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Ruling
Subject: Legal and compensation costs.
Question:
Are you eligible to claim a deduction under section 40-880 of the Income Tax Assessment Act 1997 (ITAA 1997) for legal adviser costs and settlement costs in relation to the sale of your shares?
Answer:
No.
This ruling applies for the following period
Year ending 30 June 2011
The scheme commences on
1 July 2006
Relevant facts and circumstances
You were the shareholder of your private company. At the time you were marketing the business for sale, there were several interested parties. According to their 'Statement of Claim', you held negotiations with ABC for a period of time. Due to uncertainties about the intentions of ABC, you sold your shares to XYZ, which was declared as a CGT event in the relevant year.
As a result of selling the business to XYZ, ABC commenced legal proceedings against you, XYZ and other related defendants, claiming they had secured the right to purchase the shares. ABC sought the transfer of the shares from XYZ to them or, otherwise, damages.
ABC pursued the claim aggressively. In defending your position, you incurred legal fees over a period of years and were also required to pay compensation at settlement.
Relevant legislative provisions
Income Tax Assessment Act 1997 Section 40-880
Income Tax Assessment Act 1997 Section 108-5
Income Tax Assessment Act 1997 Section 104-25
Income Tax Assessment Act 1997 Section 104-35
Income Tax Assessment Act 1997 Section 110-25
Income Tax Assessment Act 1997 Section 110-35
Reasons for decision
Section 40-880 of the ITAA 1997 is a provision of last resort which, subject to its exclusions, 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.
In considering the phrase 'in relation to' contained within subsection 40-880(2), paragraph 2.25 of the Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No. 1) Bill 2006 ('the EM') states:
The provision is concerned with expenditure that has the character of a business expense because it is relevantly related to the business. The concept used to establish this character or requisite relationship between the expenditure incurred by the taxpayer and the business carried on (current, past or prospective) is 'in relation to'. The connector 'in relation to' allows the appropriate latitude to enable the deductibility of qualifying capital expenditure incurred before the business commences or after it has ceased.
In discussing the types of business capital expenditure to which subsection 40-880(2) applies, paragraphs 2.19 and 2.20 of the EM state:
Expenditure on the structure by which an entity carries on (or used to or proposes to carry on) their business and on the profit yielding structure of the business would ordinarily be expected to be of a capital nature. Capital expenditure can also relate to a business's trading operations or the entity that will carry on the business.
The structure covers the legal entity (such as a company) or the legal relationship (such as a partnership or trust) that is the entity that carries on the business for a taxable purpose and that holds the business assets.
Taxation Ruling TR 2011/6 is about core issues in relation to section 40-880 of the ITAA 1997. Paragraphs 86 to 91 of the ruling provide the following two theoretical examples:
Wayne and Blayne are shareholders in X Pty Ltd. As their personal relationship deteriorates Blayne considers whether or not to sell his shares and incurs capital expenditure on professional advice. The sale does not proceed because they resolve their relationship issues. Blayne's expenditure is not in relation to the business for the purpose of paragraph 40-880(2)(a).
XYZ Pty Ltd carries on a medical research and supply business. The shareholders' involvement in the business includes providing medical expertise and services to the company. Because of other commitments one of the shareholders has been and will continue to be unable to devote resources to the business. The directors of XYZ Pty Ltd decide that in the interests of the business the ownership of the company should be restructured to replace the inactive shareholder with a private equity investor with the business acumen to push the company forward and inject capital for the purpose of future growth. To facilitate the restructure XYZ Pty Ltd paid $X to the shareholder as an incentive to agree to the sale of his shares to the equity investor. The expenditure is capital expenditure of the company in relation to the business for the purpose of paragraph 40-880(2)(a).
In your case, your legal adviser costs and settlement costs were not in relation to the structure, the profit yielding structure or the trading operations by which a business was carried on. Instead, your legal adviser costs and settlement costs were in relation to you as a shareholder and in relation to an alleged personal breach of contract by you about to whom you would sell your personal shareholdings.
In summary, your case is the same as the first example from Taxation Ruling TR 2011/6 quoted above, in which expenditure is not in relation to the business for the purpose of paragraph 40-880(2)(a).
To conclude, your legal adviser costs and settlement costs incurred to settle your legal dispute are not deductible under section 40-880 of the ITAA 1997 because they are neither 'business capital expenditure' nor capital expenditure 'in relation to' a business that used to be carried on.
Further, if your legal adviser costs were business capital expenditure, they would be prohibited from deductibility under section 40-880 of the ITAA 1997 as they form part of the cost base of a capital gains tax (CGT) asset.
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