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Ruling

Subject: Deductibility of legal expenses

Question and answer:

Are the legal expenses incurred by you in your capacity as a grower in relation to the Supreme Court Proceedings in relation to the timber project deductible?

No.

This ruling applies for the following periods:

Year ended 30 June 2012.

Year ended 30 June 2013.

The scheme commenced on: 1 July 2011.

Relevant facts:

You incurred legal expenses borne from a class action that you and other investors are a part of.

You are a group member in the Court proceedings which commenced in 2012 and are expected to run for the next few months.

The class action relates to the allegation of mismanagement of the X scheme.

You are hopeful mismanagement will be proved allowing another company to run the scheme.

Your claim is that you were mislead in relation to the purchase of the investment and you are challenging the validity of the loan.

You first became involved in the scheme prior to 2010.

The scheme company went into liquidation.

You are currently represented Lawyers, with a total of $X in legal fees (invoices provided) incurred since 20YY, with actions ongoing.

You have provided a Certificate of ownership, showing you own X woodlots for an area X hectares, dated at the beginning of 20XX, and fully financed.

Relevant legislative provisions:

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

Section 8-1 of the Income Tax Assessment Act 1997 (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 losses or outgoings are of a capital, private or domestic nature.

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. If the advantage to be gained is of a capital nature, then the expenses incurred in gaining the advantage will also be of a capital nature.

Generally, the treatment of a settlement sum or damages payment will follow the treatment of the other legal costs incurred in relation to a particular matter.

The leading case on the deductibility of legal expenses is Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; 2 ATD 169. In this case the taxpayer was the proprietor and publisher of an evening newspaper who claimed outgoings (for legal advice, defence costs and damages awarded) in connection with libels the newspaper had published. A majority of the Full High Court allowed the deduction as publishing the newspaper was both the source of income and cause of the liability and secondly, the risk of libel was a regular and almost unavoidable incident or inherent risk of publishing.

 In FC of T v. Rowe (1995) 60 FCR 99; (1995) 31 ATR 392; 95 ATC 4691, the court accepted that legal expenses incurred in defending the manner in which a taxpayer performed his employment duties were allowable. The activities which produced his income were what exposed him to the liability against which he was defending himself.

 In Case V116, AAT Case 4502 (1988) 88 ATC 737; 19 ATR 3703 the Administrative Appeals Tribunal allowed a deduction for legal expenses by a solicitor employed as a director of a company to defend defamation proceedings. Senior Member Roach stated that the duties of the solicitor's position created the risk of defamation proceedings and the legal expenses were:

· as directly related to the performance of his duties as a director, and thereby his incoming earning activities, as are the expenses incurred by divisions of the media which incur expense in dealing with allegations that they have defamed others.

In Case U102 87 ATC 621; AAT Case72 (1987) 18 ATR 3515 a secretary-manager of a sporting club initiated defamation proceedings in the Supreme Court to obtain an apology, recovery of expenses and damages. The legal action was undertaken to protect the taxpayer's reputation, not his continued employment with the club. The events which gave rise to the expenses incurred were not regarded as what is normally expected of a secretary-manager of a club in the course of producing assessable income. The expenses were considered private in nature as the need for them arose out of the taxpayer's reaction to what he saw as a slur upon his personal good name and reputation.

Accordingly, for legal expenses to be deductible, you have to be able to show that it was the very act of performing the prescribed or authorised activities of your employment that exposed you to the legal expenses. If it is something other than employment duties that exposed you to the legal expenses, the necessary nexus with the earning of assessable income cannot be established and the expenses are not allowable.

