Private ruling: Deductibility of settlement payment
Date of advice: 21 April 2016
Published: June 2016
Ruling period: Income year ended 30 June 2016
Date scheme commenced: 1 July 2015

Ruling: Q1: Is the settlement payment denied as a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) because of paragraph 8-1(2)(a)? | A1: Yes | Q2: Does the settlement payment qualify for deduction under section 40-880 of the ITAA 1997? | A2: Yes

Relevant facts and circumstances: The trustee is a trustee of a number of discretionary trusts. The assets of the trusts include, amongst other things, two properties, on which the trusts carry on a business. As a result of an irrecoverable family breakdown, legal action was brought against the trustee by the plaintiffs concerning a claim for relief in equity with respect to the land and associated business assets. The relevant Court found in favour of the plaintiffs that they were entitled to a proprietary remedy so as to recognise their unfulfilled expectation as to a beneficial interest in the land and associated assets. A copy of the judgement was provided to the Commissioner. The final court orders provided that: • the trustee holds one of the properties on constructive trust for the plaintiffs, and has done so for a number of years. • The trustee is liable to pay equitable compensation to the plaintiffs of a certain sum.

Relevant legislative provisions: Section 8-1 of the ITAA 1997 | Section 40-880 of the ITAA 1997

Reasons for decision: Summary: The settlement payment is denied as a deduction under section 8-1 of the ITAA 1997 because it is considered to be capital in nature. | Detailed Reasoning - Detailed reasoning: Section 8-1 of the ITAA 1997 provides that: (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. (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. (3) A loss or outgoing that you can deduct under this section is called a general deduction. Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent that they are incurred in gaining or producing assessable income except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income. For the settlement sum to constitute an allowable deduction, it must be shown that it was 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). The nature of the expenditure must also be considered ( Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634). Expenses as a result of legal action are generally deductible if the expenses 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) 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 (1980) 49 FLR 183). In this situation, the plaintiffs took the trustee to court for relief in equity with respect to the land and other associated assets. Whilst the trust carries on business, the legal action did not arise out of the day to day activities of that business and was not incidental or relevant to the production of the taxpayer's assessable income. It is unlikely therefore that a deduction would be available under subsection 8-1(1) of the ITAA 1997. Further, it is considered that these expenses are predominantly of a capital nature and therefore fail subsection 8-1(2) of the ITAA 1997. To determine whether or not a loss or outgoing is of a capital nature depends on whether it relates to the taxpayer's "profit yielding structure" within which the profits are earned, or whether it relates to part of the money-earning process ( Sun Newspapers Ltd & Associated Newspapers Ltd v. FC of T (1938) 61 CLR 337). The trustee was required to defend the plaintiffs' actions in court in order to try and keep or maintain the properties and equipment and indeed keep intact the business as a whole. There was a possibility that the courts could transfer the whole business and all its assets over to the plaintiffs. Indeed, the courts did find partly in favour of the plaintiffs in respect of one of the properties and a constructive trust over that property as well as a lump sum equitable payment was ordered. It is considered that the settlement payment is therefore of a capital nature as it did not arise out of the day to day activities of the business, but was an associated cost as a result of defending legal action to try to preserve or maintain the profit yielding structure of the business as a whole. Therefore, as the settlement payment is considered predominantly of a capital nature, there is no deduction available under section 8-1 of the ITAA 1997. | Summary: The expenditure is deductible to the taxpayer pursuant to section 40-880 of the ITAA 1997 over a 5 year period. | Detailed Reasoning - Detailed reasoning: Section 40-880 of the ITAA 1997 provides that: Object (1) The object of this section is to make certain business capital expenditure deductible over 5 years, or immediately in the case of some start-up expenses for small businesses, if: (a) the expenditure is not otherwise taken into account; and (b) a deduction is not denied by some other provision; and (c) the business is, was or is proposed to be carried on for a taxable purpose. Deduction (2) 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: (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; or (d) 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. (2A) … Limitations and exceptions (3) You can only deduct the expenditure, for a business that you carry on, used to carry on or propose to carry on, to the extent that the business is carried on, was carried on or is proposed to be carried on for a taxable purpose. (4) You can only deduct the expenditure, for a business that another entity used to carry on or proposes to carry on, to the extent that: (a) the business was carried on or is proposed to be carried on for a taxable purpose; and (b) the expenditure is in connection with: (i) your deriving assessable income from the business; and (ii) the business that was carried on or is proposed to be carried on. (5) You cannot deduct anything under this section for an amount of expenditure you incur to the extent that: (a) it forms part of the * cost of a * depreciating asset that you * hold, used to hold or will hold; or (b) you can deduct an amount for it under a provision of this Act other than this section; or (c) it forms part of the cost of land; or (d) it is in relation to a lease or other legal or equitable right; or (e) it would, apart from this section, be taken into account in working out: (i) a profit that is included in your assessable income (for example, under section 6-5 or 15-15); or (ii) a loss that you can deduct (for example, under section 8-1 or 25-40); or (f) it could, apart from this section, be taken into account in working out the amount of a * capital gain or * capital loss from a * CGT event; or (g) a provision of this Act other than this section would expressly make the expenditure non-deductible if it were not of a capital nature; or (h) a provision of this Act other than this section expressly prevents the expenditure being taken into account as described in paragraphs (a) to (f) for a reason other than the expenditure being of a capital nature; or (i) it is expenditure of a private or domestic nature; or (j) it is incurred in relation to gaining or producing exempt income or non-assessable non-exempt income. (6) The exceptions in paragraphs (5)(d) and (f) do not apply to expenditure you incur to preserve (but not enhance) the value of goodwill if the expenditure you incur is in relation to a legal or equitable right and the value to you of the right is solely attributable to the effect that the right has on goodwill. (7) You cannot deduct an amount under paragraph (2)(c) in relation to a business proposed to be carried on unless, having regard to any relevant circumstances, it is reasonable to conclude that the business is proposed to be carried on within a reasonable time. (8) You cannot deduct anything under this section for an amount of expenditure that, because of a market value substitution rule, was excluded from the cost of a depreciating asset or the cost base or reduced cost base of a CGT asset. 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 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. It was discussed in question 1 above that the payment by the taxpayer was of a capital nature as it was an associated cost of defending the legal action to try to preserve or maintain the profit yielding structure of the business as a whole. There is a clear link between the expenditure incurred and the business that has been (and continues to be) carried on by the taxpayer, and that it therefore is ' in relation to' that business. It can be seen that this is the type of expenditure that section 40-880 was intended to apply to. It is considered by the Commissioner that none of the limitations or exceptions in subsections 40-880(3) - (8) are applicable in this instance. Therefore, the payment is deductible to the taxpayer in accordance with section 40-880 over a 5 year period.