Private ruling: Deductibility of settlement payments
Published: July 2012
Ruling period: The income year ended 30 June 20XX
Date scheme commenced: When the binding settlement was reached.

Ruling: Q1: Is Tranche 1 of the settlement sum, to be paid by the company, deductible under section 8-1 of the ITAA 1997 for the income year ended 30 June 20XX? | A1: Yes.

Relevant facts and circumstances: The company is an Australian resident company. The company carries on a business. Legal action was proposed to be brought against the company. The applicant to the proposed legal action alleged they had suffered a loss due to the actions of the company. A settlement was reached on a commercial basis, with no admission of liability by the company. Pursuant to the settlement reached, the company will pay the settlement sum in two tranches. The company will pay Tranche 1 of the settlement sum by 30 June 20xx. Payment of Tranche 2 of the settlement sum is subject to certain contingencies which will be resolved on or before 30 June 20yy.

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

Reasons for decision: Detailed Reasoning - Detailed reasoning: 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. Incurred in gaining or producing assessable income or carrying on a business For legal expenses to constitute an allowable deduction, it must be shown that they were 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; (1949) 4 AITR 236; (1949) 8 ATD 431). Legal expenses are incurred in gaining or producing assessable income if they 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; (1932) 39 ALR 46; (1932) 2 ATD 169) 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; (1980) 11 ATR 276; 80 ATC 4542). In Herald and Weekly Times , a newspaper publisher was entitled to deduct both legal costs incurred in defending defamation proceedings and the damages payments it made to successful claims because the nature of the taxpayer's business exposed it to risk of such action. In Magna Alloys , legal expenses incurred by a company in defending its directors and managers against conspiracy charges (involving the payment of secret commissions to employees of purchasers of the taxpayer's products) were deductible because the expenses were incurred in defending the manner in which directors and managers performed their duties. Establishing a nexus between a loss or outgoing and the gaining of assessable income can be difficult particularly where the expenditure is considered to be abnormal, involuntary or outside the regular activities of the taxpayer. However, determining the deductibility of a loss or outgoing on the basis of the degree of volition or normality of the expenditure is not reflected in the leading legal authorities. In Charles Moore v FCT (1956) 95 CLR 344, the taxpayer claimed a deduction for loss of money occasioned when an employee was the subject of an armed robbery on the way to bank the previous day's takings. In allowing the deduction the High Court held at 349: "In the case of a large departmental store such as the taxpayer carries on, the ordinary course of business requires that, day by day and as soon as may be, the takings shall be deposited in the bank. It is necessary to the conduct of the business as it is to place goods on the shelves or to deliver them to customers. They are operations in the course of gaining and producing the assessable income by means of carrying on the business." The High Court went on to state at 351: "Phrases like … "incidental and relevant" when used in relation to the allowability of losses as deductions do not refer to the frequency, expectedness or likelihood of their occurrence or the antecedent risk of their being incurred, but to their nature or character. What matters is their connection with the operations which more directly gain or produce the assessable income." In Commr of Taxation v (DP) Smith (1981) 147 CLR 578; 11 ATR 538; 81 ATC 4114 the High Court said (at ATC 4117): "What is incidental and relevant in the sense mentioned falls to be determined not by reference to the certainty or likelihood of the outgoing resulting in the generation of income but to its nature and character and generally to its connection with the operations which more directly gain or produce the assessable income.." In Nevill v FCT (1936) 56 CLR 290, the taxpayer paid a significant sum to terminate the contract of one its managing directors (which was received by the director as capital). The Commissioner argued that the payment was not deductible because it was not incurred exclusively in the production of income. The High Court held the payment to be deductible saying at 300: "The payments in question were actually made bona fide in the course of business in the interests of the efficiency of the business ... The expenditure was made for the purpose of increasing the efficiency of the company and therefore increasing its income producing capacity." As explained at paragraphs 8 and 9 of Taxation Ruling TR 2004/2, "business activities" is not confined to the core activities by which income is earned, but includes outgoings which are relevant and incidental to the gaining of assessable income such as engaging an accountant to keep and audit books because they are incurred in relation to the management of the taxpayer's income producing enterprise. Also, as explained at paragraphs 13 and 18 of TR 2004/2, activities such as the preparation of financial reports, the preparation of accounts, the auditing of accounts, the fees payable to the Stock exchange and the like are part of the operations of a business that is carried on for the purpose of gaining assessable income, even though such activities are not productive of revenue. As stated in ATO ID 2002/663, the treatment of a settlement sum or damages payment will follow the treatment of legal costs incurred in relation to a particular matter i.e. if legal expenses incurred in relation to a matter are an allowable deduction under section 8-1, then any compensation payment or settlement payment made in relation to the matter will also be an allowable deduction. | Detailed Reasoning - Expenditure not of a capital nature: In determining whether a deduction for legal expenses is allowable under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered, ie whether capital or revenue ( 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. The question of whether expenditure is of a capital nature revolves around the character of the advantage sought by the expenditure; whether an enduring benefit is obtained as a result of the outgoing [ Sun Newspapers v FCT (1938) 61 CLR 337 and BP Australia Limited v FCT (1965)112 CLR 386]. In FCT v Snowden & Wilson Pty Ltd (1958) 99 CLR 431, the taxpayer company carried on business in Western Australia. Part of the company's business involved the building of houses for customers on terms. Allegations of unfair and dishonest practices were made against the company in the State's Legislative Assembly and, subsequently, a Royal Commission was appointed to investigate the matter. The company claimed as a deduction the