Edited version of your private ruling

Authorisation Number: 1012561678188

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Ruling

Subject: Legal expenses

Question

Are you entitled to a deduction for legal expenses incurred?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 2013

Year ended 30 June 2014

The scheme commenced on:

1 July 2012

Relevant facts

You are a professional.

A relation is employed to do part-time work at your business.

You live several kilometres away from your business.

If your relation needs to stay overnight in town, they sleep in a flat at the rear of the business.

Your relation had a few friends at the flat for a small gathering. Two of the guests gained access to the business premises.

A person received small abrasions caused by your relation.

Your relation was charged with an offence.

All the prosecution witnesses stated that the incident occurred at your business premises when it actually occurred in a family room in the flat. The publicity indicated that people had access to your business records.

You had to fight the case as you believed that your relation was innocent and also to prevent incorrect statements concerning your business. The negative impact of your clients' loyalty can greatly affect the profitability of the business.

You incurred legal costs to protect the income generating capacity of the business and to protect the business methods.

You will not be reimbursed for the legal costs.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

Legal expenses

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 or are necessarily incurred in carrying on a business for the purpose of 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, or a provision of the ITAA 1997 prevents it.

A number of significant court decisions have determined that for an expense to be an allowable deduction:

· it must have the essential character of an outgoing incurred in gaining assessable income or, in other words, of an income-producing expense (Lunney v. FC of T; (1958) 100 CLR 478) (Lunney's case), 

· there must be a nexus between the outgoing and the assessable income so that the outgoing is incidental and relevant to the gaining of assessable income (Ronpibon Tin NL v. FC of T, (1949) 78 CLR 47), and

· it is necessary to determine the connection between the particular outgoing and the operations or activities by which the taxpayer most directly gains or produces his or her assessable income (Charles Moore Co (WA) Pty Ltd v. FC of T, (1956) 95 CLR 344; FC of T v. Hatchett, 71 ATC 4184).

For legal expenses to constitute an allowable deduction, it must be shown that they are incidental or relevant to the production of the taxpayer's assessable income or business operations. Also, in determining whether a deduction for legal expenses is allowable 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.

The following guidelines for determining whether a loss or outgoing is of a capital nature have been set down by the High Court in Sun Newspapers Ltd. and Associated Newspapers Ltd. v. Federal Commissioner of Taxation (1938) 5 ATD 23; 5 ATD 87; 61 CLR 337: 

· the expenditure is related to the business structure itself, that is, the establishment, replacement or enlargement of the profit yielding structure rather than the money earning process, or  

· the nature of the advantage has lasting and enduring benefit, or

· the payment is 'once and for all' for the future use of the asset or advantage rather than being recurrent and ongoing.

That is, where the expenditure is incurred for the purpose of securing an enduring benefit, rather than a revenue purpose, the expenditure is capital in nature and is not deductible.

Outgoings incurred in the preservation of an existing capital asset have been held to be capital in nature (John Fairfax & Sons Pty Limited v. Federal Commissioner of Taxation (1959) 101 CLR 30; (1959) 7 AITR 346; (1959) 11 ATD 510).

Legal expenses are generally deductible if they arise out of the day to day activities of the taxpayer's business (Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 39 ALR 46; (1932) 2 ATD 169 (the Herald and Weekly Times case)) 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 80 ATC 4542; (1980) 11 ATR 276). It follows, that expenditure will be deductible in earning assessable income if the subject of the claim is something that might ordinarily be expected to occur in carrying out the income earning activities.

In Case U102 87 ATC 621 the taxpayer was a secretary-manager of a large sporting club. Comments about the management of the trust funds were made on television that was defamatory in nature in respect to the trustees. The trustees commenced proceedings for damages for defamation. The Administrative Appeals Tribunal (AAT) held that a deduction for the legal expenses incurred was not allowable. It was found that 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. Alternatively, it was stated that the expenditure was capital in nature as it was incurred in an endeavour to retain and restore his position as a leading figure in the sports management industry and with it a standing sufficient to pursue his own interest away from the club in the future.

In Case W94 89 ATC 792; AAT Case 5376 (1989) 20 ATR 4001 the taxpayer, a public servant incurred legal fees in defending and then appealing against disciplinary charges of improper conduct resulting from his compulsive gambling. It was found that the expenses incurred were not incidental or relevant to the gaining of the taxpayer's assessable income. It was the conduct of the taxpayer through his compulsive gambling which led to the charges which, in turn, led to him incurring legal costs. The expenses incurred were not incidental or relevant to the gaining of the taxpayer's assessable income.

The proper characterisation of legal expenses depends upon the circumstances of why the proceedings were necessary. It is not sufficient to rely on what was intended or expected to be achieved by the proceedings, for example, to protect one's reputation or keep one's job. The relevant issue is what gave rise to the circumstances that made it necessary to incur the expenses. However, the character of legal expenses is not determined by the success or failure of the legal action (No. 3 Board of Review Case B31, 70 ATC 148).

It is a long standing principle that a taxpayer does not satisfy section 8-1 of the ITAA 1997 merely by demonstrating some casual connection between the expenditure and the derivation of income. What must be shown is a closer and more immediate connection. The expenditure must be incurred in gaining or producing your assessable income (Lunney's case). These principles have been affirmed by the High Court in Commissioner of Taxation v Payne [2001] HCA 3.

Although your situation differs from the above cases, the principles are relevant.

In your case, you incurred the expenses in relation to your relation's actions and behaviour outside the work place. That is, the legal costs arose from the personal conduct of your relation during a social gathering. The actions did not occur at a time when your relation was carrying out employment duties or working for your business. Costs incurred to show your relation was innocent relate to a private matter.

Furthermore, your legal expenses did not arise in defending actions undertaken in carrying out your day to day income earning activities nor were your duties the cause of the expenditure. Although the successful operation of the business will enable you to derive assessable income, the legal action does not have the necessary connection with your assessable income.

Even if it could be said that the legal costs were incurred to ensure the derivation of future income from the business, the expenses would be characterised as being of a capital nature as the expenditure was concerned with the protection of the business operation, rather than with the derivation of assessable income.

Legal expenses incurred in preserving the business and to help restore the business's reputation and good name and client loyalty are not deductible as they are considered to provide an enduring advantage. The advantage sought is the restoration of a capital asset, that is, your means of producing income. As such, the character of the legal expenses is considered to be capital in nature and the expenses are not deductible under section 8-1 of the ITAA 1997.

In conclusion, you are not entitled to a deduction under section 8-1 for the ITAA 1997 for the legal expenses incurred as they are considered to be insufficiently connected with your assessable income earning activities and are private or capital in nature.

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