Edited version of your private ruling

Authorisation Number: 1012470575141

Ruling

Subject: Deductibility of legal expenses

Question 1

Can X Pty Ltd (the "Company") claim a deduction for legal fees and settlement costs pursuant to section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

This ruling applies for the following period:

1 July 2011 to 30 June 2012

The scheme commences on:

1 July 2011

Relevant facts and circumstances

The applicant has applied for a private binding ruling ("PBR") for X Pty Ltd (the "Company"), The questions and issues for the ruling are as follows:

Can the Company claim an outright deduction for legal fees and settlement costs paid to a supplier in relation to a trade mark dispute?

The facts describing the scheme are set out below:

The taxpayer was accused of repackaging goods and then on selling this material as their own product. The supplier sued the taxpayer. The Company and the supplier agreed on a settlement.

The settlement arrangement was on the basis of not accepting liability. The settlement was on the basis that the Company would pay the legal fees of the supplier together with reserved fixed costs.

The Legal Dispute

3. The Company was accused by Z Pty Ltd ("Z") of:

a. Infringing Z's Australian Trade Mark;

b. Contravening sections 52 and 53 of the Trade Practices Act 1974 (Cth); and/or

c. sections 9, and 12 of the Fair Trading Act 1999 (Vic); and/or

d. sections 18 and 23 of the Australian consumer law (being schedule 2 as applied under Subdivision A of Division 2 of Part XI of the Competition and Consumer Act 2010 (Cth);

e. committing the tort of passing off; and

f. infringing Z's copyright.

Remedies sought

The remedies sought by Z as a result of the dispute were, broadly, an injunction restraining the Company from:

· Using the Z Trade Marks, or any other sign which is substantially identical or deceptively similar thereto, on or in relation to any goods not made by or sold with the license or authority of Z;

· Reproducing in a material form the Z Copyright Work or any substantial part thereof, without the licence or authority of Z, or authorising any other party to make such a reproduction;

· In any other way infringing Z's copyright in the Z Copyright Work; and

· The Company pay Z's costs on a party and party basis, to be taxed in default of agreement.

However, the Company signed a notice of offer to compromise. It was agreed that the Company pay Z a settlement sum.

The Company consented to specified restraining orders.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

The General Deduction Provision - section 8-1

All references are to the Income Tax Assessment Act 1997, unless otherwise indicated.

Section 8-1 contains the general rules for deductibility. It consists of both positive limbs (those provisions which set out the criteria necessary for a loss or outgoing to be deductible) and negative limbs (those provisions which set out exclusions from deductibility).

The positive limbs in subsection 8-1(1) state:

8-1(1) You can deduct from your assessable income any loss or outgoing to the extent that:

a) it is incurred in gaining or producing your assessable income; or

b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

The negative limbs in subsection 8-1(2) state:

8-1(2) However, you cannot deduct a loss or outgoing under this section to the extent that:

a) it is a loss or outgoing of capital, or of a capital nature; or

b) it is a loss or outgoing of a private or domestic nature; or

c) it is incurred in relation to gaining or producing your exempt income or your non-assessable non-exempt income; or

d) a provision of this Act prevents you from deducting it.

To be deductible, the expenditure must satisfy one of the positive limbs, and not be excluded by any of the negative limbs.

Deductibility of legal expenses under section 8-1

A taxpayer's income-producing activities may expose them to a range of legal expenses, including fees for legal advice, for preparing and lodging documents, the costs of litigation, arbitration and mediation, and settlement or damages payments.

Legal expenses incurred by a taxpayer in defending criminal charges or civil proceedings are generally deductible under section 8-1 if the occasion of the expenditure is found in what is productive of the taxpayer's actual or expected income (FCT v. Day (2008) 70 ATR 14).

In determining whether legal costs are deductible under section 8-1, the nature and character of the expenditure must be determined. For example, expenses arising from legal proceedings are generally deductible if the expenses arise out of the taxpayer's day-to-day business, investment, or employment activity and the legal proceedings have a real connection to the taxpayer's income producing activities (Herald & Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; 39 ALR 46) (Herald and Weekly Times).

In relation to the deductibility of legal fees, the High Court in Herald and Weekly Times held that legal costs incurred in defending a defamation suit brought against a publisher of a newspaper did have the requisite nexus as an ordinary incident of the business of conducting a newspaper. Duffy CJ and Dixon J stated at 188:

The liability to damages was incurred, or the claim was encountered, because of the very act of publishing the newspaper. The thing which produced the assessable income was the thing which exposed the taxpayer to the liability or claim discharged by the expenditure.

