Edited version of private ruling

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Ruling

Subject: Legal expenses

Are you entitled to a deduction for legal expenses?

No.

Relevant facts

You earn income from providing professional services.

You did not lodge tax returns for a number of income years or make provision for payment of income tax or pay income tax for any of the years.

You did not lodge business activity statements (BAS) for several income years or make provision for payment of goods and services tax or pay such tax for any of the years.

You were convicted in respect of your failure to lodge your income tax returns and failing to lodge BAS on time. You pleaded guilty to all charges.

You became bankrupt due to your tax debt.

You faced a hearing at a tribunal to determine if your conduct constituted professional misconduct. The question that was to be determined was whether you were presently a fit and proper person to engage in professional practice in your field. In doing so, the tribunal considered whether your past conduct showed a probable permanent unfitness for practice in your field.

You had a history of alcohol and gambling addiction throughout the period in which you did not meet your tax obligations.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that a loss or an outgoing is an allowable deduction if it is incurred in producing assessable income or in carrying on a business for the production of assessable income unless that loss or outgoing is capital or of a private or domestic nature.

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).

Legal expenses are generally deductible if the expenses 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 (Rowe's case), the court accepted that legal expenses incurred in defending the manner in which a taxpayer performed their employment duties were allowable. The activities which produced the taxpayer's income were what exposed them to the liability against which they were defending themselves. No significance was placed by the court on the taxpayer's status as an employee.

In Case W94 89 ATC 792; AAT Case 5376 (1989) 20 ATR 4001 (Case W94), the taxpayer faced various disciplinary charges for misconduct relating to his compulsive gambling. Most of the charges were found proven and he would have been dismissed but for mitigating circumstances. Instead the taxpayer was demoted a level. The taxpayer appealed and, a day before the appeal was due to be heard, withdrew his appeal.

The Administrative Appeals Tribunal (AAT) held that expenditure incurred on legal fees in circumstances where the conduct of the taxpayer was not related to their income earning activities, was not 'incidental and relevant' to the gaining or production of the taxpayer's assessable income.

The legal expenses were incurred by the taxpayer in defending disciplinary charges of misconduct. The activities to which the charges related were not authorised employment duties and the activities were not undertaken for the purpose of earning assessable income. The legal expenses were not incurred as a result of the taxpayer defending the manner in which they performed their employment duties.

If the expenses were incurred in protecting the underlying profit yielding structure or assets of the business they are considered to be capital in nature and will not be deductible.

In Case V140 88 ATC 874; AAT Case 4596 (1988) 19 ATR 3859, a solicitor was denied a deduction for legal expenses incurred in defending certain allegations before the Statutory Committee of the Law Society of New South Wales, concerning the solicitor's trust account. The Committee ordered the taxpayer be suspended from practice for a period of twelve months, and to pay the costs of the Law Society. The Administrative Appeals Tribunal (AAT) held that the payments made by the taxpayer were not deductible as the payments were characterised as capital expenditure.

Further, in Case X84 90 ATC 609; AAT Case 6528 (1990) 21 ATR 3721, the AAT held that legal expenses incurred by a medical practitioner in defending charges brought against him at a Medical Disciplinary Tribunal inquiry, were not deductible because the expenditure was incurred to protect a structural asset, that is, their registration as a medical practitioner, and was of a capital nature.

In your case, you had a history of alcohol and gambling addiction throughout the period in which you did not meet your tax obligations. As a result of not meeting these tax obligations, you were convicted in respect of your failure to lodge your income tax return and failing to lodge BAS on time and later filed for bankruptcy.

Your case can be distinguished from Rowe's case in that the expenses were not related to your duties as a practitioner in your field and did not relate to actions undertaken for the purpose of earning assessable income. The legal expenses were not incurred as a result of you defending the manner in which you performed your employment duties but rather in respect of your fitness to hold a practising certificate.

The decision in Case W94 can be applied to your case. Your legal expenses were incurred in defending charges relating to your personal misconduct, that is, the gambling and alcohol addictions and your failure to lodge your income tax and BAS returns.

Consequently, as you did not incur the legal expenses in defending the performance of your normal employment duties through which you earned assessable income but to protect a structural asset, the legal expenses incurred are not deductible under section 8-1 of the ITAA 1997 as they are considered to be capital in nature.

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