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This edited version has been archived due to the length of time since original publication. It should not be regarded as indicative of the ATO's current views. The law may have changed since original publication, and views in the edited version may also be affected by subsequent precedents and new approaches to the application of the law.

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Edited version of your written advice

Authorisation Number: 1012766371728

Ruling

Subject: Legal expenses

Question 1

Will the money from the settlement constitute assessable income in accordance with section 6-5 of The Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

Question 2

Will the money from the settlement constitute capital proceeds of any CGT event in Division 104 of the ITAA 1997?

Answer

No

Question 3

Will the money from the settlement reduce the cost base of the business for any future capital gain under section s110-45 of the ITAA 1997?

Answer

Yes

Question 4

Are the legal expenses associated with seeking the settlement deductible under section 8-1 of the ITAA 1997?

Answer

No

This ruling applies for the following period:

Income year ended 30 June 2015

The scheme commences on:

1 July 2014

Relevant facts and circumstances

You purchased an ongoing business.

The entity selling the business made false statements about the gross monthly income of the business ($x per month but actual figure was less than $x per month).

You commenced legal proceedings against the party that sold you the business.

You have entered into a settlement where you will receive an amount of $x.

You have incurred $x worth of legal expenses.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 110-45

Reasons for decision

Compensation

Subsection 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of an Australian resident taxpayer includes ordinary income derived directly or indirectly from all sources during the income year.

Ordinary income has been held to include income from providing personal services, income from property and income from carrying on a business. Other characteristics of income that have evolved from case law include receipts that:

In Taxation Ruling TR 95/35 the Commissioner defines a compensation receipt, or compensation, as any amount received by a taxpayer in respect of a right to seek compensation or a cause of action, or any proceeding instituted by the taxpayer in respect of that right or cause of action, whether or not:

A compensation amount normally assumes the nature of that which it is designed to replace. If the compensation is paid for the loss of a capital asset or amount, then it will be regarded as a capital receipt and not ordinary income. In your circumstances the amount of compensation relates to a capital asset being the business and consequently capital in nature.

Taxation Ruling TR 95/35 provides the Commissioner's view on the capital gains tax (CGT) consequences of compensation payments. Paragraph 10 provides that if a taxpayer is compensated for having paid excessive consideration to acquire an asset, the amount referable to the overpayment represents recoupment of all or part of the acquisition costs. Consequently the settlement payment will not be included in your assessable income but will reduce the first element of the cost base of the property for any future capital gain under section 110-45 of the ITAA 1997.

Legal expenses

Section 8-1 of the 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 outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income. 

In determining whether a deduction for legal expenses is allowed under section 8-1 of the ITAA 1997, the nature of the expenses 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 is of a capital or private nature, then the expenses incurred in gaining the advantage will also be of a capital or private nature. An amount that is capital in nature will remain capital notwithstanding that it is specifically included in the assessable income of the taxpayer. 

It is considered that the advantage sought in the litigation was the recovery of the purchase price that you overpaid for the business. It follows that the advantage sought is capital and nature and therefore the legal expenses are not deductible.

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