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Ruling

Subject: Income Tax - deductions - expenses incurred in a legal settlement.

Question 1:

Is the whole or part of the Amount paid deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer:

No

Question 2:

If the whole or portion of the Amount is not deductible under section 8-1 of the ITAA 1997, can a portion or whole of the Amount be deducted in terms of section 40-880 of the ITAA 1997?

Answer:

Yes, portion of the Amount is deductible

Question 3:

If a deduction is not allowable under sections 8-1 or 40-880 of the ITAA 1997, is there any event which would crystallise a capital gain (or loss) in accordance with the Capital Gains Tax (CGT) provisions of the ITAA 1997?

Answer:

Yes.

This ruling applies for the following period

1 July 20XX to 30 June 2011

The scheme commenced on

200Y

Relevant facts

The A Trust

In 199X, the A Trust was established by deed with A Pty Ltd as the trustee (A).

From 199X to 200Z, the A Trust operated the 'Business'.

There were three principals of the Business who each held a one third interest, either directly or through a nominated entity, in the A Trust.

The principals were employed to work in the Business.

In 200X one of the principal's (the Plaintiff's) employment was terminated.

the Plaintiff's subsequently set-up a competing business.

The Taxpayer

In 200Y, the Taxpayer (a trust) by deed with B Pty Ltd as trustee

The two remaining individuals are directors of B Pty Ltd.

The Taxpayer is the B Unit Trust which operates the B Business.

The directors are employed to work in the B Business and are paid a salary for their professional services.

The majority of the annual turnover of the B Business is derived directly from professional services provided by the directors.

Disposal of the Business

In 200Y, the directors of A Pty Ltd as trustee of the A Trust, resolved to transfer the Business to the B Pty Ltd trustee for the Taxpayer for $$$ consideration.

In 200Z, an agreement was made to transfer the Business from A Pty Ltd as trustee of the A Trust, to B Pty Ltd as trustee for the Taxpayer.

The plaintiff received $ representing its respective entitlement on disposal of the Business as a unit holder of the A Trust.

Court proceedings against the directors and B Pty Ltd as trustee for the Taxpayer

In 200A the plaintiff commenced proceedings in the Supreme Court of New South Wales against the directors of A Pty Ltd and against B Pty Ltd as trustee for the Taxpayer because it was claimed that the Business had been sold at an undervalue (the 'Dispute').

Valuation reports for the value of a one third interest in the Business were presented to the court in the Dispute and varied widely

The valuations were independently reviewed.

The Taxpayer's revenue growth and net profits were claimed to have been adversely affected by the time diverted from running the B Business to defending claims made.

Various disputes have been ongoing between the defendant and the plaintiff until an agreement for final settlement was reached in 20XX.

The Deed of Settlement, Release, Guarantee and Indemnity (the 'Deed')

In 20XX, the parties agreed to an out of court settlement and signed the Deed

The Deed nominated six parties to the settlement.

The parties agreed to settle the Dispute on the terms set out in the Deed

The Deed released the Taxpayer from the Dispute

The Deed required HB, as trustee for the Taxpayer, to pay amounts totalling $$$$$

The settlement

The directors agreed to pay the plaintiff the agreed sum

The directors agreed to settle in order that they could focus on the business rather than the resolution of the dispute.

The Taxpayer has paid a total of $$$$$+$ (being $ originally paid as a result of the 200Z agreement and $$$$$ as per the Deed).

The Taxpayer seeks to apportion the outgoings as:

· a one-third interest in the Business based on an average of the valuations (i.e. less than $)

· greater than $$$$$+ being the balance of the expenditure incurred in deriving assessable income of the Taxpayer (the' Amount').

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 40-880

Question 1:

Summary

The settlement paid did not arise directly from the day to day income producing activities. The payment was incurred to protect the profit-yielding structure of the business therefore no deduction is allowable in terms of section 8-1 of the ITAA 1997.

Detailed reasoning

Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which 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 under subsection 8-1(2) of the ITAA 1997 for expenses to the extent that they are of a capital, private or domestic nature.

Taxation Ruling TR 95/33 at paragraph 11 states:

Where, having regard to the overall objective circumstances, there is an obvious commercial connection between the loss or outgoing and the carrying on of the taxpayers' business, it will not be generally necessary to have regard to the taxpayer's subjective purpose, motive or intention.

In order to consider the issue, two questions need to be answered in determining whether the expense is deductible under section 8-1 of the ITAA 1997. The first is whether the expense has the essential character of expenditure that has a sufficient connection with the operations or activities, which more directly gain or produce assessable income.

If the answer is affirmative the courts have differentiated between two types of expenses when determining deductibility. The first being deductible revenue or income related expenses and secondly expenses referrable to capital account that will not qualify for deductions under section 8-1 of the ITAA 1997.

