Private ruling: Deductibility of legal expenses
Published: September 2014
Ruling period: 1 July 20XX to 30 June 20ZZ

Ruling: Q1: Can The Taxpayer claim a tax deduction under section 8-1 of the ITAA 1997 for X% of the total legal expenses incurred as a consequence of a family court action? | A1: No | Q2: If the answer to Question 1 is yes, in which year or years is The Taxpayer required to claim the deduction? | A2: N/A Issue 2 Deductibility of legal expenses under section 40-880 of the ITAA 1997. | Q3: If the answer to Question 1 is no, can The Taxpayer claim a deduction under section 40-880 of the ITAA 1997 for X% of the legal expenses as a consequence of a family court action? | A3: No | Q4: If the answer to Question 1 is yes, in which financial year should the claim commence? | A4: N/A

Relevant facts and circumstances: Company A was incorporated on dd/mm/yyyy. It is a holding company with 100% direct shareholding in Company B, Company C, Company D, Company E, and Company F. Through these companies, Company A also indirectly owns 100% of the shares in Company G (The Taxpayer), which is a trading entity, dealing certain recycling. The Taxpayer is also the only trading entity of the aforementioned companies. There is no Tax Consolidation and each entity is taxed in its own right. Mr A is the sole director of each of the above companies. There are X ordinary shares in Company A, of which the shareholding is made up as follows: Number of shares Held by On behalf of A Mrs A Self B Mr A As trustee for the Trust 1 C Mr A and Mrs A D As trustees for Trust X D - As trustees for Trust Y D - As trustees for Trust Z Trust 1 The Trust 1 was established by deed dated dd/mm/yyyy. It is the beneficial owner of 50% of the shares in Company A. X (hereafter referred to as the spouse ), half sibling, A, sibling, Y and their sibling, Z are the only four discretionary beneficiaries of the Trust 1. B is the spouse of A and is the trustee of the Trust 1. Upon the vesting day (being dd/mm/yyyy or such earlier day determined by the trustee by deed) the trust fund shall be transferred to the discretionary beneficiaries in equal shares. Trust X, Trust Y and Trust Z Trust X, Trust Y and Trust Z have each been created by deed on dd/mm/yyyy and each subsequently varied by Deed (undated, but stamped dd/mm/yyyy). Each of the trusts is identical in terms, except for the primary beneficiaries which are: • the spouse (for Trust X) • Y (for Trust Y), • Z ( for Trust Z). The trustees of these trusts are B and A, who hold D shares in Company A in their capacity as Trustees of each of these trusts. The original deed of each of the three trusts (as at dd/mm/yyy) provided, among other things, that the trust fund would vest in the named beneficiary upon the named beneficiary reaching 30 years of age. In the spouse's case the Trust fund would have vested on dd/mm/yyyy. Each of the three trusts were amended by deed undated (but stamped dd/mm/yyyy) and signed respectively by each of the named beneficiaries, including the spouse to the effect that each trust renounced the vesting date being upon the named beneficiary reaching 30 years of age. The vesting date was altered to the later of the date of death of the last surviving of B and A or such date as the Trustees in their absolute discretion determine. (The aforementioned companies and trusts are collectively referred to as the Group hereafter) The following trusts also exist outside the Group: i. Trust N, created by deed on dd/mm/yyyy. X is the trustee of this trust. The said trust beneficially owns the property in an Australia state, as well as a bank gold term deposit account with a balance at dd/mm/yyyy of $X. The said deposit matured on dd/mm/yyyy. The primary beneficiary of Trust N is the spouse's sibling, Y. The secondary beneficiaries of the said trust include the spouse and X (hereafter referred to as the spouse ). ii. Trust O, created by deed on dd/mm/yyyy. B is the trustee of this trust. The said trust beneficially owns the property in an Australian state, as well as a bank gold term deposit account with a balance at dd/mm/yyyy of $X. The said deposit matured on dd/mm/yyyy. The primary beneficiary of Trust O is the spouse. The secondary beneficiaries of the said trust included the other spouse. iii. Trust P, created by deed on dd/mm/yyyy. B is the trustee of this trust. The said trust beneficially owns the property in an Australian state, as well as a bank gold term deposit account with a balance at dd/mm/yyyy of $X. The said deposit matured on dd/mm/yyyy. The primary beneficiary of Trust P is the spouse's sibling, Z. The secondary beneficiaries of the said trust include the spouse and spouse. On dd/mm/yyyy, the spouse filed an application in the Family Court ( the Court ) against the other spouse. In order to establish the value of the property of the marriage and facilitate the payment of money due to her as result of the court proceedings, B and A were added on dd/mm/yyyy as respondents in the following capacities: 1. B and A as Trustees for Trust 1; 2. B and A as Trustees for Trust X; 3. B and A as Trustees for Trust Y; 4. B and A as Trustees for Trust Z; 5. B and A as Trustees for Trust N; 6. B and A as Trustees for Trust O; 7. B and A as Trustees for Trust P; 8. B in their capacity as the Governing Director of Company A. (Hereafter referred to as the Third Parties ) On dd/mm/yyyy an affidavit by B was filed with the Court in which they