Private ruling: Deductibility of legal expenses
Published: March 2013
Ruling period: Year ended 30 June 2012
Date scheme commenced: 1 July 2011

Ruling: Q1: Is the amount of a lump sum paid due to an out of court settlement deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: No | Q2: Are legal fees you incurred in defending a claim that you breached certain terms of a franchise agreement deductible under section 8-1 of the ITAA 1997? | A2: No


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

Reasons for decision: Summary: Section 8-1 of the ITAA 1997 allows a deduction for all losses or outgoings to the extent that 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. However, no deduction is allowed to the extent that the losses or outgoings are of a capital, private or domestic nature or are incurred in gaining or producing exempt income. | Detailed Reasoning - Lump sum settlement payment: For a settlement sum (or part of it, where specified) to constitute an allowable deduction, it must be shown that it was incidental or relevant to the production of your assessable income. Also, in determining whether a deduction for the settlement sum is deductible, the nature of the expenditure must be considered. The nature or character of the settlement sum follows the advantage that is sought to be gained by incurring the expenditure. In Foley Brothers Pty Limited v FC of T (1965) 13 ATD 562, a payment was made by a taxpayer under terms of settlement to obtain a release from obligations undertaken by a previous agreement. It was held to be a payment on capital account. In the course of their judgment, Kitto, Taylor and Menzies JJ said: 'The freedom thus acquired was clearly enough an enduring advantage.' In your case, you paid an undissected amount as full and final settlement of the action between you and the franchisor. The deed fully releases you from all claims made against you under the action. The advantage that you obtained upon signing the settlement agreement is of an enduring benefit which allows you to continue without the burden of the dispute and is considered capital in nature and not deductible under section 8-1 of the ITAA 1997. | Detailed Reasoning - Legal Expenses: In determining whether a deduction for legal expenses is allowed under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered ( Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634, (1946) 3 AITR 436; (1946) 8 ATD 190). The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses. Legal expenses are generally deductible if they arise out of the day to day activities of your business ( Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 2 ATD 169) and the legal action has more than a peripheral connection to your income producing activities ( Magna Alloys & Research Pty Ltd v. Federal Commissioner of Taxation 80 ATC 4542; (1980) 11 ATR 276). 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). In Case X84 90 ATC 609; AAT Case 6528 (1990) 21 ATR 3721 ( Case X84 ), the AAT held that legal expenses incurred by a medical practitioner in defending charges brought against him at a Disciplinary Tribunal inquiry, were not deductible because the expenditure was incurred to protect a structural asset, that is, their registration as a medical practitioner, and was of a capital nature. Even if you are able to satisfy the first limb of section 8-1 of the ITAA 1997, it is still necessary to determine whether the legal expenses are capital in nature and so precluded from deduction. There is no issue in your case of the legal expenses being losses or outgoings of a private or domestic nature. In your case, the alleged breaches did not arise from the day to day conduct of your business activities. You were required to defend allegations that you acted in breach of a Franchise Agreement concerning carrying on a new business. The object of the legal expenditure was to preserve your business to protect your future income. A taxpayer's right to carry on a business is part of the profit yielding structure of the business, and legal expenses incurred in protecting that structure are of a capital nature. Accordingly, the legal expenses incurred were of a capital nature, being in relation to your business structure and are therefore not deductible under section 8-1 of the ITAA 1997.

Relevant facts: You purchased a franchise for which you were to pay a licence fee. | In signing the agreement, as franchisee, you agreed that you did not own and will not acquire any title to the know-how, trademarks, trade names and other intellectual property used by franchisees. | You also agreed that you must not, during the restraint term and anywhere in the restraint territory: | a) divert elsewhere any trade or business which ordinarily be transacted by a franchisee; | b) sell, rent or permit use of any customer list; and | c) have any interest in, be engaged in or perform any business that is the same or similar to the business conducted by franchisees. | You subsequently had an argument with the franchisor and you stopped paying the franchisor and went out on your own. | As a result, the franchisor sued you for taking customers. | You incurred legal costs in defending the action for the purpose of protecting your income for the future. | You reached an out of court settlement whereby you paid the franchisor a lump sum amount.