Private ruling: Legal expenses
Published: February 2015
Ruling period: Income year ended 30 June 2015
Date scheme commenced: 1 July 2014

Ruling: Q1: Will the money from the settlement constitute assessable income in accordance with section 6-5 of The Income Tax Assessment Act 1997 (ITAA 1997)? | A1: No | Q2: Will the money from the settlement constitute capital proceeds of any CGT event in Division 104 of the ITAA 1997? | A2: No | Q3: Will the money from the settlement reduce the cost base of the business for any future capital gain under section s110-45 of the ITAA 1997? | A3: Yes | Q4: Are the legal expenses associated with seeking the settlement deductible under section 8-1 of the ITAA 1997? | A4: No

Relevant facts and circumstances: You purchased an ongoing business. The entity selling the business made false statements about the gross monthly income of the business ($x per month but actual figure was less than $x per month). You commenced legal proceedings against the party that sold you the business. You have entered into a settlement where you will receive an amount of $x. You have incurred $x worth of legal expenses.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 6-5 | Income Tax Assessment Act 1997 section 8-1 | Income Tax Assessment Act 1997 section 110-45

Reasons for decision: Detailed Reasoning - Compensation: Subsection 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of an Australian resident taxpayer includes ordinary income derived directly or indirectly from all sources during the income year. Ordinary income has been held to include income from providing personal services, income from property and income from carrying on a business. Other characteristics of income that have evolved from case law include receipts that: • are earned • are expected or relied upon • have an element of periodicity, recurrence or regularity • replace income. In Taxation Ruling TR 95/35 the Commissioner defines a compensation receipt, or compensation, as any amount received by a taxpayer in respect of a right to seek compensation or a cause of action, or any proceeding instituted by the taxpayer in respect of that right or cause of action, whether or not: • in relation to any underlying asset • arising out of court proceedings • made up of dissected amounts. A compensation amount normally assumes the nature of that which it is designed to replace. If the compensation is paid for the loss of a capital asset or amount, then it will be regarded as a capital receipt and not ordinary income. In your circumstances the amount of compensation relates to a capital asset being the business and consequently capital in nature. Taxation Ruling TR 95/35 provides the Commissioner's view on the capital gains tax (CGT) consequences of compensation payments. Paragraph 10 provides that if a taxpayer is compensated for having paid excessive consideration to acquire an asset, the amount referable to the overpayment represents recoupment of all or part of the acquisition costs. Consequently the settlement payment will not be included in your assessable income but will reduce the first element of the cost base of the property for any future capital gain under section 110-45 of the ITAA 1997. | Detailed Reasoning - Legal expenses: 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 except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income. In determining whether a deduction for legal expenses is allowed under section 8-1 of the ITAA 1997, the nature of the expenses must be considered ( Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 3 AITR 436; (1946) 8 ATD 190). The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses. If the advantage is of a capital or private nature, then the expenses incurred in gaining the advantage will also be of a capital or private nature. An amount that is capital in nature will remain capital notwithstanding that it is specifically included in the assessable income of the taxpayer. It is considered that the advantage sought in the litigation was the recovery of the purchase price that you overpaid for the business. It follows that the advantage sought is capital and nature and therefore the legal expenses are not deductible.