In Re Pech and FCT (2001) 47 ATR 1215, legal expenses incurred in defending a right to have used a trade mark in the past were held to be deductible, i.e. the expenses related to the way the taxpayers had conducted their business, and not to the preservation of an asset.

It must be noted that the success or failure of a taxpayer's claim or defence is not relevant to the question of the deductibility of legal fees (Federal Commissioner of Taxation v. Snowden & Willson Pty Ltd (1958) 99 CLR 431 at 436).

The positive limbs of section 8-1

The two limbs of subsection 8-1(1) are not mutually exclusive, and therefore, a business expense is frequently deductible under either limb. Where the applicability of the first or second limb is in question, the inquiry must always be concerned with the connection between the expense and the particular process of derivation of income.

Paragraph 8-1(1)(a)

The first positive limb, paragraph 8-1(1)(a), is available to all taxpayers, whether in business or not. It allows a deduction for any loss or outgoing to the extent that it is incurred in gaining or producing the taxpayer's assessable income.

In most cases, the question of whether the 'expenditure has been incurred in gaining or producing income will look at the scope of the operations or activities, and their relevance to expenditure, rather than to the taxpayer's reasons for the expenditure' (Commissioner of Taxation v. Day [2008] HCA 53 at 39).

To be deductible under the first positive limb, there needs to be a connection between the expenditure and the production of assessable income. A 'very wide application' should be given to the expression 'incurred in gaining or producing the assessable income' (Amalgamated Zinc (de Bavay's) Ltd v. FCT (1935) 54 CLR 295 at 309). However, the connection must be relevant and incidental to gaining or producing assessable income (Ronpibon Tin NL v. FC of T (1949) 78 CLR 47).

Paragraph 8-1(1)(b)

The second positive limb, paragraph 8-1(1)(b), allows a deduction for expenditure necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income, and is only available to taxpayers carrying on a business. The loss or outgoing must be part of the cost of trading operations to produce income (John Fairfax & Sons Pty Ltd v. FCT (1959) 101 CLR 30) and must have the character of a working or operating expense of the business, or be an essential part of the cost of its business operations.

Working or operating expense

The expression "in carrying on" suggests that expenditure under the second positive limb must possess the character of a working expense, or form part of the trading operations of the business. In John Fairfax & Sons Pty Ltd v. FCT (1959) 101 CLR 30 at 49, Menzies J stated:

To be deductible, an outlay must be part of the cost of trading operations to produce income, i.e., it must have the character of a working expense.

…

…there must, if an outgoing is going to fall within its terms, be found (i) that it was necessarily incurred in carrying on a business; and (ii) that the carrying on of the business was for the purpose of gaining assessable income. The element that I think is necessary to emphasise here is that the outlay must have been incurred in the carrying on of a business; that is, it must be part of the cost of trading operations.

Application to the facts

Based on the facts provided, the Company's production of assessable income is principally derived from the distribution of products.

The Company's business necessitates the sale of products for the purpose of generating a profit. In this case, the thing that produced the Company's assessable income, namely the sale of products, was arguably something that exposed the Company to the claim that is the subject of the legal expenditure.

Therefore, as discussed above, the costs incurred in defending the legal proceedings are relevant and incidental to the Company's income-producing activities, as they were incurred in the course of producing profits from the sale of products.

Accordingly, the positive limbs in subsection 8-1(1) are satisfied.

The negative limbs of section 8-1: capital vs. revenue

Of the four negative limbs, the exclusion in paragraph 8-1(2)(a) is most relevant to the issues under consideration; namely, the exclusion of "a loss or outgoing of capital, or of a capital nature". Therefore, despite satisfying the requirements in subsection 8-1(1), the legal expenditure may still be excluded under subsection 8-1(2).

The terms 'capital' and 'revenue' are not statutorily defined, however, the case law has developed a number of indicia that assist in the determination.

The leading Australian case on whether expenditure is considered 'capital' or 'revenue' is Sun Newspapers Limited v. FCT (1938) 61 CLR 337 (Sun Newspapers). Dixon J, at 363, considered the following as key in determining whether an expense is 'capital' or 'revenue' in nature:

There are, I think, three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment.