stated at paragraph 2 that they understood that the Orders sought against the various trusts of which they were the sole trustee or joint trustee together with A are to the effect that there should be declarations made in respect of the spouse's "title of rights" to the property of the various trusts and to the effect that the assets of the trusts are to be treated as 'property of the parties to the marriage of either of them" and therefore divisible between the spouses by orders of the Family court. In this affidavit, B expresses his concerns about the cost of the proposed valuation as well as the legal expenses to be incurred as a result of including various trusts in the proceedings, as requested by the spouse. Attached to the affidavit was a letter from their lawyer, dated dd/mm/yyyy which estimated the prospective expenses of the proposed valuations to be in excess of $100,000 or even double that amount. In the Consolidated minute of Orders Sought filed by the spouse's solicitors on dd/mm/yyyy, the spouse requested valuations by a Single Expert Witness of i. X% of the shares in Company A; ii. Y% of the shares in Company A; and iii. Z% of the shares in Company A. Further, in the same documents, the valuation of the following properties was requested: i. Property A, B and C ii. Property D (the former matrimonial home); and iii. Each item of real property held in the name of the Taxpayer. It was requested that the parties pay the fees and expenses of the Single Expert Witnesses as the Court deems appropriate. It was also attempted to further join B in their capacity as director of The Taxpayer, Company B, Company C, Company D, Company E, and Company F. However the court did not give effect to this request. Also, no orders have been made by the Court in relation to the valuation of the shares of any entity in the Group. It is stated on behalf of The Taxpayer that the spouse believed that their spouse was entitled to X% of the whole of Company A and its investments. Furthermore it became clear to her that the ultimate source of funds to a claim, if they were to be successful, was The Taxpayer, through Company A. Interim orders were made by the Court on dd/mm/yyyy, pursuant to which B was ordered to pay or cause to be paid to the spouse's solicitors, the sum of $X. Final orders made by consent on dd/mm/yyyy , pursuant to which the spouse was ordered to pay or cause to be paid to their spouse a lump sum of $Y. The legal fees and disbursements paid on behalf of the Third Parties, including Counsel's fees and Solicitors' fees, totalled approximately $Z. The legal invoices were addressed to B C/- G Group; or B, G Group. During the family court proceedings The Taxpayer provided the funding to meet the legal fees of the parties named to the action. In the letter dated dd/mm/yyyy from The Taxpayer's lawyer, the opinion is expressed that X% of the legal expenses relate to Company A and that Y% should be properly allocated to the spouse. In this advice the lawyer points out that they are not providing tax advice and states that they rely in providing their opinion upon the evidence before the court, the Interim Orders made and the Orders which were made against the Third Parties. Taxpayer's arguments The Taxpayer states that the objectives of itself and Company A in incurring the legal expenses were the following: • To protect the ongoing business including earning capacity and avoid disruption to the business activity of The Taxpayer- the trading and income producing entity; • Avoid any potential restructure of Company A and its investments including The Taxpayer that may subsequently impinge on the earning capacity of the trading entity; • Avoid incurring valuation expenses of Company A and its investment entities including The Taxpayer as the principal trading entity; • Maintain the assets of Company A and its investment intact to avoid disruption to funding capabilities; and • Protect the existing ownership rights of the shareholders of Company A. The Taxpayer further stated that the expenses were incurred to avoid excessive disruption to The Taxpayer's business and ultimately it's earning capacity. Accordingly it is argued that a deduction for X% of the legal expenses appears appropriate under section 8-1 of the ITAA 1997. The Taxpayer refers the Commissioner to Case W30, ATO ID 2004/145 and ATOID 2003/145. In the event that a tax deduction is not available under section 8-1 of the ITAA 1997 it is The Taxpayer's opinion that a deduction can be made over a period of five years under section 40-880 of the ITAA 1997. The Taxpayer based this conclusion on consideration of the following legal references: • That legal expenses incurred to preserve a capital asset or prevent a takeover are deemed to be capital in nature ( John Fairfax & Sons Pty Ltd v FCT (1959) 101 CLR 30); • The expenditure has not been otherwise taken into account or denied under subsection 40-880(1) of the ITAA 1997; • The capital expenditure was incurred in relation to the business under subsection 40-880(1) of the ITAA 1997; • The business is carried on for a taxable purpose under subsection 40-880(3) of the ITAA 1997; • The nature and circumstances for the expenditure do not meet any of the expressly denied items under subsection 40-880(5) ITAA 1997; • The expenditure does not meet the allowable deductions stipulated under section 25-5 of the ITAA 1997; • The expenditure was incurred after 1 July 2005.

