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Ruling

Subject: Legal expenses

Questions and Answers:

Are your legal expenses incurred in relation to your dispute deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Yes.

This ruling applies for the following periods:

Year ending 30 June 2011

Year ending 30 June 2012

The scheme commences on:

1 July 2010

Relevant facts and circumstances

You incurred legal expenses in relation to an alleged breach of confidentiality in respect of your former employer where you purchased specific parts for your trading stock from a public supplier. Although your former employer conceded it did not hold any patent, registered design or trademark in respect to the parts and the genus of trading stock, it held these items were company secrets.

You denied a breach of confidentiality occurred, given the product information is in the public domain. However, to avoid further legal costs, you ceased to defend a right to trade the relevant trading stock because it represents only a small portion of your overall business operations.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Section 8-1 of the ITAA 1997 allows a deduction for all losses or 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.

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 & Weekly Times v. Federal Commissioner of Taxation (1932) 48 CLR 113; 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 Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; 5 ATD 87; (1938) 1 AITR 403).

Legal expenses can be characterised as an outgoing on revenue account or an outgoing of a capital nature depending on the cause or purpose for which the legal expenses were incurred (Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 3 AITR 436; 8 ATD 190).

Outgoings incurred in the preservation of an existing capital asset have been held to be capital in nature (John Fairfax & Sons Pty Limited v. Federal Commissioner of Taxation (1959) 101 CLR 30; (1959) 7 AITR 346; (1959) 11 ATD 510).

In the Administrative Appeals Tribunal case of Pech & Anor v Commissioner of Taxation [2001] AATA 573; (2001) 47 ATR 1215; 2001 ATC 2210, a deduction for legal expenses was allowed in relation to defending an alleged infringement of a trade mark. Here, Pech used a trademark he devised (but did not register) in his sale of goods. The trademark was later registered by a business associate. The business associate then sued Pech for unauthorised use of the trademark. The Tribunal held Pech's legal expenses were revenue in nature and deductible because where legal costs are incurred in defending a taxpayer or its officers from criticism of the method of trading of the business, the outgoings will clearly be in the nature of revenue and not capital. Also, the legal costs could not procure a future permission to use the trademark. The legal proceedings were to defend a right to use the trademark in the past; a right that could have been revoked at any time.

Similarly, in ATO ID 2001/52, a deduction for legal expenses was allowed in relation to legal action brought against the taxpayer by an overseas company accusing the taxpayer of passing off and misleading conduct by arranging for the manufacture, importation and sale in Australia of products substantially identical to those manufactured and imported by the overseas company. It was the sale of these products which gave rise to the legal proceedings which, in turn, involved the company in the expenditure under consideration. The legal expenses were not capital in nature as the expenses related to the operation of the business rather than to the business structure itself.

In the High Court case of Federal Commissioner of Taxation v. Duro Travel Goods Pty Ltd (1953) 87 CLR 524; 27 ALJ 297; [1953] ALR 608, in relation to a plaintiff, a deduction for legal expenses was allowed in relation to legal action to prevent infringement of a trade mark. It was held the expenditure was not incurred for the purpose of creating a new asset or advantage or for the purpose of increasing the value of any existing part of the profit-yielding subject. Nor was it undertaken to preserve the profit-yielding subject or any part of it for no attack was made upon the validity of the respondent's existing rights and those rights remained, notwithstanding the expenditure, precisely as they were before. The expenditure was incurred in the course of and for the purpose of exploiting those rights to the fullest extent in the course of the taxpayer's business. In other words, the expenditure was incurred so the respondent could maximise their sales turnover.

Similarly, in Federal Commissioner of Taxation v Consolidated Fertilizers Ltd 91 ATC 4677, it was held expenditure made to defend the confidentiality of commercially valuable information was likely to be of a revenue kind, especially where the task of preserving and maintaining confidentiality is a continuing one. In arriving at that decision, it was stated the taxpayer was already the possessor of a profit yielding subject and did not incur expenditure with the character of an outgoing used to acquire an asset or for the purpose of enhancing or enlarging a business by adding some profit yielding subject. It was also stated that the expenditure and development of valuable trade secrets led directly to the requirement that the taxpayer be prepared to protect that knowledge in the ordinary course of its business. Any expenditure thereon would be an outgoing generated by the constant demands the business had to be ready to meet. It was enough that there is a potential for such an outgoing to be in the nature of revenue. Finally, it was stated that a distinction must be made between expenditure incurred for the purpose of preserving and protecting a business as such, being expenditure for a particular purpose on an isolated occasion, and expenditure which the nature of business may require as part of its prudent management

In your case, your legal expenses are deductible under section 8-1 of the ITAA 1997 because the relevant expenses arose as a consequence of the day to day activities of your business, namely, the purchase of a commonly available part used in your trading stock. Your legal expenses were not incurred in defending your business structure, a capital asset or any intellectual property. Your situation is similar to those in the court decisions and ATO ID 2001/52 cited above, which all allowed a revenue deduction.

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