Edited version of private ruling

Authorisation Number: 1011553872315

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Ruling

Subject: legal expenses

1. Are you entitled to a deduction for legal expenses in relation to your employment as director and manager of a company?

No.

2. Are you entitled to apportion the legal costs between you and your spouse?

No.

This ruling applies for the following period:

1 July 2009 to 30 June 2010

The scheme commences on:

1 July 2009

Relevant facts

You were a director and manager of a private company. This company manufactured, installed and distributed goods.

By Deed of Guarantee and indemnity you, and others, agreed unconditionally and irrevocably to guarantee and indemnify an insurance company against all loss or damage, costs and expenses that they were to incur as a result of its obligations pursuant to home warranty policies of insurance by which they provided insurance cover to policy holders who engaged your company (the builder) to perform building works, and who were to suffer loss as a consequence of defective works or failure by the builder to complete building works.

The insurance company issued various home owners home warranty policies of insurance agreeing to indemnify them in the event of loss being suffered in the event of non-compliance of building works or defective works by the builder.

The insurance company paid various amounts to policy holders as claims against the builder for loss and damages.

The insurance submitted that it was entitled to be indemnified by you by virtue of the Deed of Guarantee signed by you and in a Deed of Release you settled the matter.

A Notice of Order Made was entered into in a magistrates' court. The plaintiff was one of your company's customers. You were named as defendant in view of the Deed of Guarantee and Indemnity. The order cited you to pay this customer for goods sold during the year. This action was settled as described in the Deed of Settlement and release.

Costs were incurred in obtaining the deeds of release in the cases of both customers.

You provided other indemnities and/or guarantees to secure good and services for the company in favour of several other companies.

Reasons for decision

Question 1

Section 8-1 of the Income Tax Assessment Act 1997 (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.

To be deductible to a taxpayer, any expenditure incurred must be incidental or relevant to the gaining or producing of their assessable income or the carrying on of a business for the purpose of gaining or producing their assessable income.

The courts, on a number of occasions, have determined legal expenses to be an allowable deduction if the expenses arise out of the day to day activities of the taxpayers. The actions out of which the legal expenses arise have to have more than a peripheral connection to the taxpayer's income earning activities.

In determining whether a deduction for legal expenses is allowed 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. 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.

The Federal Court has confirmed in Bell & Moir Corporation Pty Ltd v. FC of T (1999) 99 ATC 4738; 42 ATR 421 that payments made under guarantees, given to a bank and finance company on behalf of a company in which the taxpayer had a one-third stake, were capital in nature and not deductible. It was found that the advantage sought by the taxpayer in providing the guarantees was the extension of credit facilities to the company. This served to strengthen the base from which the company carried on business so that the taxpayer could continue to trade with it. Such an enduring benefit was ordinarily capital in nature.

The giving of a guarantee was analogous to the taxpayer making a loan to the company of the guaranteed funds. Losses incurred as a result of loans made in order to secure an enduring benefit are regarded as capital losses, unless made as part of the regular business of the taxpayer.

The Commissioner has set out his views on the deductibility of guarantee payments under the Income Tax Assessment Act 1936 (ITAA 1936) subsection 51(1) in Taxation Ruling TR 96/23. We note that references to the ITAA 1936 subsection 51(1) are to be taken as references to section 8-1 of the ITAA 1997.

Taxation Ruling TR 96/23 paragraph 124 states:

A payment by a guarantor is deductible under subsection 51(1) if the giving of the guarantee, the guarantor's payment under the guarantee and the incurring of the loss or outgoing are acts done in gaining or producing assessable income or in carrying on business for that purpose-provided the loss or outgoing is not of a capital, private or domestic nature. In essence, the loss or outgoing must bear the character of an income producing expense or a working expense of a business.

Paragraph 125 of TR 96/23 states that if a guarantor is engaged in a business of giving guarantees for reward, a loss or outgoing arising on a failure by a principal debtor to pay the guarantor is more likely to bear the requisite character to be deductible under subsection 51(1) of the ITAA 1936.

Paragraph 136 of TR 96/23 lists several cases where it was found that guarantees by shareholders or directors are not deductible under subsection 51(1). In a typical case, reported as Case V115 88 ATC 733, Senior Member PJ Roach did not allow a deduction under subsection 51(1) of the ITAA 1936 for payment made by the taxpayer who was a director and shareholder of a land development company and who was a creditor of the company under a guarantee given by the taxpayer in respect of the company's liabilities.

Paragraph 137 of TR 96/23 explains liabilities arising under contracts of guarantee will not be deductible under subsection 51(1) of the ITAA 1936 if the provision of guarantees and the losses or outgoings arising under the guarantees are not regular and normal incidents of the taxpayer's earning activities. In Case Q39 83 ATC 171 at 173; (1983) 26 CTBR (NS) Case 103 at 694, Mr KP Brady, Chairman, referred to a line of Board cases stretching from 1946 which concluded that payments under guarantees are capital.

