Private ruling: Legal Fees
Published: February 2012
Ruling period: Income year ended 30 June 2010 | Income year ended 30 June 2011 | Income year ended 30 June 2012
Date scheme commenced: 1 July 2009

Ruling: Q3: For the proportion of legal expenses that may not be deductible to the Company under section 8-1 of the ITAA 1997, are they deductible under subsection 40-880(2) of the ITAA 1997? Advice/Answers No

Relevant facts and circumstances: The taxpayer Company, (Company A) and Company B and its directors entered into various agreements to purchase Company A from Company C and its associate. Numerous agreements were entered into by the various parties in order to execute the purchase. These agreements included inter alia, Sale of Business Deed agreement, Shareholder Agreement, Supply Agreement, etc. Disputes arose as a consequence of allegations of misrepresentations by the previous owners of Company A regarding some of these agreements. Initially, attempts were made to negotiate these issues, and subsequently court proceedings were pursued to obtain the necessary relief. Company C and its associate as plaintiff, in the first instance, lodged claims against the taxpayer Company A and Company B and its directors. Company A, Company B and its directors as defendants, in the first instance, and subsequently plaintiff's by counterclaim lodged a defense, further amended defense and counterclaims. The court proceedings that ensued ultimately ended in a Settlement Agreement. The Settlement Agreement resulted in Company A, Company B and its directors agreeing to pay a settlement sum of money to the Plaintiffs (Company C and its associate) and the Plaintiffs accepting the setting aside of some of the agreements. The settlement sum resulted in the transfer of the First Plaintiff's shareholding interest in Company A. The legal expenses which are the subject of this application have been incurred and paid by Company A in defending these claims.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 8-1 | Income Tax Assessment Act 1997 section 40-880

