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Ruling
Subject: Legal expenses
Question 1
Are legal fees you incurred in defending a claim that you breached restraint of trade conditions in relation to the sale of a business deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?
Answer
No
This ruling applies for the following period
Year ending 30 June 2012
Year ending 30 June 2013
Year ending 30 June 2014
The scheme commenced on
1 July 2011
Relevant facts and circumstances
You sold a business to a third party but retained the property premises which were subsequently leased.
Subsequent to the sale, the purchaser ('the plaintiff') commenced legal proceedings against you, claiming that you as the vendor had breached a restraint of trade agreement.
The plaintiff alleges that before the sale of the business you entered into the restraint of trade agreement which had the effect of preventing you from competing with the plaintiff's business.
You were the first of several defendants in the action, which included a director of your company
You have incurred and continue to incur legal expenses in defending the action, which is still before the courts
You are defending your assets and your director from the claims.
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 that they are incurred in gaining or producing assessable income or are necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. However, no deduction is allowed to the extent that the losses or outgoings are of a capital, private or domestic nature or are incurred in gaining or producing exempt income.
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) 3 AITR 436; (1946) 8 ATD 190). The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses.
Legal expenses are generally deductible if they arise out of the day to day activities of your 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 your income producing activities (Magna Alloys & Research Pty Ltd v. Federal Commissioner of Taxation 80 ATC 4542; (1980) 11 ATR 276).
Where 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 and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 87; (1938) 1 AITR 403).
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 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 Case AAT Case 5596; AAT Case X3 90 ATC 114; (1989) 21 ATR 3154, two partners operated a business. The partners decided to terminate the business and dispose of the premises. A sale was proceeding until the purchaser withdrew. The partners sought legal advice as to whether they could take action against the purchaser. The Tribunal confirmed the Commissioner's submission that the legal expenses were of a capital nature and thus not allowable as a deduction.
In your case, the alleged offences did not arise from the day to day conduct of your business activities. You were required to defend allegations that you acted in breach of a Restraint of Trade Agreement.
A taxpayer's right to carry on a business is part of the profit yielding structure of the business, and legal expenses incurred in protecting that structure are of a capital nature.
As the legal expenses arose from an alleged breach of a Restraint of Trade Agreement and are not related to gaining or earning assessable income, you are not able to deduct the cost of the legal expenses. The legal expenses incurred are a loss or outgoing of a capital nature and are therefore not deductible under section 8-1 of the ITAA 1997.
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