Your contentions and references

Case Decision Summary (CDS) 10208 issued in March 1997 confirmed that legal fees and administration expenses incurred in disputing a decision not to make a superannuation payout to the estate were deductible. It was held that the expenses were incidental and relevant to the gaining and producing of assessable income by the estate. This CDS was withdrawn and replaced with ATO Interpretive Decisions (ATO ID) 2001/75 which was also withdrawn as the amount the estate recovered was an eligible termination payment (ETP) and as an ETP is a capital item it is not deductible under section 8-1 of the ITAA 1997.

CDS 10122 (withdrawn), ATO ID 2001/27, ATO ID 2002/ 665 (withdrawn) held that the legal expenses incurred by the taxpayer relate to charges arising out of actions undertaken by the taxpayer in the course of his employment, were deductible. The general principle is that a deduction is allowed where the expense has arisen as a consequence of the day to day activities. The taxpayers in these publications were providing employee services, they were not directors providing indemnities or guarantees for their employers.

ATO ID 2002/814 held that where the taxpayer is carrying on a business and prepares a return relating to tax the expense is deductible under section 8-1 of the ITAA 1997. Your claim for expense deduction does not relate to a return of tax matters.

FC of T v Day 2007 ATC 5426; (2007) 67 ATR 936 referred to a taxpayer as an employee, he was not providing indemnities or guarantees for his employer.

In the case Willersdorf-Greene v Commissioner of Taxation 2009 AATA 649 the Tribunal found that the taxpayer's involvement in the fuel 'scheme' was clearly directed to gaining or producing commission income for himself. He was not an employee or director of a company giving a guarantee on behalf of that company.

ATO ID 2002/174 allowed a deduction for warranty costs after the cessation of a partnership business. In this case the warranty costs were incurred by the partnership and had a direct nexus with the assessable income of the partnership. The partnership provided the warranty it was not an employee or director providing a warranty for their employer.

ATO ID 2010/37 allows a deduction for a tax indemnity payment because it was a regular part of the taxpayer's business operations, as a developer/supplier of technological products and a holding company to its subsidiaries, to enter into R&D syndication arrangements (as a lender, licensor, contractor or indemnity provider). In your case being a director and employee of a company did not require this type of tax indemnity to be given on a regular basis.

ATO ID 2010/37 also discussed FC of T v. Email Ltd 99 ATC 48687; (1999) 42 ATR 698 (Email) where the issue before the Full Federal Court was whether an indemnity payment was capital or of a capital nature. In determining whether the indemnity payment is capital or of a capital nature, the Full Federal Court said that:

…it is the character of the advantage sought which will generally provide the greatest guidance for it tells most about the essential character of the outgoing itself and that it is the character of the advantage which the indemnity was calculated to effect, not directly the character of the payments themselves which must fall for consideration.

The Full Federal Court also said in Email that the identification of what expenditure is calculated to effect:

…involves both a consideration of the character of the expenditure and in many cases an examination of the business structure and the operations of the business in the course of which the expenditure has been incurred.

In that case, in considering the character of the advantage which the indemnity was calculated to effect, the Full Federal Court focussed on the immediate advantage which the giving of the indemnity was designed to effect (in that particular case, it was the sale of the shares at the maximum possible price) rather than the 'ultimate' advantage (which was the expected dividend flow from the subsidiaries to the taxpayer). Consequently, in Email, the Full Federal Court concluded that the advantage was not of a revenue nature.

In your case giving indemnities and guarantees was not a regular part of your business operation, your indemnities and guarantees provided the catalyst to commence business which was the immediate advance sought rather than the 'ultimate' advantage which was the expected development of a successful business.

Tax Determination TD 93/29 and ATO ID 2010/131 discuss the deductibility of legal expenses in relation to recovering wages of an employee. The taxpayers in these cases were not directors of a company providing indemnities or guarantees for their employer.

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, there must be an evident connection between the expenditure in instituting the proceedings and the taxpayers earning activities. The taxpayer in this case was an employee and the basis of the legal costs related to his employment duties, his costs did not relate to a guarantee or indemnities given as a director and employee of a company.

Your other case references in relation to revenue and capital with comments attached:

Conclusion

You have incurred legal expenses in settling debts in your capacity as a guarantor. No deduction is allowable under section 8-1 of the ITAA 1997 for legal expenses associated with settling debt as the activity does not sufficiently relate to earning your assessable income.

As described in Case Q39 83 ATC 171; (1983) 26 CTBR (NS) Case 103, Mr KP Brady, Chairman, found that if the provision of guarantees and the losses or outgoings arising under the guarantees are not regular and normal incidents of the taxpayer's earning activities then the payments made under guarantees are capital. Therefore, no deduction is allowable under section 8-1 of the ITAA 1997.

Question 2

Summary

As you are not entitled to a deduction under section 8-1 of the ITAA 1997 for legal expenses in relation to your employment as director and manager of a company no apportionment is available.

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