In Hallstroms Proprietary Limited v. FCT (1946) 72 CLR 634 at 646-648 (Hallstroms), Dixon J, affirming his previous judgment in Sun Newspapers, elaborated by stating:

What is an outgoing of capital and what is an outgoing on account of revenue depends on what the expenditure is calculated to effect from a practical and business point of view, rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process.

…

Legal expenses ... take the quality of an outgoing of a capital nature or of an outgoing on account of revenue from the cause or purpose of incurring the expenditure. We are, therefore, remitted to a consideration of the object in view when the legal proceedings were undertaken, or of the situation which impelled the taxpayer to undertake them.

[emphasis added]

None of the indicia are, of themselves, decisive. However, in accordance with the above, it is clear that the character of the advantage sought by incurring the expenditure is the primary, if not critical factor in determining the character of the expenditure.

In the numerous cases since Sun Newspapers, the courts have analysed the three central matters detailed by Dixon J (i.e., the character of the advantage sought, the manner in which it is to be used or relied upon, and the means adopted to obtain it), and in doing so, they have developed further indicia to assist in the correct characterisation of expenditure.

The character of the advantage sought

As previously noted, the character of the advantage sought is generally the main factor to consider when determining whether expenditure is capital or revenue. For example, as discussed in Hallstroms at 646-648, where the expenditure is made with the intention of creating an asset or an advantage for the enduring benefit of a trade (in the absence of circumstances leading to an opposite conclusion) the outgoing will generally be treated as capital expenditure, rather than revenue expenditure.

In considering the character of the advantage sought, Dixon J at 359 in Sun Newspapers made a distinction between expenditure on capital account, and that on revenue account:

The distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity, structure, or organization set up or established for the earning of profit and the process by which such an organization operates to obtain regular returns by means of regular outlay, the difference between the outlay and returns representing profit or loss.

Outgoings to secure or to enhance a structural asset (whether tangible or intangible) are of a capital nature, whereas expenditure on a revenue asset (e.g. trading stock) is on revenue account. Likewise, expenditure to reduce or dispose of a structural asset is on capital account, as discussed in John Fairfax & Sons Pty Ltd v. FCT (1959) 101 CLR 30 (John Fairfax & Sons).

Where expenditure is incurred to preserve or protect a taxpayer's underlying profit-yielding structure (e.g. by eliminating competition), the application of the Sun Newspapers criteria (and the principle that the profit-yielding subject does not need to be a tangible asset) generally makes the expenditure capital. For example, the courts have held that the following expenses were on capital account:

In Hallstroms, Dixon J dissented to the majority decision, and concluded that legal expenses incurred in opposing a competitors petition to renew a patent were capital in nature because they related to the protection of the taxpayer's income-earning structure. Dixon J pointed to the fact that the competitor's patent had caused a severe decline in the taxpayer's fortunes, and that, without access to the patent, the taxpayer would 'have had to go out of business or into some other form of manufacture'.

Dixon J's dissenting judgement in Hallstroms was affirmed in the case of Broken Hill Theatres Pty Ltd v. FC of T (1952) 85 CLR 423, where the taxpayer incurred legal expenses from opposing a license application by a potential competitor, which if successful, granted the taxpayer protection from competition for 12 months. The nature of the business was of a kind that can only be carried on by persons who are licensed to exhibit motion pictures. It was determined that the expense was a capital outlay.

In John Fairfax & Sons, costs incurred in defending the legal title to a newly acquired asset (a substantial shareholding in another newspaper company) were considered capital in nature.

Conversely, expenditure that has been considered 'revenue' includes the following:

In FCT v. Duro Travel Goods Pty Ltd (1953) 87 CLR 524 the High Court (Taylor J) held that expenditure to protect the taxpayer's interest in a trademark was on revenue account. Taylor J reasoned that the expenses were operating costs incurred in the process of exploiting the taxpayer's rights in its capital asset (i.e. they were not incurred to preserve the profit-yielding subject but arose out of the taxpayer's day-to-day business activities).

In Magna Alloys & Research Pty Ltd v. Federal Commissioner of Taxation (1980)11 ATR 276 (Magna Alloys) Brennan J at 290 stated:

The capital of the business was in no way increased by the expenditure incurred. True it is that the expenditure protected the reputation and goodwill of Magna's business, but the attack which was made arose out of the day to day selling activities of that business and it was the business purpose of vindicating the methods by which it was conducted that brings the expenditure within s 51(1)…Expenditure incurred in attempting to vindicate the business methods of the taxpayer, overcoming the obstacle to its trading which had been raised by the prosecutions is properly to be regarded as a cost on revenue account.