Relevant legislative provisions: Section 8-1 of the ITAA 1997 | Section 40-880 of the ITAA 1997 | ATO View relied on | Taxation Ruling TR 2011/6

Reasons for decision: Detailed Reasoning - Issue 1: Deductibility of legal expenses under section 8-1 of the ITAA 1997. | Detailed Reasoning - Question 1: Can The Taxpayer claim a tax deduction under section 8-1 of the ITAA 1997 for X% of total legal expenses incurred as a consequence of a family court action? | Summary: The legal expenses fail to satisfy both the first and the second limb of section 8-1 of the ITAA 1997 in that there is no connection between the expenses and the income generating activities of the business of The Taxpayer and the expenses are also of a domestic/private nature and are therefore not deductible. | Detailed Reasoning - Detailed reasoning: Family Law Context Section 79 of the Family Law Act 1975 (FLA 1975) enables the Family Court to make orders altering interests in matrimonial property on the breakdown of matrimonial relationships. Section 90AE of the FLA 1975 commenced on 17 December 2004. Section 90AE gives the Family Court certain powers to make orders under section 79 of the FLA 1975 in relation to third parties. Paragraph 90AE(2)(b) of the FLA 1975 specifically empowers the Court to make an order that alters the rights, liabilities or property interests of a third party in relation to the marriage. Prior to 17 December 2004, the Family Court was not empowered to make orders directly against a private company. Rather, property of a party to matrimonial property proceedings was treated by the Family Court as including any property which a party had an ability to unilaterally invest in or divest as controlling shareholder, trustee or otherwise. In such cases, the Family Court might have made an order against a party with a controlling interest to cause the private company to pay money or transfer property to the other matrimonial party. Paragraph 90AE(2)(b) of the FLA 1975 now empowers the Family Court to make orders directly against a third party such as a private company of which one or both of the matrimonial parties are shareholders. In practice such orders have been for the private company to make a payment of money or a transfer of property to one or both of the parties to the matrimonial proceedings. Rule 6.02(1) of the Family Law Rules 2004 now requires that if a party seeks an order affecting a third party, the third party is a necessary party to the proceedings. Therefore, such orders would now be expected to be made directly against the third party rather than against a matrimonial party. The application of section 8-1 of the ITAA 1997 The deductibility of legal expenses is determined under section 8-1 of the ITAA 1997, which states the following: | Detailed Reasoning - 8-1(1): You can deduct from your assessable income any loss or outgoing to the extent that: (a) it is incurred in gaining or producing your assessable income ; or (b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income . | Detailed Reasoning - 8-1(2): However, you cannot deduct a loss or outgoing under this section to the extent that: (a) it is a loss or outgoing of capital, or of a capital nature ; or (b) it is a loss or outgoing of a private or domestic nature ; or (c) it is incurred in relation to gaining or producing your * exempt income or your * non-assessable non-exempt income; or (d) a provision of this Act prevents you from deducting it. [emphasis added] Therefore, for legal expenses to be deductible under section 8-1, they have to be: • incurred by The Taxpayer; • 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) and; • not of a capital, private or domestic nature. Even though there was an attempt by the spouse to join B to the proceedings in their capacity as managing director of The Taxpayer, The Taxpayer was not added by the Court as a party to the proceedings. It is stated by The Taxpayer that, during the family court proceedings, it provided the funding to meet the legal fees of the parties named to the action. Although the majority of the invoices for legal fees are addressed to "B, c/- G Group" it is not clear whether this refers to Trial as representative of the group of entities, referred to as the G Group or as representative of The Taxpayer. However, even if the expenses have been incurred by The Taxpayer, the expenses also have to satisfy the other requirements of section 8-1 in order to be deductible under this section. The deductibility of expenses of legal proceedings does not depend on The Taxpayer's success in those proceedings, but rather the character of legal expenses follows the purpose of incurring the expense. In Hallstroms Pty Ltd v FC of T (1946) 72 CLR 634 Dixon J said at p. 647: '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.' In FC of T v Day [2008] HCA 53 the legal expenses of an employee incurred in defending three sets of disciplinary charges brought against him by his employer were found to be allowable deductions. A significant fact was that the legal expenses were incurred in responding to disciplinary action internal to the employment and existing for no other purpose. Of significance was that the taxpayer was exposed to the action by reason of his employment as a public servant and the consequences of the action only affected his employment . B acknowledged (as per their sworn affidavit filed with the Court on dd/mm/yyyy) that they understood that the Orders sought against the