Edited version of private ruling

Authorisation Number: 1011550578445

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Ruling

Subject: Legal expenses

1. Are you entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for legal expenses incurred in defending an insolvent trading case?

Yes.

2. Alternatively, will you make a capital loss in relation to the legal expenses incurred?

It is not necessary to answer this question.

This ruling applies for the following period:

Year ended 30 June 2008

The scheme commences on:

1 July 2007

Relevant facts and circumstances

You were a director of a company.

You received wages and directors fees while the company was operating.

The company could not pay its liabilities and it was wound up.

You were subsequently personally sued by the creditors for insolvent trading.

The court case continued for several years, and you were found not to be insolvent trading and accordingly you were not personally liable for the company's debts.

Costs were originally awarded to you. This decision was reversed on appeal.

You have forwarded a copy of the court judgment in relation to the appeal, together with copies of the invoices in relation to the expenses.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not fully considered the application of Part IVA of the ITAA 1936 to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA of the ITAA 1936 applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA, go to our website www.ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: Part IVA: the general anti-avoidance rule for income tax.

Reasons for decision

Question 1

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, or necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income, except where the outgoings are 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 N.L.Tongkah Compound N.L. v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 8 ATD 431; (1949) 4 AITR 236).

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) 8 ATD 190; (1946) 3 AITR 436). The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses.

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) 2 ATD 169) and the legal action has more than a peripheral connection to the taxpayer's income producing activities (Magna Alloys & Research Pty Ltd v. FC of T 80 ATC 4542; (1980) 11 ATR 276).

In Federal Commissioner of Taxation v. Rowe (1995) 60 FCR 99; 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.

However, in Case N9 81 ATC 56; 24 CTBR (NS) Case 81 (Case N9), the Board of Review disallowed a deduction for legal expenses incurred by a director of a number of companies in defending himself on charges under various State statutes that stood to affect his future appointment as a director. The Board stated:

In the instant case there is no evident connection between the expenditure in any year in defending the charges laid against the taxpayer and his income earning activities whether as a director or otherwise. The various charges laid against him relate to actions by him which in our view must be seen as being outside the scope of his duties as a director. It is not within the scope of the normal duties of a director to act in any kind of improper or dishonest way, or to act outside the provisions of statutes which may affect a business and its operations e.g. the Companies Act and attendant sanctions.

Case N9 would indicate that where there is evidence or suggestion of malfeasance, or where the actions are found to be motivated by a desire for personal gain and are not as a result of work duties, then the legal expenses would not be allowable as a deduction.

The fact that the outgoing is incurred in a year later than the year in which the income was derived and the fact that in the meantime the business had ceased will not determine the issue of deductibility. Provided the occasion for the loss or outgoing is to be found in the business operations directed to gaining or producing assessable income, that loss or outgoing will be deductible unless it is capital or of a capital nature (Placer Pacific Management Pty v. FC of T 95 ATC 4459; (1995) 31 ATR 253 and AGC (Advances) Ltd v. Federal Commissioner of Taxation (1975) 132 CLR 175; 75 ATC 4057; (1975) 5 ATR 243). This principle may in certain circumstances apply in the case of an employee as well as to business taxpayers.

Applying the above to your circumstances

In your case, you incurred legal expenses to protect yourself against the claim of trading while insolvent. You derived assessable income from the company in the form of wages and directors fees.

Your directorial duties included the legal obligation that you did not allow the company to trade while insolvent. The copy of the court judgment forwarded by you confirms that the court case related to your directorial duties.

You incurred legal expenses in defending your position on the basis that you had not failed in your directorial duties, that is, that the company was not insolvent. There appears to be no evidence or suggestion of malfeasance or a desire for personal gain in this case.

Accordingly, you are entitled to a deduction for legal expenses as the expenses were incurred in defending the way in which you performed your duties.

Question 2

As advised by the applicant, in view of the above determination that you are entitled to a deduction for the legal expenses under section 8-1 of the ITAA 1997, it is not necessary to answer this question.

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