Payments which arise from legal settlements are generally deductible if the expenditure:

• arose out of, or concerned the day to day income producing activities of the taxpayer (Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 39 ALR 46; (1932) 2 ATD 169 (Herald and Weekly Times Ltd Case))
• is not undertaken to protect the taxpayer's profit yielding subject
• has more than a peripheral connection to the taxpayer's business (Magna Alloys and Research Pty Ltd v. Commissioner of Taxation (1980) 49 FLR 183; (1980) 11 ATR 276; 80 ATC 4542; (1980) 33 ALR 213 (Magna Alloys Case); Putnin v. Commissioner of Taxation (1991) 27 FCR 508; 91 ATC 4097; (1991) 21 ATR 1245 (Putnin's Case)
• may arise out of litigation concerning the taxpayer's professional conduct (Magna Alloys Case and Putnin's Case).

The legal action and resultant settlement has arisen from the professional conduct of the parties and addresses issues which are more than peripherally related to the business.

It is claimed that there were several ongoing disputes between the Taxpayer and the plaintiff which were affecting the profitable running of the business through the distraction of the employees of the business being restrained from trading.

In accordance with the Deed the settlement payment did not arise from the day to day income producing activities but rather the ownership of the Business. In accordance with the facts provided the discord between the parties commenced at some time prior to June 200X when the plaintiff's employment was terminated.

In accordance with the facts provided the legal action was initiated as the result of a dispute over the value of the sale price. This action and resultant settlement can only be seen as related to the profit yielding subject of the Business and not the day to day activities of carrying on a business. The settlement discharges all parties from existing and future actions regarding the conduct of all parties to the Business as unit trust owners, company directors and employees as well as other issues.

The money paid as a subsequence of the settlement arrangement has resulted in a sustained advantage for the Business that has no need to be repeated. The freedom from any further action in relation to this dispute is pivotal to the settlement. As stated in Sun Newspapers Ltd & Associated Newspapers Ltd v FC of T (1938) 61 CLR 337; 5 ATD 87 at 355 per Latham J, an enduring benefit does not require that the taxpayer obtain an actual asset, it may be a benefit which endures, in the way that fixed capital endures. If expenditure produces some asset or advantage of a lasting character for the benefit of the business it will be considered to be capital expenditure.

The payment of the settlement is seen as bringing into existence an advantage for the enduring benefit of the business and lacks the essential character of expenditure connected to the daily operations or activities of the Business. Therefore no deduction is allowable in terms of section 8-1 of the ITAA 1997.

Question 2:

Summary

A portion of the Amount which is attributable to the settlement payment (that is the amount of $$$$$) is deductible in terms of section 40-880 of the ITAA 1997.

Detailed reasoning

Subject to the limitations and exceptions contained in subsections 40-880(3) to 40-880(9) of the ITAA 1997, subsection 40-880(2) of the ITAA 1997 provides that 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.

In First Provincial Building Society Limited v. Commissioner of Taxation (199X) 56 FCR 320; 95 ATC 4145; (199X) 30 ATR 207, Hill J. considered the phrase 'in relation to' within the context of paragraph 26(g) of the Income Tax Assessment Act 1936 . He considered the words 'in relation to' in that context included a relationship that may either be direct or indirect, provided that the relationship consisted of a real connection, but that a merely remote relationship is insufficient.

It is necessary to consider the legislative context of subsection 40-880(2) of the ITAA 1997 in order to determine whether there is a sufficient and relevant connection between the expenditure incurred and the taxpayer's business. In discussing the types of business capital expenditure to which subsection 40-880(2) of the ITAA 1997 applies, the EM states:

   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.

These paragraphs indicate that capital expenditure incurred on the structure by which an entity carries on (or used to or proposes to carry on) their business, on the profit yielding structure of the business, or relating to the business's trading operations, are capable of being described as capital expenditure incurred 'in relation to' that business for the purposes of subsection 40-880(2) of the ITAA 1997. Whether such capital expenditure is incurred 'in relation to' the particular business will depend on whether there is a sufficient and relevant connection between the incurring of the expenditure and that business on the facts of the particular case.

In this case, the Taxpayer incurred capital expenditure on a settlement payment to finalise all of the claims between the parties to the Deed.

The plaintiffs and defendants had made claims and counter claims regarding the parties' conduct as directors, shareholders, unit holders and employees with a subsequent payment made to the plaintiff as detailed in the Deed. It is accepted that the settlement payment was incurred by the Taxpayer.

In these circumstances, there is a sufficient and relevant connection between the Taxpayer's incurrence of the capital expenditure on the settlement payment and the business carried on. Accordingly, the expenditure the Taxpayer incurred on the settlement payment is capital expenditure incurred in relation to its business for the purposes of paragraph 40-880(2)(a) of the ITAA 1997.

A deduction allowable under section 40-880 of the ITAA 1997 is however, subject to the limitations and exclusions to deductibility outlined in subsections 40-880(3) to (9) of the ITAA 1997.

