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Ruling

Subject: Legal expenses

Question 1

Are you entitled to claim a deduction for expenses incurred for legal and drug testing purposes?

Answer

No

Question 2

Are you entitled to claim a deduction for legal expenses incurred to pursue your entitlement to your share of the partnership net assets?

Answer

No

This ruling applies for the following period

Year ended 30 June 2009

Year ended 30 June 2010

Year ended 30 June 2011

The scheme commenced on

1 July 2008

Relevant facts

· You have suffered from a medical condition throughout your life.

· You became addicted to medication, and as you were a practising as a professional in your industry, you notified the registration board of the situation.

· The Board allowed you to continue to practice your profession but imposed several conditions including regular drug testing.

· You were required to attend a Tribunal hearing after a complaint that you had not been completely compliant with the conditions of your registration. As a result, several of the conditions were changed and if the conditions were breached again you could have faced deregistration and been unable to work in your industry.

· Your health improved and there were no further issues until a family incident occurred and you didn't attend drug testing on that day. As a result you were asked to attend a second tribunal hearing. It was determined at that hearing that you should be deregistered for a short period.

· You continued to undergo regular drug testing from that day in order to provide proof of your continuing compliance so that you could re-apply for registration. Some time later you attended a third tribunal hearing and were re-instated with continuing conditions on your registration and allowed to practice in your profession again.

· You paid for all drug testing and legal expenses.

During this time you were also a partner where you worked. When you were de-registered the other partners expelled you from the partnership and refused to pay you your financial entitlements. As a result you enlisted legal representation to resolve the issue.

You received part payment of your share of the net assets of the partnership.

The parties entered into a settlement deed where the partners agreed to pay you a further amount.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Question 1

Summary

You are not entitled to a deduction under section 8-1 of the ITAA 1997 as the expenses are considered capital in nature.

Detailed reasoning

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.

For legal expenses to constitute an allowable deduction, it must be shown that they were incidental and relevant to the production of the taxpayer's assessable income (Ronpibon Tin NL & Tong Kah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 4 AITR 236; (1949) 8 ATD 431).

The nature of the expenditure must also be considered (Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 8 ATD 190). The nature or character of the legal expense 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 expense incurred in gaining the advantage will also be of a capital nature. If the legal and drug testing expenses arose out of the day to day income earning activities of the taxpayer they are considered to be revenue in nature and deductible under section 8-1 of the ITAA 1997. The action out of which the legal expenses arose has to have more than a peripheral connection to the taxpayer's current income earning activities.

In Case X84 90 ATC 609; AAT Case 6528 (1990) 21 ATR 3721, the Administrative Appeals Tribunal 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, the ultimate advantage you were seeking was your continued registration as a professional. You incurred expenses including legal fees and drug testing fees to that end. The advantage you were seeking was to provide you with a lasting benefit and is considered to be capital in nature. The expenses incurred did not arise from the day to day income earning activities but from your right to practice as a professional.

Therefore, the expenses including legal and drug testing expenses incurred in relation to protecting your right to remain registered as a professional are not an allowable deduction under section 8-1 of the ITAA 1997 as they are capital in nature.

Question 2

Summary

The legal expenses incurred in relation to regaining your share of the net assets of the partnership are considered capital in nature and therefore not deductible under section 8-1 of the ITAA 1997.

Detailed reasoning

If the legal and drug testing expenses arose out of your the day to day income earning activities, they are considered to be revenue in nature and deductible under section 8-1 of the ITAA 1997. The action out of which the legal expenses arose has to have more than a peripheral connection to your current income earning activities.

In Creer v FC of T 28 ATR 442; (1994) 94 ATC 4454 (Creer's Case), a partner's share of the firm's profit was reduced by the firm's performance committee. Shortly after the reduction it was suggested to the taxpayer that he retire and accept a consultancy. The taxpayer reluctantly accepted the reduction in his share of the firm's profit but declined to resign. In the next year the taxpayer's share of profits was reduced further. The taxpayer then referred the dispute to arbitration. The taxpayer incurred legal expenses and claimed a deduction accordingly.

The Commissioner only allowed half of the deduction on the grounds that that the legal fees also involved capital expenditure by the taxpayer in securing his position as a partner. The cause of the incurring of the legal fees was the reduction of the taxpayer's income entitlement from the partnership and its purpose was the restoration of that entitlement. The occasion for the expenditure of the legal fees was the arbitration which produced an increase in the income allocated to the taxpayer. This was sufficient to conclude that the expenditure was on revenue account as an outgoing incurred in producing assessable income.

In your case you incurred legal fees in order to recoup your entitlement to the net assets (capital) of the partnership and not any outstanding profits from the partnership. As outlined above, in Creer's case, the partner incurred legal fees to restore his entitlement to his share of the partnership's profits, not the capital held by the partnership. The legal expenses were incurred to restore your entitlement to the capital held in the partnership in the form of the net assets. It is therefore considered the legal expenses were capital in nature.

You are not entitled to a deduction for these legal expenses as they are capital in nature.

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