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Edited version of your written advice
Authorisation Number: 1012715654658
Ruling
Subject: Deductibility of settlement sums, legal expenses and interest
Question 1
Is interest incurred and paid in the 2012-13, 2013-14 & 2014-15 financial years for a loan to pay the settlement sum, deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?
Answer
Yes
Question 2
Are legal expenses incurred by you in the 2012-13, 2013-14 & 2014-15 financial years in relation to the Court case with the entity deductible under section 8-1 of the ITAA 1997?
Answer
Yes
Question 3
Are the lump sum and monthly payments paid in the 2013-14 financial year and monthly payments paid in the 2014-15 financial year in relation to the civil court case with your customer deductible under section 8-1 of the ITAA 1997?
Answer
Yes
Question 4
Are legal expenses incurred by you in the 2013-14 financial year in relation to the Court case with your customer deductible under section 8-1 of the ITAA 1997?
Answer
Yes
This ruling applies for the following periods
Year ended 30 June 2013
Year ended 30 June 2014
Year ending 30 June 2015
The scheme commenced on
1 July 2012
Relevant facts
You operated a business as a sole trader.
You entered into a contract with a customer to provide services.
Progress payments were made by the customer to you under the contract.
Disagreements occurred between the customer and you regarding the provided services which caused the business relationship to deteriorate and finally communication ceased between the customer and you.
Court case with entity
The entity took you to court in the 2011-12 financial year.
Your business then ceased.
The matter was resolved out of Court and you agreed to pay the entity an amount as full and final settlement of their claim.
You took out a loan in the 2011-12 financial year to pay the settlement sum and have since paid interest on the loan.
The settlement amount represented required rectification work and legal fees incurred by the entity.
Civil claim
The customer took civil claims proceedings against you in the 2013-14 financial year.
The matter was settled out of court and you agreed to pay an amount as full and final settlement of the claim and the proceedings.
You and the customer entered into a Deed of Settlement.
The settlement sum was to be paid as follows:
• Within a certain period of the settlement date you were to pay an amount; and
• After that date you agreed to pay an amount on the same day every month until the full balance of the outstanding amount was paid.
Relevant legislative provisions
Income Tax Assessment Act 1997 Section 8-1
Reasons for decision
Question 1
Section 8-1 of the ITAA 1997) discusses general deductions. Subsection 8-1(1) of the ITAA 1997 states 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.
However, you cannot deduct a loss or outgoing if it a loss or outgoing of capital or of a capital nature, private or domestic in nature, is incurred in relation to gaining or producing your exempt income or your non-assessable non-exempt income or a provision of this Act prevents you from deducting it.
Case 17/96 96 ATC 230 outlines that interest is deductible when a business is being conducted. It does not matter that the outgoing was in a year later than the year in which the income was derived or that the business had ceased to exist.
In your case you agreed to pay the entity an amount as full and final settlement of their claim. You took out a loan to pay the settlement sum and have since paid interest on the loan. You are entitled to a deduction for the interest incurred on the loan as the occasion of the business outgoing was found in the business operations directed towards the gaining or production of assessable income for the business. In these circumstances, it does not matter that the expenses were in a year which was later than the year in which the income was derived or that the business had ceased to exist.
Question 2
Section 8-1 of the ITAA 1997 allows a deduction for a loss or outgoing to the extent to which it is incurred in gaining or producing your assessable income except where the loss or outgoing is of a capital or private nature.
In determining whether a deduction for legal expenses is allowable, 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 courts, on a number of occasions, have determined legal expenses to be an allowable deduction if the legal expenses arise out of the day to day activities of the taxpayer's business or employment (Magna Alloys and Research Pty Ltd v. FC of T (1980) 49 FLR 183, (1980) 11 ATR 276; 80 ATC 4542).
In your case the payment of the settlement sum occurred as a result of day to day activities of the business. You are therefore entitled to a deduction for legal expenses incurred in relation to the settlement sum.
Question 3
Section 8-1 of the ITAA 1997 discusses general deductions.
Case 17/96 96 ATC 230 outlines that interest is deductible when a business is being conducted. It does not matter that the outgoing was in a year later than the year in which the income was derived or that the business had ceased to exist.
In your case you agreed to pay the customer an amount as an out-of-court settlement. This amount was to be paid as an upfront payment and a number of equal monthly payments.
You are entitled to claim a deduction for the upfront payment and monthly payments as the occasion of the business outgoing was to be found in the business operations directed towards the gaining or production of assessable income for the business. In these circumstances, it does not matter that the expenses were in a year which was later than the year in which the income was derived or that the business had ceased to exist.
Question 4
Section 8-1 of the ITAA 1997 allows a deduction for a loss or outgoing to the extent to which it is incurred in gaining or producing your assessable income except where the loss or outgoing is of a capital or private nature.
As previously discussed deductions are allowable if the legal expenses arise out of the day to day activities of the taxpayer's business or employment.
In your case you incurred legal expenses in relation to the civil court case. The payment of the legal expenses occurred as a result of day to day activities of the business. You are therefore entitled to a deduction for legal expenses incurred in relation to this issue.
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