Reasons for decision: 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 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. For legal expenses to constitute an allowable deduction, it must be shown that they are incidental or relevant to the production of the taxpayer's assessable income or business operations ( Ronpibon Tin NL & Tong Kah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 4 AITR 236; (1949) 8 ATD 431). Also, in determining whether a deduction for legal expenses is allowable 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 ( Hallstroms )). 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 the taxpayer's business ( Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 39 ALR 46; (1932) 2 ATD 169) 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 80 ATC 4542; (1980) 11 ATR 276). The Full Federal Court in Placer Pacific Management Pty Ltd v. FC of T 95 ATC 4459, (1995) 31 ATR 253 (Davies, Hill, Sackville JJ) stated the following: ... provided the occasion of a business outgoing is to be found in the business operations directed towards the gaining or production of assessable income generally, the fact that that outgoing was incurred in a year later than the year in which the income was incurred [sic] and the fact that in the meantime business in the ordinary sense may have ceased will not determine the issue of deductibility. Since AGC (Advances) Ltd v. FC of T 75 ATC 4057; (1975) 5 ATR 243 and more recently Placer Pacific (supra) , it is clear that the statement of the Court in Ronpibon Tin (supra) that: ... it is both sufficient and necessary that the occasion of the loss or outgoing should be found in whatever is productive of assessable income ... The above supports the proposition that a loss or outgoing can be deductible even if it is incurred after the cessation of income earning activities. But in order to be deductible the occasion of the outgoing must be found in those income earning activities. It is also noted that the success or failure of a taxpayer's claim or defence is not relevant to the question of the deductibility of the legal fees ( Federal Commissioner of Taxation v. Snowden & Willson Pty Ltd (1958) 99 CLR 431 at 436 ( Snowden )). The question of whether legal fees are capital in nature has been the subject of much judicial consideration. The classic exposition of the test was by Dixon J in Sun Newspapers Ltd & Associated Newspapers Ltd v. FC of T (1938) 61 CLR 337; (1938) 5 ATD 87; (1938) 1 AITR 403. In his judgment he referred to three tests: There are, I think, three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it, that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment. In Hallstroms , Dixon J said that legal expenses: … take the quality of an outgoing of a capital nature or of an outgoing on account of revenue from the cause or purpose of incurring the expenditure. We are, therefore, remitted to a consideration of the object in view when the legal proceedings were undertaken, or of the situation which impelled the taxpayer to undertake them. Generally, the treatment of a settlement sum or damages payment will follow the treatment of the other legal costs incurred in relation to a particular matter. | Detailed Reasoning - Application to your circumstances: Who incurred the legal fees? The legal fees have been incurred and paid by Company A. | Detailed Reasoning - Dispute: Company A, Company B and its directors were parties to the legal dispute from which legal fees were incurred by Company A and from which flowed a Settlement Agreement. The legal fees were incurred and paid by Company A as a consequence of claims and counter claims regarding these agreements. | Detailed Reasoning - Settlement Agreement: The 'Settlement Agreement' was an outcome of the legal dispute which resulted in Company A and Company B and its directors as defendants in the settlement claim agreeing to pay to the Plaintiffs the settlement sum. The settlement sum resulted in the transfer of the First Plaintiff's shareholding interest in Company A as consideration for most of the agreements being set aside as a part of the Settlement Agreement. | Detailed Reasoning - Legal Fees: 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. With regards to the second limb, the High Court in John Fairfax & Sons Pty Ltd v. FC of T (1959) 101 CLR 30 at 48; 11 ATD 510 at 519 said that an outlay must be part of the cost of trading operations to produce income, that is, it must have the character of a working expense. The legal fees incurred in relation to this agreement arose out of disputes in relation to alleged misrepresentations by the previous owners in relation to financial information given at the time that the relevant parties were contemplating the purchase of the business. When Company B acquired the business it was purchasing an underlying profit yielding structure and is considered to be a capital transaction. The entering of the dispute, in relation to this agreement, was to protect its investment in the underlying profit yielding structure of the business. The dispute is between Company B and Company C and its associate. The dispute does not relate to the business activities of Company A. It is accepted that Company A has incurred and paid the expenses. However, as these expenses have no relationship to the gaining or producing of Company A's assessable income it is not possible for Company A to satisfy the positive limbs of section 8-1 of the ITAA 1997. Therefore, no deduction is allowable to Company A for the legal expenses. As the positive limbs are not satisfied it is not necessary to consider if the expenses are capital in nature. | Detailed Reasoning - Question 2: If the legal fees are not deductible to Company A under section 8-1 of the ITAA 1997, then is a proportion of the legal fees, if any, deductible? Answer: No | Detailed Reasoning - Detailed reasoning: Legal fees are not deductible to Company A under section 8-1 of the ITAA 1997. Please refer to reasons for decision discussion under 'Question 1'. | Detailed Reasoning - Question 3: For the proportion of legal expenses that may not be deductible to Company A under section 8-1 of the ITAA 1997, are they deductible to the Company under subsection 40-880(2) of the ITAA 1997? Answer: No | Detailed Reasoning - Detailed reasoning: Section 40-880 provides a deduction for specified categories of capital expenditure, called 'business related costs', that would otherwise be non-deductible under the general deduction provisions such as section 8-1 and other deduction provisions. Section 40-880 of the ITAA 1997 is a provision of last resort. In other words, section 40-880 only applies to expenditure if no other provision allows or denies a deduction or otherwise takes the expenditure into account. The object of section 40-880 is to make certain business capital expenditure deductible over 5 years if: · the expenditure is not otherwise taken into account; and · a deduction is not denied by some other provision; and · the business is, was or is proposed to be carried on for a taxable purpose. The expenditure must be capital expenditure which is business related. | Detailed Reasoning - Subsection 40-880(2): Subject to the limitations and exceptions contained in subsections 40-880(3) to (9), subsection 40-880 (2) provides that you can deduct, in equal proportions over a period of 5 income years starting in the year in which you incur it, capital expenditure you incur: · in relation to your business; · in relation to a business that used to be carried on; or · in relation to a business proposed to be carried on; or · to liquidate or deregister a company of which you were a member, to wind up a partnership of which you were a partner or to wind up a trust of which you were a beneficiary that carried on a business. On the facts of this case, the relevant paragraph to consider is paragraph 40-880(2)(a). This paragraph applies if it is considered that the relevant capital expenditure was incurred in relation to the existing business of the Company. In considering the phrase 'in relation to' contained within subsection 40-880(2) of the ITAA 1997, paragraph 2.25 of the Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No. 1) Bill 2006 states: The provision is concerned with expenditure that has the character of a business expense because it is relevantly related to the business. The concept used to establish this character or requisite relationship between the expenditure incurred by the taxpayer and the business carried on (current, past or prospective) is 'in relation to'. The connector 'in relation to' allows the appropriate latitude to enable the deductibility of qualifying capital expenditure incurred before the business commences or after it has ceased. In discussing the types of business capital expenditure to which subsection 40-880(2) of the ITAA 1997 applies, the Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No.1) Bill 2006 states: 2.19. Expenditure on the structure by which an entity carries on (or used to or proposes to carry on) their business and on the profit yielding structure of the business would ordinarily be expected to be of a capital nature. Capital expenditure can also relate to a business's trading operations or the entity that will carry on the business. 2.20. The structure covers the legal entity (such as a company) or the legal relationship (such as a partnership or trust) that is the entity that carries on the business for a taxable purpose and that holds the business assets. These paragraphs indicate that capital expenditure incurred on the structure by which an entity carries on (or used to or proposes to carry on) their business, on the profit yielding structure of the business, or relating to the business's trading operations, are capable of being described as capital expenditure incurred 'in relation to' that business for the purposes of subsection 40-880(2) of the ITAA 1997. Whether such capital expenditure is incurred 'in relation to' the particular business will depend on whether there is a sufficient and relevant connection between the incurring of the expenditure and that business on the facts of the particular case. | Detailed Reasoning - Legal Fees: The legal fees that have been incurred and paid by Company A have been determined under question one to be not deductible on the basis that it does not meet the positive limbs of the general deduction provisions of section 8-1 of the ITAA 1997. Similarly, section 40-880 of the ITAA 1997 does not have application as the legal fees that have been incurred by Company A are not related to its structure nor is the capital expenditure related to its business. This is because the legal expenses relate to actions taken by Company B and have no relationship to any business activities undertaken by Company A. | Detailed Reasoning - Conclusion: The expenditure that was incurred by Company A was not in relation to its business for the purposes of paragraph 40-880(2)(a) of the ITAA 1997. Based on the above, the expenditure that Company A incurred in the form of legal fees is not deductible under section 40-880 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. | Are the legal fees incurred in relation to the dispute deductible to the Company under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)? | If the legal fees are not deductible to the Company under section 8-1 of the ITAA 1997, then is a proportion of the legal fees, if any, deductible? | Are the legal fees incurred in relation to the dispute deductible under section 8-1 of ITAA 1997 to the taxpayer Company (Company A)?