Subsection 40-880(3) of the ITAA 1997 provides that you can only deduct the expenditure, for a business that you carry on, used to carry on or propose to carry on, to the extent that the business is carried on, was carried on or is proposed to be carried on for a taxable purpose. The relevant business for the purposes of the application of subsection 40-880(3) is the business to which the relevant paragraph in subsection 40-880(2) applies. In this case, the relevant business is the B Business carried on by the B Unit Trust (the Taxpayer) with B as the trustee company.

As the business was carried on wholly for a taxable purpose, subsection 40-880(3) of the ITAA 1997 does not apply to limit the amount the Taxpayer can deduct under section 40-880 for the expenditure.

Subsection 40-880(4) deals with expenditure incurred for a business that another entity used to carry on and is not applicable to this ruling.

Subsections 40-880(5) to (9) of the ITAA 1997 set out further limitations and exclusions to deductibility under section 40-880 of the ITAA 1997. On the facts of this case only paragraph 40-880(5)(f) of the ITAA 1997 needs to be relevantly considered.

Paragraph 40-880(5)(f) of the ITAA 1997 provides that you cannot deduct anything under section 40-880 for an amount of expenditure you incur to the extent that it could, apart from that section, be taken into account in working out the amount of a capital gain or capital loss from a CGT event.

In accordance with the facts provided:

· $ was paid in consideration for the respective entitlement on the disposal of the Business as a unit holder of the A Trust.

· The Dispute was initiated in the Supreme Court of New South Wales by the plaintiff because the Business was sold at an undervalue

· the settlement awarded to the plaintiff was $$$$$ (in excess of the amount originally paid)

· The Deed addressed issues ranging from the conduct of the plaintiffs and defendants as shareholders, unit holders, directors etc

A deduction is allowable under section 40-880 of the ITAA 1997 for the undissected amount paid in settlement of the Deed. That is the portion of the Amount which can be attributed to the settlement of the legal dispute regarding the business being sold. Any rights created as a result of the terms of the Deed do not have a market value and do not represent expenditure which forms the cost base of any CGT asset.

In view of the facts provided the deduction is limited to $$$$$ as the expenditure incurred on a settlement amount cannot form part of the cost base (or reduced cost base) of a CGT asset and it could not be taken into account in working out the amount of a capital gain or capital loss from a CGT event. Therefore, the exception in paragraph 40-880(5)(f) of the ITAA 1997 will not apply.

Accordingly the Taxpayer can deduct the capital expenditure incurred on the settlement amount over five years under section 40-880 of the ITAA 1997 commencing in the income year ended 30 June 2011 and followed by a further 20% of the capital expenditure in each of the following four years.

The total deduction of $$$$$ allowed under section 40-880 represents a portion of the Amount as described in the facts provided for the case.

Question 3:

Summary

The portion of the Amount ($$$$$+) which is not deductible in terms of section 40-880 of the ITAA 1997 forms part of the cost price of the B Business which would be crystallised (not necessarily as a capital loss) upon the sale of the business in an A1 disposal of a CGT asset.

Detailed Reasoning

Subsequent to 200Z wherein an agreement was made to transfer the Business from A Pty Ltd as trustee of the A Trust to B Pty Ltd as trustee for the Taxpayer an amount of $ was paid to the plaintiff which was representative of the respective entitlement on the disposal of the Business as a unit holder of the A trust.

The Taxpayer has apportioned the Amount paid to the plaintiff as $$$$$+ being the amount paid in excess of the value of a one third interest in the business based upon the average of two market valuations. This remaining reduced amount being the value of the one third interest attributed to the business acquired.

Section 112-20 of the ITAA 1997 outlines market value substitution rules where the first element of the cost base or reduced cost base of an asset which is acquired from another entity is its market value if:

· You did not incur expenditure to acquire it

· Some or all of the expenditure you incurred to acquire it cannot be valued, or

· You did not deal at arms length with the other entity in connection with the acquisition

The general modifications in Subdivision 112-A of the ITAA 1997 do not apply in this case because the Taxpayer incurred expenditure to acquire the business and the parties dealt with each other at arms length. Therefore the amount of $ and not a one-third share of the average valuation amount is attributable to the acquisition of the share of the business from the plaintiff.

Paragraph 40-880(5)(f) of the ITAA 1997 provides that you cannot deduct anything under section 40-880 of the ITAA 1997 for an amount of expenditure you incur to the extent that it could, apart from this section, be taken into account in working out the amount of a capital gain or capital loss from a CGT event.

The expenditure could be taken into account in cost base (or reduced cost base) as it forms part of the cost base (or reduced cost base) of a CGT asset (being the B Business).

For the foregoing reasons, paragraph 40-880(5)(f) of the ITAA 1997 applies to reduce the Amount claimed by the Taxpayer under section 40-880 of the ITAA 1997 in respect of capital expenditure as recorded in the facts.

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