Edited version of private ruling

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Ruling

Subject: legal expenses for lease application

1. Are any of the expenses relating to your efforts to secure a new lease deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

No.

2. Are any of the expenses relating to your efforts to secure a new lease deductible under section 25-20 of the ITAA 1997?

No.

3. If you are successful in obtaining the lease, will any of your costs relating to your efforts to secure a new lease be deductible under section 40-880 of the ITAA 1997?

No.

4. If you are successful in obtaining the lease, will all of your costs relating to your efforts to secure a new lease form part of the cost base of a capital gains tax (CGT) asset?

Yes.

5. If you are successful in obtaining the lease, will your CGT cost base be reduced by recoupments of your legal expenses awarded to you by the court?

Yes.

6. If you are not successful in obtaining the lease, will all of your costs relating to your efforts to secure a new lease be deductible over five years under section 40-880 of the ITAA 1997?

Yes.

7. If you are not successful in obtaining the lease, will recoupments of your legal expenses awarded to you by the court be assessable recoupments under subsection 20-30(1) of the ITAA 1997?

Yes.

Relevant facts and circumstances

You held a government land lease, where you carried on (and remain carrying on) a business. The lease expired and the Department of Lands called for expressions of interest in the lease rather than renew it to you.

You incurred legal expenses in preparing your expression of interest (first set of costs). The lease tender was won by another party, who did not submit a tender nor were evaluated in the same manner as you.

You then incurred legal expenses as the plaintiff in a successful court action (second set of costs), which deemed the tender process by the Department of Lands was unfair and ordered the Department of Lands to re-do the expression of interest tender in a transparent manner. You were also awarded costs by the court.

You then incurred further legal fees to ensure the compliance issues held by the Department of Lands are resolved prior to the re-opening of the re-tendering process per the order of the court (third set of costs).

You will then, in the future, incur more legal fees for your new expression of interest (fourth set of costs). However, these costs will not be so large because the bulk of your expression of interest will be a re-submission of your original expression of interest.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 20-20

Income Tax Assessment Act 1997 Section 20-25

Income Tax Assessment Act 1997 Section 20-30

Income Tax Assessment Act 1997 Section 20-40

Income Tax Assessment Act 1997 Section 25-20

Income Tax Assessment Act 1997 Section 40-880

Income Tax Assessment Act 1997 Section 108-5

Income Tax Assessment Act 1997 Section 110-25

Income Tax Assessment Act 1997 Paragraph 110-25(5A)

Income Tax Assessment Act 1997 Section 110-35

Reasons for decision

Lease costs are capital in nature

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.

In determining whether a deduction 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 per Dixon J). The nature or character of the legal expenses follows the advantage which is sought to be gained by incurring the expenses.

Where legal expenses arise as a consequence of the day to day activities of a business, the object of the expenditure is devoted towards a revenue end and the legal expenses are deductible (Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 2 ATD 169).

Where the 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 Limited v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 23; (1938) 1 AITR 403).

In the Federal Court of Australia case Kennedy Holdings and Property Management Pty Ltd v. Federal Commissioner of Taxation (1992) 39 FCR 495; (1992) 92 ATC 4918; (1992) 24 ATR 321, a payment by a lessor to the lessee to terminate the lease in order to grant a new and more profitable lease to a new tenant, was held to be capital in nature and not deductible. The payment secured a permanent advantage, that is, the surrender of the lease with the option to renew.

In your case, the advantage sought in preserving or obtaining a lease is capital in nature because its advantage is to secure an enduring benefit. A lease is considered to be a CGT asset under section 108-5 of the ITAA 1997. Accordingly, your legal expenses incurred in relation to the lease are considered capital in nature and not deductible under section 8-1 of the ITAA 1997.

Deduction unavailable under section 25-20

Subsection 25-20(1) of the ITAA 1997 provides that a deduction is allowable for the costs of preparing, registering or stamping an assignment or surrender of a lease of property where the property has been used solely for the purpose of producing assessable income.

In your case, legal expenses have been and will be incurred in order to obtain a new lease. The incurring of these expenses is prior to the preparation of the new lease. It follows these expenses will not be incurred in relation to the preparation, registration and stamping of the lease and therefore will not deductible under section 25-20 of the ITAA 1997 (if the lease is obtained).

Cost base of a CGT asset.

A lease is considered to be a CGT asset under section 108-5 of the ITAA 1997. The cost base of the lease is determined in accordance with section 110-25 of the ITAA 1997. The cost base of the lease includes the cost of acquiring the lease, such as any lease premium that a lessee has to pay to obtain the lease, as well as certain incidental costs that relate to the acquisition of the lease.

There are nine categories of incidental costs set out in section 110-35 of the ITAA 1997. These include remuneration for the services of a legal adviser.