various trusts of which they were the sole trustee or joint trustee together with A are to the effect that there should be declarations made in respect of the spouse's "title of rights" to the property of the various trusts and to the effect that the assets of the trusts are to be treated as 'property of the parties to the marriage of either of them" and therefore divisible between the spouses by orders of the Family court. Therefore the reason that The Taxpayer was exposed to the court procedures was to enable the Court to determine the value of the property of the parties to the marriage in order for it to be divided between the spouses as a result of the marriage break-down. The resulting legal expenditure does not have any connection with the income generating activities of The Taxpayer of recycling. The legal expenditure relates to the private and domestic affairs of the spouses in the dissolution of their marriage and arises from the legal relationship between the spouses. The assets that the spouse would have recourse to, by order of the Family Court were not that of Company A or The Taxpayer, but that to which the spouse is entitled. This is also clear from paragraph 6 of the Minute of Consent Orders dated dd/mm/yyyy, which states that the spouse retains the benefit of the $X paid by the Seventh Respondent (Trust O) and that Trust O is released and discharged from any claim that their spouse may have in respect of unpaid distributions from Trust O. Therefore the $X that the Trustee of Trust O was required to pay to the spouse constitutes the unpaid distributions to which the spouse was entitled under the Trust Deed. In relation to the perceived expenses of valuations of Company A and subsidiaries, there is no evidence that the Court ordered or intended to order any individual or entity other than the spouses to bear the expenses of valuations that were requested by the spouse. The only valuation eventually ordered was that of matrimonial home, for which the spouse was ordered to provide three valuations. The Commissioner considers that The Taxpayer provided the funding to meet the legal expenses of the Third Parties that related to a private and domestic matter. However these expenses are not deductible to The Taxpayer under section 8-1 of the ITAA 1997 . This position corresponds with the established ATO view of the application of the Law. In ATO ID 2002/98 (Withdrawn), the taxpayer was a partner in a partnership. The taxpayer was engaged in Family Court proceedings and incurred legal expenses defending claims in respect of disputed assets owned by the partnership. The taxpayer also had to defend the issue of shares in a family company to family members. It was decided that legal expenses incurred defending Family Court proceedings relate to a private or domestic matter and are, therefore, not deductible under section 8-1 of the ITAA. ATO ID 2002/98 was superseded by ATO ID 2002/754, which held a consistent view. ATO ID 2002/754 was withdrawn on 18 June 2010, as it was regarded as a straight forward application of the law. The legal references put forward by The Taxpayer were considered, but do not apply to the facts of this case, for the following reasons: • Case W30, 89 ATC 300: In this case the taxpayers, who were running a nursery, commenced proceedings in the Local Government Court objecting to the local authority granting approval for quarrying operations on an adjacent property. It was stated that both the findings by the Court and the evidence before the Tribunal established that the proposed quarrying operations represented a real threat to the continued profitable operation of the nursery, including the deposit of contaminated dust on the nursery, adverse effect on the operation of the misting tables and an adverse effect on the operation of the class houses. Therefore it was found that the expenses were necessarily incurred in carrying on the business of the partnership for the purpose of producing assessable income. In this case it was clear that the legal expenses were necessarily incurred in relation to the income generating activities of the nursery business. This does not apply to the legal expenses said to be incurred by The Taxpayer, as there is no nexus between the income producing activities of waste disposal and the legal proceedings in the Family Court. • ATO ID 2004/214. In this ATO ID the beneficiary incurred legal expenses in defending their vested interest in receiving annual income from a testamentary trust. In the present case there is no evidence that The Taxpayer was defending a source of income in the Family Court proceedings. The object of the involvement of the Third Parties in the Family Court proceedings (note also that The Taxpayer was not included as a third party) was to provide the Court with information which would enable it to establish the property of the marriage of the spouses and enable division thereof as a result of the breakdown of the marriage. • ATO ID 2003/145: In this ATO ID, the legal action arose as a direct result of the sale of the shares in a company, by a director acting on behalf of the taxpayer, in the normal course of the taxpayer's business. The legal action therefore has a direct connection with the taxpayer's income producing activities. The resulting legal expenses were incurred by the trustee company to defend the actions of the director and were a normal incident of the day to day trading activities undertaken by the trustee