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Ruling

Subject: deductibility of legal and accounting fees

Question

Are expenses incurred by you in relation to legal and accounting fees to remedy unauthorised actions taken by a third party deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

This ruling applies for the following periods:

Income year ended 31 December 20XX

Income year ended 31 December 20YY

Income year ended 31 December 20ZZ

Income year ended 31 December 20VV

The scheme commences on:

1 January 20XX

Relevant facts and circumstances

You are a company incorporated in Australia, and a resident of Australia for the purposes of the ITAA 1997 and the Income Tax Assessment Act 1936.

You are engaged in the manufacturing business.

You previously engaged the services of entity A to handle your tax affairs.

You advised that the fraudulent behaviour by entity A in connection with their role as your representative is as outlined below:

· you forwarded the company's completed taxation documents and/or information required for finalisation and lodgment of taxation documents with the ATO;

· you forwarded funds to what you believed was an audited trust account of entity A to pay various taxes owing to the ATO which includes income tax, GST, PAYG withholding and FBT; and

· entity A fraudulently lodged false tax documents with the ATO, generally disclosing taxes owing of a lesser amount than that paid into the account provided by the firm; then either paid the lesser amount of tax or did not pay these amounts at all and misappropriated the balance of funds in the account.

You have been the subject of various audits, negotiations and discussions with the ATO as to your obligations to pay the assessed taxation liabilities.

You have appointed entity B as your new representative to manage and fix your taxation affairs and to pursue damages against entity A.

You advised that you have incurred legal and accounting expenses in connection with the following:

· quantifying the amount of funds misappropriated by the firm (through forensic accounting investigations), including review of all incorrectly lodged disclosures to the ATO;

· liaising with the ATO in relation to determining your correct taxation liabilities and the terms of payments of those liabilities;

· reaching a compromise agreement with the ATO under which the ATO would not pursue certain amounts of the assessed taxation liabilities;

· generally cooperating with the ATO to meet your obligations under the relevant taxation legislation; and

· pursuing remedies against entity A and its principals for the recovery of the funds.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1 and

Income Tax Assessment Act 1997 section 25-5.

Reasons for decision

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 except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income.

For legal expenses to constitute an allowable deduction, it must be shown that they were incidental or relevant to the production of your assessable income. Also, the nature of the expenditure must be considered: Hallstroms Pty Ltd v FC of T (1946) 72 CLR 634; 8 ATD 190 per Dixon J. The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses.

Expenses as a result of legal action are generally deductible if the expenses arise out of the day to day activities of the taxpayer's business: Herald & Weekly Times v FC of T 48 CLR 113; 2 ATD 169; and the legal action has more than a peripheral connection to the taxpayer's income producing activities: Magna Alloys and Research Pty Ltd v FC of T (1980) ATC 4542; 11 ATR 276.

However, where the expenditure is devoted to a structural purpose or to gain an enduring benefit, rather than an operational purpose, the expenditure is of a capital nature and the expenses are not deductible: Sun Newspapers Ltd v FC of T (1938) 61 CLR 337; 5 ATD 87.

The legal and accounting expenses you incurred were in relation to the misappropriation of funds by entity A which were intended for the payment of various taxes owing to the ATO. You have engaged the services of entity B to manage and fix your taxation affairs and to pursue damages against entity A. These were incidental in gaining or producing your assessable income and arose out of the day to day activities of your business.

The legal and accounting expenditure did not contribute to your company's profitability but was more of an operational matter. The expenditure is not of a capital, private or domestic nature nor relate to the earning of exempt income.

Therefore, you are entitled to claim a deduction under section 8-1 of the ITAA 1997 for the legal and accounting expenses you incurred as a result of the misappropriation of funds by entity A.

Subsection 25-5(1) of the ITAA 1997 allows a deduction for expenditure incurred in (a) managing taxation affairs and (b) complying with an obligation imposed by a Commonwealth law, insofar as that obligation relates to the tax affairs of an entity.

Section 25-5 of the ITAA 1997 does not apply to your circumstances as the expenditure you have incurred was not as a direct consequence of the management of your tax affairs or compliance with an obligation imposed by a Commonwealth law related to your tax affairs. The legal and accounting expenses were incurred as a result of the misappropriation of funds by entity A.

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