The following are examples of legal expenses that have been held to be deductible under section 8-1 of the ITAA 1997;

· costs of defending proceedings for the unauthorised use of a trademark,

· costs of patent infringement action,

· costs incurred by an employee to prevent defamatory statements being made by a colleague,

· costs of defending misrepresentation suit in connection with sale of goods,

· costs and damages of an employer in an employee's personal injuries claim against the employer,

· costs of opinion as to whether goods could be sold in another state,

· damages and costs of a newspaper in defending a libel action,

· costs of defending an action for wrongful dismissal brought by a former director,

· cost of arbitration to settle a dispute between a solicitor and his partners as to his share of the profits and his subsequent purported expulsion from the partnership,

· costs of opposing a neighbourhood development that would cause excessive dust and damage to the taxpayer's plant nursery,

· costs of an accountant/trustee in defending a charge of conspiring with the debtor of an insolvent estate to defraud the Commonwealth, and

· legal expenses incurred by an employee in recovering wages paid by a dishonoured cheque and travel and incidental expenses relating to a legal action to recover unpaid wages.

· In addition to the previous examples, the following are examples of legal expenses that have been held not to be deductible under the general provisions of section 8-1 of the ITAA 1997; Note, however, that some may be deductible under the more specific provisions noted below.

· costs of settlement of breach of contract action, the result being that the taxpayer was free to reorganise its trading structure and method,

· costs of a company in resisting winding-up action by a dissident shareholder or directors,

· costs of a newspaper in defending acquisition of an interest in another newspaper,

· costs of resisting land resumption and disputing the compensation amount,

· an investor's expenses incurred in challenging the redemption of units he held in an investment fund,

· legal expenses in relation to an ASIC investigation incurred by a company director who did not receive any director's fees or share of profits,

· costs incurred by the owner of a shopping centre in seeking to overturn the rezoning of nearby land that would have allowed a larger shopping centre to be built,

· costs of defending an action for misrepresentation of the value of goodwill of the business sold by the taxpayer, and

· costs of defending the legal validity of a contract on the basis of which the viability of the taxpayer's business depended (PBL Marketing Pty Ltd 85 ATC 4416 see below);

· PBL Marketing Pty. Limited v. Federal Commissioner of Taxation. - Other publishers' citations: (1985) 80 FLR 411 (1985) 16 ATR 679

· Under an agreement with the Australian Cricket Board, the taxpayer company was granted the right to organise the televising of various major cricket matches. During the years in issue, a substantial part of the taxpayer's income came from the sale of the television rights.

· The Australian Broadcasting Commission began proceedings claiming that the agreement breached the Trade Practices Act and it sought an injunction restraining the parties from giving effect to the agreement. The matter was eventually settled out of court.

· The taxpayer claimed a deduction for the legal expenses incurred in defending and settling the matter. It also claimed a deduction for legal expenses in preparing submissions to the Trade Practices Commission relating to the agreement.

· The Commissioner disallowed the deduction and the taxpayer appealed, claiming that the expenditure was incurred to repel what was in effect an attack on its method of carrying on business.

· The legal expenses were capital in nature and therefore non-deductible. The whole business of the taxpayer depended on the agreement with the Cricket Board and the exclusive rights which it gave to the taxpayer. Without the agreement, the taxpayer would have had no business. Accordingly, the expenditure incurred in seeking to maintain or defend the agreement was an affair of capital.

· Certain kinds of legal expenses are specifically made deductible, even though they might not be deductible under the general deduction provisions because of their capital, private or domestic nature. These are legal expenses associated with:

· certain borrowings of money,

· the discharging of certain mortgages,

· the preparation of leases, or

· the preparation of an income tax return, the disputing of a tax assessment and the obtaining of professional tax advice.

· Certain capital legal expenses of a business may also qualify for a five-year write-off.

· In your case, you incurred legal expenses in relation to a class action to which you are a group member. The class action relates to the allegation of mismanagement of the X scheme by X. You believe that you were misled in relation to the purchase of the investment and validity of the loan. The investment in your case was the purchase of X property, financed for $X.

· The legal actions you are taking relate to the ownership of the company which manages your investment. As such the advantage sought is one of a capital nature, as it relates to protecting/improvements of the core asset which produces or has ability to produce income for taxpayers including yourself. Therefore, the legal costs incurred are non deductible and are not made deductible by any specific provisions.

Further issues for you to consider:

When the case is determined and settled, there may be consequences for the cost base of your investment.

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