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Edited version of your written advice
Authorisation Number: 1012738415019
Ruling
Subject: Legal expenses
Question
Is a deduction allowed for the legal expenses incurred?
Answer
No.
This ruling applies for the following periods:
Year ended 30 June 2010
Year ended 30 June 2011
Year ended 30 June 2012
Year ended 30 June 2013
Year ended 30 June 2014
Year ended 30 June 2015
The scheme commenced on:
1 July 200X
Relevant facts
Partnership A has developed and operated a business for several years.
The property used for the business is owned by Company B.
The partners of the partnership are directors of Company B. No director's fees were received by the partners.
A few years ago, another director of Company B, who is a relation of the partners, signed documents in Company B's name relating to other operations being undertaken on the property. The resulting income was paid into entity D, run by the relation.
The partners are being held liable as directors by the local council for expenditure required for the property due to the other operations having been undertaken on the property.
Negotiations have occurred to try to settle the dispute over the property with the relation. The relation has locked Partnership A out of the property and severely devalued the property.
Legal expenses have been incurred in relation to the dispute. The legal fees are being paid by the partners.
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.
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),
• 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.
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).
However, 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 (Sun Newspapers Ltd v. FC of T (1938) 61CLR 337; 5 ATD 87; (1938) 1 AITR 403).
Taxation Ruling TR 95/33 Income tax: subsection 51(1) - relevance of subjective purpose, motive or intention in determining the deductibility of losses and outgoings considers the decision of the Full High Court of Australia in Fletcher & Ors v. FC of T 91 ATC 4950; (1991) 22 ATR 613 and situations relevant in determining the availability of an income tax deduction.
There must be a sufficient connection between the legal expenses and the activities which produce assessable income. To determine whether the legal expenses are deductible, regard must be given to all the circumstances.
Debts are normally incurred by a business in relation to their operations and, thus, the earning of the business's assessable income. However, as highlighted in the High Court case Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153, (1926) 32 ALR 339, a loss or outgoing will not be deductible if it is incurred in gaining or producing the assessable income of an entity other than the one who incurs it. For example, where expenses are incurred by a company and paid for by a director, a deduction is not allowable to the director.
In order to determine whether the legal fees are deductible under section 8-1 of the ITAA 1997, we first need to look at the reason for the legal fees and why they were incurred.
Legal expenses have been incurred in relation to land owned by Company B. The expenses did not arise as a consequence of the day to day income earning activities and do not sufficiently relate to Partnership A's assessable income.
It is acknowledged that the dispute stopped Partnership A from successfully operating their business. However, legal expenses incurred in preserving an asset or defending ownership rights are not deductible as they are considered to provide an enduring advantage and are therefore capital in nature. Also, the dispute is more directly in relation to the property owned by Company B. As Company B is a separate entity for taxation purposes, the expenses do not directly relate to the income of Partnership A. As such, the expenses are not deductible under section 8-1 of the ITAA 1997.
It can also be said, that the legal expenses arose as a result of a family dispute. Where this is the case, the associated legal expenses relate to a private or domestic matter and are, therefore, not deductible under section 8-1 of the ITAA 1997. Whilst we acknowledge the specific circumstances, these do not change the nature of the expenses for taxation purposes.
As the legal expenses incurred relate to property not owned by Partnership A and the expenses are capital in nature, no deduction is allowable under section 8-1 of the ITAA 1997.
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