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Ruling

Subject: Deductibility of legal expenses

Question

Are legal fees you incurred in defending a claim for damages in relation to a former Joint Venture Agreement deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

This ruling applies for the following period

Year ended 30 June 2009

The scheme commenced on

1 July 2008

Relevant facts

You entered into a Joint Venture Agreement (the Agreement) to operate a business and to contribute equally to the expenses and share equally in the profits (of the business).

The Agreement was terminated in a later year.

Subsequent to the cessation of the joint venture, the other party commenced legal action claiming that you breached the Agreement in respect of business liabilities incurred and the treatment of income received by the business.

In preparation of your defence of the action, you collated documentary evidence to defend the claim.

You incurred legal expenses in defending the action.

The legal action was subsequently abandoned by the claimant.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

Summary

We have concluded that the legal expenses are characterised as having the requisite connection with your assessable income as you were exposed to the legal action by reason of your former role in the joint venture business.

Therefore, you are entitled to a deduction for the legal expenses you incurred.

Detailed reasoning

The general deduction provision, 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 and producing assessable income, except where the outgoings are of a capital, private or domestic nature.

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).

Cases where legal expenses were held to be incurred in gaining or producing assessable include the following:

In Elberg v. FCT (1998) 82 FCR 440; 98 ATC 4454; (1998) 38 ATR 623, the activity related to the unsuccessful allegation that the doctor was holding herself out to be working at a government centre when she was conducting her private practice.

In Putnin v. FCT (1991) 27 FCR 508; 91 ATC 4097; (1991) 21 ATR 1245, the activity was the unsuccessful allegation that the insolvency practitioner failed to obtain an assignment of a governing director's share from the debtor to the estate and was charged jointly with the debtor with conspiring to defraud the Commonwealth.

In FCT v. Rowe (1995) 60 FCR 9995; 95 ATC 4691; (1995) 31 ATR 392, the court accepted that legal expenses incurred in defending the manner in which a taxpayer performed his employment duties were allowable.

It is clear that legal expenses may be deductible where they arise out of litigation concerning a taxpayer's professional conduct.

In the High Court decision in Federal Commissioner of Taxation v. Day [2008] HCA 53; (2008) 70 ATR 14; 2008 ATC 20-064 (Days case), Mr Day was charged with breaching the standards of conduct and failing to fulfil his duty as an officer. It was found that the requisite connection with his assessable income was present and that he was exposed to the charges by reason of his office.

The common thread throughout these cases is that the conduct or activity giving rise to the charges was transparently and intrinsically part of the day to day activities by which each party earned their assessable income.

You state that you incurred the expenses to protect the income you had earned from the business. However, 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 your case, the action alleging that you acted in breach of your Agreement was initiated by the other party and the expenses you incurred were involuntary. As a consequence, you were required to defend your actions relating to some business issues. It is accepted you incurred the legal expenses with this objective purpose.

These issues related to the day to day activities undertaken in the course of carrying on your role in the joint venture business.

Similar to Days case, the legal expenses you incurred arose out of your conduct as an operator of the business and any income derived from that office. Therefore, the essential character of the legal expenses, arising from the nature of the allegations defended (i.e. breaches of specific clauses of the Agreement), is such that the expenses have sufficient connection with the activities that gained or produced assessable income from that office.

However, even though you are able to satisfy the first limb of section 8-1 of the ITAA 1997, it is still necessary to determine whether the legal expenses are capital in nature and so precluded from deduction. There is no issue of the legal expenses being losses or outgoings of a private or domestic nature.

Where expenditure is devoted towards a structural rather than an operational purpose, the expenditure is of a capital nature and the expenses are not deductible (Sun Newspapers Ltd and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 87; (1938) 1 AITR 403).

The legal expenses you incurred were not directed toward acquiring, preserving or expanding any capital asset, nor resulted in any alteration of business structure. The expenditure was of a defensive nature and not made to provide you with any benefit. Accordingly, the legal expenses are not of a capital nature.

Furthermore, the incurrence of the expenditure after you ceased to operate the joint venture business will not deny deductibility, as the occasion of the outgoings is found in your income earning activities before those activities ceased (Taxation Ruling TR 2004/4).

We have concluded on the facts provided that the legal expenses are characterised as having an income nature. Therefore, you are entitled to a deduction for the legal expenses you incurred in defending the legal action.

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