company to generate assessable income. As such, the legal expenses were necessarily incurred in carrying on the trustee company's business and are deductible under section 8-1 of the ITAA 1997. In the current case, the legal proceedings arose as a result of the breakdown of the marriage of the spouses and there is no connection between the legal action and the income producing activities of The Taxpayer. Therefore the legal expenses fail to satisfy both the first and the second limb of section 8-1 of the ITAA 1997 in that there is no connection between the expenses and the income generating activities of the business of The Taxpayer and the expenses are also of a domestic/private nature and are therefore not deductible. | Detailed Reasoning - Question 2: If the answer to Question 1 is yes, in which year or years is The Taxpayer required to claim the deduction? | Detailed Reasoning - Detailed reasoning: Since the answer to Question 1 is no, this question is not applicable. | Detailed Reasoning - Issue 2: Deductibility of legal expenses under section 40-880 of ITAA 1997 . | Detailed Reasoning - Question 1: If the answer to Question 1 is no, can The Taxpayer claim a deduction under section 40-880 of the ITAA 1997 for X% of the legal expenses incurred as a consequence of a family court action? | Summary: The expenditure fail to satisfy the requirements of section 40-880 of the ITAA 1997 as it is not in relation to a business from which The Taxpayer derives taxable income. Rather it relates to the private and domestic affairs of the spouse. | Detailed Reasoning - Detailed reasoning: Section 40-880 of the ITAA 1997 applies to business related capital expenditure incurred on or after 1 July 2005. Paragraphs 40-880(2)(-a) to (c) state the following; You can deduct, in legal proportions over a period of 5 income years starting in the year in which you incur it, capital expenditure you incur : (a) In relation to your business; or (b) In relation to a business that used to be carried on; or (c) In relation to a business proposed to be carried on i) Determining whether the expenses were incurred by The Taxpayer There is no statutory definition of the term "incurred" however the principles established by case law regarding the meaning of the word "incurred' in section 8-1 also apply to section 40-880. In other words, a taxpayer incur expenditure at the time they owe a present money debt that they cannot avoid paying. (see Paragraph 12 of Taxation Ruling TR 2011/6). Only the entity that incurs the expenses qualifies for the deduction. As discussed in Issue 1, it is not clear whether the legal expenses were incurred by B as representative of the group of entities known as the G Group or as representative of The Taxpayer. However, even if the legal expenses were incurred by The Taxpayer, they would still have to satisfy the further requirements of section 40-880. ii) Determining whether the legal expenses were in relation to a business The expenditure has to be in relation to a taxpayer's own business or in relation to the past or future business of another entity. As TR 2011/6 states (at paragraph 15) the expression 'in relation to' denotes the proximity required between the expenditure on the one hand and the former, current or proposed business on the other. For capital expenditure to be 'in relation to' a business, there must be a sufficient and relevant connection between the expenditure and the business. The expenditure has no relation to the recycling business of The Taxpayer. It can also not be said that the expenditure is in relation to the past or future business of Company A, as this company derives only passive income and does not conduct a business. Further, subsections 40-880(3) to (9) impose certain limitations and exceptions. Subsection 40-880 (4) states that you can only deduct the expenditure from a business that another entity used to carry on or proposes to carry on, to the extent that the business was carried on or is proposed to be carried on for a taxable purpose and the expenditure is in connection with you deriving assessable income from the business. | Detailed Reasoning - The Taxpayer receives no assessable income from either Company A or from the spouse.: In addition to the above, paragraph 40-880(5)(i) states that you cannot deduct anything under this section for an amount of expenditure you incur to the extent that it is expenditure of a private or domestic nature . As discussed in Question 1of Issue 1, the Commissioner regards the expenditure to be of a domestic nature as it relates to the Family Court procedures in relation to the private and domestic affairs of the spouses in the dissolution of their marriage and arise from the legal relationship between the spouses. The reason for the involvement of the members of the Group in the legal proceedings was for the Court to determine the property of the marriage and enable the distribution between the spouses as a result of the dissolution of their marriage. Therefore the legal expenses fail to satisfy the requirements of section 40-880 of the ITAA 1997 and no deduction is available to The Taxpayer . | Detailed Reasoning - Question 2: If the answer to Question 1 is yes, in which financial year should the claim commence? | Detailed Reasoning - Detailed reasoning: Since the answer to Question 2 is no, this question is not applicable.

Deductibility of legal expenses under section 8-1 of the Income Tax Assessment Act 1997 (ITAA1997)