Edited version of your written advice

Authorisation Number: 1012790484045

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

Year ending 30 June 2015

The scheme commenced on:

1 July 2012

Relevant facts

You are a beneficiary of a trust (the trust).

The trust operates a business.

You perform work on behalf of the business.

You are not paid salary and wages by the trust but have received distributions from the trust. Other family members have also received distributions from the trust.

Entity A engaged the services of the business.

Later the contract with entity A was terminated as the result of a number of issues.

Several months after the contract was terminated, an incident occurred in relation to entity A's business.

You were criminally charged in relation to the incident.

You have incurred legal expenses to defend yourself.

You currently still perform work for the trust's business.

The criminal matter is ongoing and has not yet been resolved.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

Summary

It is considered that the legal expenses are not deductible for a number of reasons.

Firstly, you were not defending the way that you did your work. Rather you were defending an alleged wrongful act that took place some time after the alleged victim ceased being a client. As the legal expenses did not arise out of the day to day activities of your work they are not considered to be sufficiently related to work activities.

Secondly, the legal expenses were incurred to allow you to continue to work in the future in the business, that is, to preserve your means of producing income which is a capital asset. Therefore, the legal expenses are capital in nature.

Finally, you do not earn assessable income directly from the business. Rather, you are a beneficiary of a discretionary trust that operates the business. You advised that the legal expenses are incurred in order for you to continue earning income from the business. Although you may expect to receive income from the trust, you are not presently entitled to that income. Deductions are not available to beneficiaries of discretionary trusts on the expectation of receiving income in the future from the trust.

Detailed reasoning

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:

n 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), 

n 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

n 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). 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 FC of T v. Rowe (1995) 31 ATR 392; 95 ATC 4691 (Rowe's case), the taxpayer, an employee, was suspended from normal duties and was required to show cause why he should not be dismissed after several complaints were made against him. A statutory inquiry subsequently cleared him of any charges of misconduct or neglect. The court accepted that the legal expenses incurred by the taxpayer in defending the manner in which he performed his duties, in order to defend the threat of dismissal, were allowable. Since the inquiry was concerned with the day to day aspects of the taxpayer's employment, it was concluded that his costs of representation before the inquiry were incurred by him in gaining assessable income.

Taxation Ruling IT 149 Legal expenses incurred for fines and/or breaches of the law in the course of carrying on a business states that deductions are generally not allowed for fines or legal expenses incurred for breaches of the law committed in the course of carrying on a business. That is, if a taxpayer chooses to operate in breach of the law, the associated expenditure is not incurred in the furtherance of the business. However, as highlighted, there are cases in which a taxpayer who is carrying on a business in good faith and in a reputable manner may expose himself to some risk of occasional prosecution.

The defence of criminal charges is ordinarily a private and personal matter. However, an exception may exist where the criminal charges arise due to conduct undertaken in carrying out the taxpayer's direct employment duties or business activities. For example, in Case 9/97 97 ATC 157; No 11,608 34 ATR 1230, a nightclub owner incurred legal expenses in defending criminal charges laid against an employee. The employee had injured an intoxicated patron while attempting to remove him from the premises. The deduction was allowed as the Tribunal considered that the physical handling of intoxicated patrons and the risk of an employee misjudging a situation and using excessive force was an inherent part of the taxpayer's business operations.

In Case Q99 83 ATC 491 a travelling sales representative was charged with a driving offence while undertaking a work journey. His claim for legal expenses incurred in successfully defending the charge was disallowed. It was considered that the expenses were incurred in order to protect the taxpayer's right to drive which remained a private matter even though driving was a necessary part of each taxpayer's employment.

In the High Court decision in Federal Commissioner of Taxation v. Day [2008] HCA 53; (2008) 70 ATR 14; 2008 ATC 20-064, (Day's case), Mr Day was charged with breaching the standards of conduct and failing to fulfil his duty as an officer. He was suspended without pay. It was found that the requisite connection with his assessable income was present and that he was exposed to the charges by reason of his office.

As highlighted in Day's case, the incurring of expenditure by an employee to defend a charge because it may result in dismissal may not be sufficient in every case to establish the necessary connection to the employment or service which is productive of income. Much will depend upon what is entailed in the employment and duties of the employee. Whether expenses are incurred in gaining or producing assessable income looks to the scope of the operations or activities and the relevance to any legal expenses incurred. The scope of a taxpayer's employment is a question of fact and degree.

The facts of your case are not similar to Rowe's case or Day's case as your legal expenses did not arise because you were doing your authorised working activities on behalf of the business.

In your case you were not defending the way in which you did your work. Rather you were defending the charge of an alleged wrongful act against a previous client. Such an act is not part of your authorised duties.

The charge against you is only indirectly concerned with your work activities. The connection between the legal expenses and your work activities is not sufficient to characterise the expenses as deductible.

To continue working

Legal expenses incurred in preserving employment or a business but which did not arise out of the day to day income earning activities are not deductible as they are considered to provide an enduring advantage and are therefore capital in nature. The advantage sought by you in undertaking the action is the preservation of a capital asset, that is, your means of producing income. As such, the character of the legal expenses associated with this action are considered to be capital in nature and the expenses are not deductible under section 8-1 of the ITAA 1997 (Case X84 90 ATC 609; AAT Case 6528 (1990) 21 ATR 3721).

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. 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).

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 were 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.

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.

In your case, you advised that the legal expenses were incurred in order for you to continue to earn assessable income from the business.

Even if it could be said that the legal costs were incurred to ensure the derivation of future income, 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. As such, the expenses are not deductible under section 8-1 of the ITAA 1997.

Distributions from a discretionary trust

Although you contend that the legal expenses were incurred in order for you to continue earning income from your business, it is noted that the business is operated by another entity, the trust, not yourself as a sole trader.

Taxation Ruling IT 2385 Income tax: expenses incurred by beneficiaries of discretionary trusts, states that a deduction is not allowable to beneficiaries of trusts unless it is established that they are presently entitled to the trust income when the expenditure is incurred. Where a beneficiary is not presently entitled to trust income and only has a mere expectancy of receiving trust income, then no deduction is allowable.

You have incurred legal expenses in order that the business can continue to operate and earn income. Although you may expect, as a consequence, to continue to receive income from the trust, you are not presently entitled to that income. Therefore you are not entitled to a deduction for the legal expenses.

Conclusion

The legal expenses incurred in relation to the alleged wrongful act against a former client did not arise out of your day to day work activities and are therefore not sufficiently related to work activities to be deductible. In any case, the expenses are capital in nature as they were incurred to protect the means to earn income in the future, which is a capital asset.

Even if the legal expenses in relation to the alleged wrongful act were considered to be sufficiently connected to work activities and were not capital in nature, you would still not be entitled to a deduction as you cannot claim a deduction for expenses incurred in order to receive expected future income distributions from a discretionary trust.

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