11 ATD 463; (1958) 7 AITR 308 ( Snowden's Case). Allegations of overcharging and unfair business practices were made of the taxpayer's building operations. Consequently, a Royal Commission was appointed to investigate the claims. The taxpayer defended itself and its officers before the Royal Commission and claimed to deduct its legal costs. A majority of the Full High Court allowed a claim to deduct those costs. Dixon CJ stated: the carrying on of the business of the nature described brought with it the attacks against which the taxpayer company sought to defend itself. ..But the instinct is founded upon sound if intuitive conceptions of what must be done if they are not to suffer in their pursuit of custom and profit. Whether on the merits they were in a position to defend themselves successfully or whether, on the other hand, the attacks upon them lacked adequate foundation alike seem to me to be matters not to the point. More recently, in Magna Alloys and Research Pty Ltd v FC of T 80 ATC 4542; (1980) 11 ATR 276, the Full Federal Court allowed the taxpayer its costs in unsuccessfully defending criminal charges laid against the taxpayer's directors and agents in relation to marketing practices adopted in selling the taxpayer's products. In your situation, the law was breached and charges resulted from the normal business activities of the Company. Therefore the legal expenses incurred in the defence of fines imposed are intrinsically related to the business being carried on. However, consideration must still be given to the negative limb of section 8-1 of the ITAA 1997. Subsection 8-1(2) of the ITAA 1997 excludes a loss or outgoing which is: (a) capital or capital in nature, (b) private or domestic in nature, (c) in relation to the production of exempt income and (d) prevented from being a deduction by another provision of the Act The expenditure incurred in the defence of the imposition of penalties is clearly not private or domestic in nature or incurred in relation to the production of exempt income. The legal expenses, while being incurred in the defence of penalties imposed under an Australian law are not excluded by the provisions of section 26-5 of the ITAA 1997. Consideration must be given to the possibility that the expenditure may be capital in nature. If it was determined, for example, that the expenditure was incurred in the protection of the reputation of the business (which is a capital asset) rather than in the manner in which the business is conducted on a day-to-day basis it would be possible to treat the expenditure as capital in nature. However as found in Snowden's Case by Dixon CJ: There remains, however, the question whether the expenditure may not be considered to be of a capital nature and so subject to the express prohibition contained in s. 51 (1) against allowing losses and outgoings of a capital nature. An examination of the facts does not support the view that the proceedings in Parliament and before the Royal Commission imperilled the existence of the business or the capital assets of the company. The proceedings were not necessarily directed at a winding-up of the company or a stoppage of the business. Precise definition or distinctions are difficult in such an affair. But what the company had most to fear was the embarrassment in the present and future conduct of its business and, no doubt, a decline in its custom. Although fines and penalties are not themselves deductible, legal costs incurred in defending the charges are deductible under section 8-1 of the ITAA 1997 because the Commissioner considers that the legal expenses arose from an inherent risk in the day-to-day conduct of your business activities. Your legal costs are an allowable deduction under section 8-1 of the ITAA 1997.

Please check this edited version to be sure that there are no details remaining that you think may allow you to be identified. If you have any concerns about this ruling you wish to discuss, you will find our contact details in the fact sheet. | Reasons for decision: While these reasons are not part of the private ruling, we provide them to help you to understand how we reached our decision.