From the case law, several relevant factors arise that aid in the distinction between capital and revenue. Firstly, legal fees that are incurred to overcome an obstacle to a taxpayer's day-to-day business activities lend weight to it being revenue expenditure. However, legal fees that are incurred to free a taxpayer from competition, or to protect its monopoly over a significant part of its business, or otherwise imperils the existence of the business, or the capital structure of the business, will lend weight to it being capital expenditure.

Application to the facts

In the present case, the expenditure concerned a revenue asset (trading stock). The purpose of the expenditure was not to secure a capital asset, but to defend the use of trading stock. The Company was not attempting to acquire a capital asset (the trade mark) but was defending its sale of the product, as their use of the trademark and copyright resulted from a misunderstanding between the Company and X.

The legal fees have been incurred in response to the day-to-day business activities of the Company. The Company was accused of infringing copyright, for passing off a product as its own, and for using X's trade mark without a license to do so. In this instance, the expenditure arose out of the day-to-day selling activities of the Company, and not an attempt to free the Company from competition, or protect their profit yielding structure.

The manner in which it is to be used, relied upon, or enjoyed by the taxpayer- the recurrence of the expenditure or the advantage sought

The second indicator in determining the character of the expenditure is the manner in which it is to be used, relied upon or enjoyed by the taxpayer.

The regularity of an expense may give some indication as to its character. If the expenditure is recurring, it may be more likely to be revenue in nature. Conversely, if the expense is "one-off", it may be more likely to be capital in nature (Vallambrosa Rubber Co Ltd v. Farmer (1910) 5 TC 529).

In accordance with the above, the lasting or recurrent character of both the expenditure and the advantage sought are important factors. However, as Dixon J cautioned in Sun Newspapers, "recurrence is not a test, it is no more than a consideration the weight of which depends on the nature of the expenditure". In other words, the crucial factor is the nature of the expenditure, rather than how many times it is repeated.

Therefore, the absence of recurrence or otherwise is not a conclusive test (National Bank Limited v. Federal Commissioner of Taxation 97 ATC 5153; Sun Newspapers Limited v. Federal Commissioner of Taxation (1938) 61 CLR 337 at 362). The real test is between expenditure made to meet a continuous demand for expenditure, as opposed to expenditure made once and for all (Vallambrosa Rubber Co Ltd v. Farmer (1910) 5 TC 529 at 536).

Application to the facts

In the present case, the legal expenses were not incurred to remove a competitor, or to secure a capital asset, therefore, it was not a payment made 'once and for all'. The nature of the expenditure was to remove a perceived breach of copyright, and an unauthorised use of a trademark, which arose from the day-to-day trading of the Company.

Therefore, the legal expenses are not considered capital in nature.

The means adopted to obtain it

In general, the case law has established that if the advantage sought to be gained by incurring the legal expenses is of a revenue nature, the expenses will be of a revenue nature. If the advantage sought to be gained is of a capital nature, the expenses will be of a capital nature.

Application to the facts

The legal expenditure was incurred in response to legal action, as instigated by X. The Company was defending their actions in using X's product. The Company agreed to settle. The lasting qualities of the advantage sought were to remove the threat of legal action against the Company, and not to strengthen or preserve the business or profit yielding structure of the business.

Therefore, as concluded above, the legal expenses are not considered capital in nature.

Conclusion

In the present case, the Company has been accused of passing off a product as their own (contravening the law of torts), infringing X's copyright, using a trade mark without authorisation, and contravening the Trade Practices Act 1952. In defending the claim, the Company has incurred legal expenses, including settlement costs and legal fees.

The legal expenses incurred by the Company, in defending the claims brought against it, relate to the process of the derivation of the Company's assessable income. This expenditure does not result in the establishment, replacement or enlargement of the profit yielding subject of the business.

For the reasons stated above, the legal expenses incurred by the Company in defending the proceedings brought against them by X, are outgoings of a revenue nature, and are not considered to be capital. Therefore, the legal expenses are deductible under section 8-1.

Copyright notice

© Australian Taxation Office for the Commonwealth of Australia

You are free to copy, adapt, modify, transmit and distribute material on this website as you wish (but not in any way that suggests the ATO or the Commonwealth endorses you or any of your services or products).