Private ruling: legal expenses
Published: February 2012
Ruling period: Year ended 30 June 2008 | Year ended 30 June 2009 | Year ended 30 June 2010
Date scheme commenced: 1 July 2007

Ruling: Q1: Is the Company A entitled to a deduction for legal expenses? | A1: 

Relevant facts and circumstances: The deceased passed away. In accordance with the deceased will the assets were evenly distributed between Trust A and Trust B. Trust A inherited the total shareholding in Company A. The beneficiary of Trust B (Beneficiary B) contested the distribution of profits of Company A which were earned from the date of death to the date when the will received assent. A judgement was reached in favour of the Beneficiary B. The company incurred the legal expenses of the beneficiary of Trust A (Beneficiary A) in relation to defending against the action undertaken by Beneficiary B.

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

Reasons for decision: Summary: Section 8-1 of the Income Tax Assessment Act ITAA 1997 allows a deduction for any loss or an outgoing to the extent to which it is incurred in gaining or producing the assessable income or is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income, except where the loss or outgoing is of a capital, private or domestic nature. For legal expenses to constitute an allowable deduction, it must be shown that they are 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). Also, 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 ( 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 to be gained is of a capital nature, then the expenses incurred in gaining the advantage will also be of a capital nature. Legal expenses are generally deductible 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 (the Herald and Weekly Times case )) and the legal action has more than a peripheral connection to the taxpayer's income producing activities ( Magna Alloys and Research Pty Ltd v. Federal Commissioner of Taxation 80 ATC 4542; (1980) 11 ATR 276 ). Paragraph 12 of Taxation Ruling TR 2004/2 states that for an outgoing to be deductible under the second limb of section 8-1 of the ITAA 1997 as expenditure necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income, it must have the character of a working or operating expense of the entity's business or be an essential part of the cost of its business operations. The circumstances of the case at hand indicate that the legal expenses were incurred for the purpose of determining who was eligible to receive dividend income from the company between the date of death and date of distribution of the testatrix's estate. Various decisions of the Court indicate that these type of legal expenses are not deductible under section 8-1 of the ITAA 1997. In IR Commrs (Ceylon) v Appuhamy (1963) AC 17; (1963) 1 ALL ER 69 (PC) the taxpayer purchased and conducted a certain business and later defended an action brought by a syndicate which claimed that the taxpayer had acquired the business as its agent and that the syndicate was thus entitled to share in the business profits. The Privy Council disallowed a claim to deduct the taxpayer's defence costs on the ground that the expenditure was not incurred in producing the profits but, rather in disputing ownership of that profit after, or before, it was earned. In John Fairfax & Sons Pty Ltd v. FC of T (1959) 101 CLR 30; 11 ATD 510 Menzies J stated (at page 49) in his judgement: To make a payment to acquire or to defend the acquisition of a favourable position from which to earn income or to enter into an arrangement will yield income is not in general an outlay incurred either in gaining or in carrying on business for the purpose of gaining assessable income; such payment in the case of a trading company occurs at a stage to remote from the receipt of income to be so regarded. To be deductible an outlay must be part of the cost of trading operations to produce income, ie., it must have the character of a working expenses. In the case of Company A, the legal expenses were not incurred defending Beneficiary A's conduct as a director or employee of the company but rather in his capacity as beneficiary of a testamentary trust. The charges were not brought in any way as a result of the day to day activities of the company but rather as a challenge to Beneficiary A's distribution of company income. The legal expenses incurred were not fundamentally directed towards defending Beneficiary A's title to the net assets which correspond to the quantum of the disputed dividends. As such the expenses are considered structural rather than operational and not deductible.

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