In your case, the first and fourth sets of costs are similar in nature and can be considered to be going towards the acquisition of a new lease. The first (and fourth if incurred) set of costs are legal expenses incurred to prepare an expression of interest. These costs would form part of the cost base of the asset (the lease) under section 110-25(3) ITAA 1997 as second element incidental costs. This is assuming the lease is ultimately acquired by you and the fourth set of costs are actually incurred.

The second and third set of costs, arguably have less nexus to your proposed acquisition of the lease than the first and the fourth set of costs. However, looking at the second set of costs, we consider there is a sufficient nexus between the expenses and the acquisition of the lease because the legal expenses were incurred for the purposes of challenging an unfair decision in granting the lease to another party and having that decision set aside. Had you not challenged the decision and incurred these expenses, you would not have had a further opportunity to acquire the lease.

Looking at the third set of costs, these are costs incurred to ensure various compliance issues are resolved. On the basis these are actual legal expenses, these can also be included as second element incidental costs incurred in relation to acquiring the lease on a similar basis as the second set of costs, that is, incurred to put you in a position to enable you to attempt to acquire the lease by lodging a new expression of interest. These costs can therefore be included in the cost base of the lease under section 110-35(2).

We note your legal expenses cannot be attached to the cost base of the goodwill of your current business. Section 110-25(5A) of the ITAA 1997 states capital expenditure you incurred to preserve goodwill cannot form part of the cost base of a CGT asset.

Deductibility under section 40-880

Section 40-880 of the ITAA 1997 is a provision of last resort which allows a deduction over five income years for certain business capital expenditure incurred after 30 June 2005 which is not otherwise taken into account or denied a deduction by some other provision.

Subsection 40-880(2) of the ITAA 1997 states you can deduct, in equal proportions over a period of five income years starting in the year in which you incur it, capital expenditure you incur:

· in relation to your business, or

· in relation to a business that used to be carried on, or

· in relation to a business proposed to be carried on, or

· to liquidate or deregister a company of which you were a member, to wind up a partnership of which you were a partner or to wind up a trust of which you were a beneficiary, that carried on a business.

However, there is an exclusion in paragraph 40-880(5)(d) of the ITAA 1997, which states you cannot deduct anything under this section for an expenditure incurred that is in relation to a lease or other equitable right.

Similarly, there is an exclusion in paragraph 40-880(5)(f) of the ITAA 1997, which states you cannot deduct anything under this section for an expenditure incurred that could be taken into account in working out the amount of a capital gain or a capital loss from a CGT event.

In your case, if you are successful in obtaining the lease, paragraphs 40-880(5)(d) and 40-880(5)(f) of the ITAA 1997 specifically exclude a deduction for your legal costs under section 40-880 of the ITAA 1997.

On the other hand, if you are not successful in obtaining the lease, the capital expenditure you have incurred will be in relation to a proposed business, satisfying subsection 40-880(2) of the ITAA 1997. Further, your capital expenditure will not be in relation to a lease or a CGT event, thus not subject to the exclusions in paragraphs 40-880(5)(d) and 40-880(5)(f). This is because having not obtained a lease, your capital expenditure is not in relation to a lease or a CGT asset.

Conclusion

To conclude, if you are successful in obtaining the lease, your associated legal expense will form part of the CGT cost base of that lease under section 110-25 of the ITAA 1997. If you are not successful in obtaining the lease, your associated legal expense will be deductible over five years under section 40-880 of the ITAA 1997, with the first deduction available in the year the expenditure was incurred.

Recoupment of legal expenses

In addition, if you are successful in obtaining the lease, your legal expenses as incidental costs under section 110-35 of the ITAA 1997 will be reduced by the amount awarded to you by the court. Subsection 110-45(3) of the ITAA 1997 states expenditure does not form part of any element of the cost base to the extent of any amount you have received as recoupment of it.

If you are not successful in obtaining the lease, the amount awarded to you by the court will be assessable to you. Item 1.9 in subsection 20-30(1) of the ITAA 1997 states any recoupments of deductions allowed under Division 40 of the ITAA 1997 are assessable recoupments. As the deductions are allowable over more than one year, section 20-40 of the ITAA 1997 applies so that the total of assessable recoupments to be included in assessable income at a particular time is limited to the total amount that can be deducted at that time. Any part of an assessable recoupment that is not included in assessable income in the year of receipt because of this limit is assessable in later income years to the extent that further amounts are deductible under Division 40 of the ITAA 1997 in the later income years. That is, the amount awarded to you will be assessable over more that one income year. Its inclusion in your tax returns as assessable income will effectively counteract the section 40-880 of the ITAA 1997 deduction in each of your tax returns until the amount has been completely offset.

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