legal fees it incurred in appearing before the Royal Commission and the sums it had spent mounting an advertising campaign, the aim of which was to counter the effects of the adverse publicity the company had received. The Commissioner appealed against the majority decision of the Board of Review allowing the deduction. He argued that the expenditure was not incurred in producing assessable income; alternatively, it was capital and therefore not deductible. The appeal was dismissed. It was held by a majority (4-1) that: The expenditure was necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. As the proceedings in Parliament and before the Royal Commission did not, on the facts, imperil the existence of the company or its capital assets, the expenditure was not capital in nature. The expenditure was, therefore, deductible under the then equivalent of section 8-1. In Hallstroms Pty Ltd v FCT (1946) 72 CLR 634, the taxpayer company was engaged in the manufacture and sale of domestic refrigerators. One of its competitors, Electrolux Pty Ltd, held a patent for a refrigerator which was a great improvement upon that which was sold by the taxpayer company. The patent expired on 18 August 1938 and on 29 December 1938, Electrolux filed a petition seeking an extension of the patent for ten years. The taxpayer company, which had spent considerable sums of money preparing to manufacture refrigerators on the Electrolux model as soon as the patent expired, incurred legal expenses in successfully opposing the petition. It sought to deduct those expenses from its assessable income for the year of income ended 30 June 1940. The Commissioner denied the deduction on the basis that the outgoings in question were of a capital nature. It was held by a majority (3-2) that the expenses were deductible by virtue of the then equivalent of section 8-1. The expenditure was made to enable the taxpayer company to maintain its position - namely, its right to manufacture and sell refrigerators in accordance with a patent that had expired. As the company did not acquire any new asset or right by the expenditure, it could not be said that the expenditure was of a capital nature. | Detailed Reasoning - Incurred in the year of income: As explained in Taxation Ruling TR 97/7, to be deductible under section 8-1 in a particular year, the expenditure must have been incurred in that year. A liability has been incurred if, in the relevant year, the taxpayer is definitively committed, or has completely subjected itself, to the expenditure (J ames Flood v FCT (1953) 88 CLR 492). A taxpayer may completely subject itself to a liability, notwithstanding that the liability is defeasible. Thus, it has been held that pay-roll tax was found to have been incurred in the year in which the wages were paid, even though the employer lodged no return and paid no pay-roll tax until a default assessment was issued some years later ( Layala Enterprises Pty Ltd (in Liq) v FCT 98 ATC 4858). On the other hand, a loss is not incurred if it is no more than impending, threatened or expected ( James Flood ). This depends on the contractual arrangements between the parties (ATO ID 2004/716). A taxpayer cannot deny liability to pay an alleged debt and at the same time be said to have incurred that debt for the purposes of claiming a deduction. A debt, unpaid and denied by the taxpayer, is merely a loss or outgoing which is impending, threatened or expected, and therefore not "incurred": Softwood Pulp & Paper Ltd v FC of T 76 ATC 4439. In James Flood , the taxpayer company which carried on the business of motor-body builder and general engineer, set aside a sum of money as a provision for holiday pay for its employees. The company was legally bound by an industrial award to give its employees holiday pay although the award recognised that certain events (such as absenteeism) could cause an employee to lose the right to such pay. The company claimed that the sums set aside were deductible under the then equivalent of section 8-1. The Commissioner argued that the sums were not deductible as the company had not 'incurred' a loss or outgoing as required by that provision. It was held that the sums set aside were not deductible. As the taxpayer company's duty to provide holiday pay to any employee was subject to a variety of contingencies, it could not be said that the taxpayer had 'incurred' an outgoing. While the provision does not require that there should be an actual disbursement, it does require that the taxpayer be 'definitely committed' to an outgoing. On the facts, that requirement had not been met. | Detailed Reasoning - Application of law to facts: The settlement payments relate to a purported breach of the day-to-day activities of the company's business. Therefore, the settlement payments have more than a peripheral connection to the taxpayer's income producing activities. As a result, the settlement payments are incurred in gaining or producing assessable income for the purpose of section 8-1. The settlement payments are not of a capital nature because they are not related to the establishment, replacement or enlargement of the company's profit yielding structure. They are not a once and for all payment for the future use of an asset or advantage because on finalisation of the settlement there will be no future asset or advantage as a result of having incurred the payments, .i.e the nature of the advantage sought by incurring the payments is not one that provides a lasting or enduring benefit. The primary purpose for incurring the expense is to respond to the legal action proposed to be brought against the company. Whilst it is recognised that the expenditure on legal expenses to defend and settle the allegations raised by the applicant may be associated with long term benefits to the reputation and goodwill of the company, it was noted in Magna Alloys that whilst expenditure on legal expenses may serve to protect the reputation and goodwill of a business, this will not make the expenditure one of capital if the taxpayer is defending the way in which it operated its commercial activities in the course of carrying on its business. Under the terms of the settlement, the company is definitively committed to pay the Tranche 1 amount of the settlement sum by 30 June 20xx. Therefore, these amounts are deductible in the year ended 30 June 20xx. | Detailed Reasoning - Detailed reasoning: Under the terms of the settlement, the Tranche 2 amount of the settlement sum will not be paid until certain contingencies are met on or before 30 June 20yy. Therefore, the company will not be definitively committed to pay the Tranche 2 amount until, and if, the contingencies are met in the 20yy year. As a result, this amount will be deductible in the year ended 30 June 20yy provided the contingencies are met.

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. | Question 2: Is Tranche 2 of the settlement sum, to be paid by the company, deductible under section 8-1 of the ITAA 1997 for the income year ended 30 June 20yy? | This ruling applies for the following period: Year ending 30 June 20yy.