Private ruling: Damages
Date of advice: 24 June 2015
Published: June 2015
Ruling period: Year ended 30 June 2014
Date scheme commenced: 1 July 2013

Ruling: Q1: Are you entitled to a deduction for the amount of damages in settlement of a dispute relating to your conduct as a company director? | A1: Yes

Relevant facts and circumstances: You were self-employed. You were also engaged as a director of another company. During the relevant financial year the other directors the company launched legal action against you. They alleged that you were in breach of your duties as a director and had breached the agreement between the parties in respect of the conduct of the company. A settlement was made whereby you have to pay damages in full settlement of the dispute. You received director's fees in addition to your sole trader income.

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

Reasons for decision: Summary: Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for a loss or an outgoing to the extent to which it is incurred in gaining or producing assessable income, except where the loss or outgoing is of a capital, private or domestic nature. It is accepted that you earned assessable income from your duties as a director. | Detailed Reasoning - Legal 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) 39 ALR 46; (1932) 2 ATD 169) and the legal action has more than a peripheral connection to your income producing activities ( Magna Alloys and Research Pty Ltd v. FC of T (1980) 49 FLR 183; (1980) 11 ATR 276; 80 ATC 4542). In FC of T v. Rowe (1995) 31 ATR 392; 95 ATC 4691 the taxpayer, an employee, was suspended from normal duties and was required to show cause why he should not be dismissed after several complaints were made against him. A statutory inquiry subsequently cleared him of any charges of misconduct or neglect. The court accepted that the legal expenses incurred by the taxpayer in defending the manner in which he performed his duties, in order to defend the threat of dismissal, were allowable. Since the inquiry was concerned with the day to day aspects of the taxpayer's employment, it was concluded that his costs of representation before the inquiry were incurred by him in gaining assessable income. Where an expense is incurred involuntarily, your motives in pursuing the action will be irrelevant to the determination of its deductibility. It is the objective circumstances which compel you to incur the expense which determine its deductibility ( Shokker v. FC of T 99 ATC 4504; 42 ATR 257). In Putnin v. FC of T 91 ATC 4097; (1991) 27 FCR 508 an accountant was trustee under a particular deed of arrangement. They administered the estate without obtaining an assignment of the debtor's share in a company and the share was subsequently dealt with by the debtor. They were later charged with conspiring with the debtor to defraud the Commonwealth and incurred legal expenses in defending this action. The court found the expenditure arose out of his prosecution, in which they were defending their activities by which income had been earned and they were allowed a deduction for this legal expenditure. Their Honours stated: It may be a natural incident of the conduct of the operations of a particular kind of business that claims of the commission of torts, or even crimes, may arise, although it is to be hoped not often, and have to be repelled. In Elberg v FC of T 38 ATR 623; 38 ATR 623 a doctor was charged with dishonestly obtaining property by deception. The charges alleged they falsely held themselves to be on duty with their employment when they were actually deriving income from their private practice. Merkel J said: In my view, as in Putnin, the present case is one which concerns expenditure which may relevantly be described as involuntary. Also, as in Putnin, and I would add Rowe, Magna Alloys and Herald and Weekly Times, the expenditure arose out of proceedings in which the taxpayer was defending her activities in a particular operation of her business, in the present case, as a doctor, by which she earned her income. In your situation, it is accepted that the damages were awarded as a consequence of the way in which you performed your duties as company director, and were therefore incurred in earning your assessable income. Accordingly you are entitled to a deduction for the damages that were awarded against you.