Private ruling: Legal and interest expenses
Published: May 2012
Ruling period: Year ended 30 June 2010 | Year ended 30 June 2011
Date scheme commenced: 1 July 2009

Ruling: Q2: Are you entitled to claim a deduction for the interest incurred on a loan which was used to pay damages and costs as ordered by the Court, even though the business has ceased trading? Advice/Answers Yes


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

Reasons for decision: Summary: The expenses incurred, as a result of the Court Order, were paid for using the machine illegally. Without the machine your business does not exist. The machine is the profit-making structure of your business. The expenses were not incurred in the day to day operation of the business but for damages and costs for using the machine illegally. The expenses are capital in nature and not deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) | 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. However, a deduction will not be allowed where the outgoings are of a capital, private or domestic nature. It is clear that the expenditure in the present case was necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. However, the issue that requires further examination is whether the expenditure is capital in nature. The nature or character of legal expenses follows the advantage which is sought to be gained by incurring the expenses. Where legal expenses arise as a consequence of the day to day activities of a business, the object of the expenditure is devoted towards a revenue end and the legal expenses are deductible ( Herald & Weekly Times v. Federal Commissioner of Taxation (1932) 48 CLR 113; 2 ATD 169). Where the 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 v. Federal Commissioner of Taxation (1938) 61 CLR 337; 5 ATD 87; (1938) 1 AITR 403). Legal expenses incurred in fending off the threatened extinction of the profit-yielding subject or business, are not deductible under s 8-1 of the ITAA 1997. Examples of these kinds of expenditure include: · expenditure incurred by a brewing and bottling company in campaigning against the introduction in New Zealand of alcohol prohibition was not deductible ( Ward & Co Ltd v C of T (NZ) (1923) AC 145; R & McG 412) · expenses incurred in defending proceedings challenging the legality of an agreement (granting the taxpayer exclusive rights to televise major cricket matches) upon which the taxpayer's whole business depended were not deductible ( PBL Marketing Pty Ltd v FC of T 85 ATC 4416) · the taxpayers carried on business as service station operators. An oil company had sought to terminate a lease and supply contract. The taxpayers commenced legal proceedings to prevent termination of the contracts. The legal expenses were not deductible as they were capital in nature. The arrangements with the oil company gave the taxpayer the vital means for the conduct of the business. It was the severe threat to the continuation of the business which precipitated the litigation. It went to the very business structure of the taxpayers ( W Wehbe Pty Limited & Anor v FC of T 93 ATC 5015). As a result of the Court Order you were stopped from using the machine. By being restrained from using the machine you were unable to carry on the business. The machine formed the profit-yielding structure of the business, without the machine the profit-yielding structure of the business ceased to exist. The costs incurred as a result of the Court Order are therefore not deductible under section 8-1 of the ITAA 1997 because they are capital in nature. | Summary: You are entitled to claim a deduction for the full amount of interest incurred on a loan used to pay damages and costs as a result of a Court Order despite the fact that the business has ceased operating. | Detailed Reasoning - Detailed reasoning: Section 8-1 of the ITAA 1997 allows a deduction for expenses necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. However, no deduction is allowable if the expense is of a private, domestic or capital nature. In general the character of interest is determined with reference to the use to which the borrowed funds are put ( Commissioner of Taxation v. Roberts; Commissioner of Taxation v. Smith (1992) 37 FCR 246; 92 ATC 4380; (1992) 23 ATR 494). Taxation Ruling TR 2004/4 outlines deductions for interest incurred prior to the commencement of, or following the cessation of, relevant income earning activities. Outgoings of interest are a recurrent expense. The fact that borrowed funds may be used to purchase a capital asset does not mean the interest outgoings are therefore on capital account (see Steele 99 ATC 4242 at 4249; (1999) 41 ATR 139 at 148). | Detailed Reasoning - Interest incurred after assessable income: Where interest has been incurred over a period after the relevant borrowings (or assets representing those borrowings) have been lost to the taxpayer and relevant income earning activities (whether business or non-business) have ceased, it is apparent that the interest is not incurred in gaining or producing the assessable income of that period or any future period. However, the outgoing will still have been incurred in gaining or producing 'the assessable income' if the occasion of the outgoing is to be found in whatever was productive of assessable income of an earlier period. Whether or not the occasion of the outgoing of interest is to be found in what was productive of assessable income of an earlier period requires a judgment about the nexus between the outgoing and the income earning activities. An outgoing of interest in such circumstances will not fail to be deductible merely because: · the loan is not for a fixed term; · the taxpayer has a legal entitlement to repay the principal before maturity, with or without penalty; or · the original loan is refinanced, whether once or more than once. However, if the taxpayer: · keeps the loan on foot for reasons unassociated with the former income earning activities; or · makes a conscious decision to extend the loan in such a way that there is an ongoing commercial advantage to be derived from the extension which is unrelated to the attempts to earn assessable income in connection with which the debt was originally incurred, · the nexus between the outgoings of interest and the relevant income earning activities will be broken. A legal or economic inability to repay is suggestive of the loan not having been kept on foot for purposes other than the former income earning activities. In application to your case you took out a loan to pay damages and costs associated with your business. The business has ceased operating however you still have an on-going obligation to pay the interest expense on the loan. You were not in a financial position to pay the damages and costs awarded to the applicants by the Court so you took out a loan for that purpose. The proceeds of the loan have not been re-drawn for any other purpose. You have other financial obligations and do not have the capacity to pay the loan out before the loan term ends. You are entitled to a deduction for on-going interest expense on a loan used to pay Court-awarded damages and costs 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. | Legal expenses and Interest | Question 1: Is the payment, paid as a result of a Court Order for damages and costs, deductible? | Relevant facts: You worked as an employee of a company using a specific machine. | After working for the company for a period of time you decided to go out on your own as a sole trader and you imported the same machine. You started your business in the 2008-09 financial year. | The company, and others, initiated legal action in the Federal Court against you. | It was found by the Court that: | · By using the machine, you infringed a registered Australian patent | · You infringed a registered trade mark | · You infringed the copyright of one of the applicants | · You breached the Trade Practices Act 1974; and | · You breached a "Bi-Lateral Non-Disclosure Agreement" between yourself and one of the applicants. | · You be restrained from using, importing, advertising, marketing or promoting, distributing, selling, or by way of trade, offering or exposing for sale, leasing or renting or otherwise utilising the machine | · You pay a nominated sum to the second applicant by way of damages and costs in these proceedings, however if you paid a lower nominated amount by a specified date the second applicant will not enter judgement for the original amount. | · You paid the lower nominated amount as ordered by the Federal Court. | As a result of the Court action, the income from your business ceased immediately and the business ceased trading. | As a result of your personal financial situation you were forced to borrow the money to pay the capital amount to the applicant as awarded by the Federal Court. | You incurred interest on the loan. You continue to incur interest expenses despite the fact that your business has ceased operating. | You have other financial obligations and do not have the capacity to repay the loan before the loan term ends.