Edited version of your written advice

Authorisation Number: 1013099423107

Date of advice: 28 September 2016

Ruling

Subject: Legal expenses

Question 1

Are you entitled to claim a deduction for the legal expenses incurred in pursuing capital proceeds from your real estate agent under D10 "Cost of Managing Tax Affairs"?

Answer

No

Question 2

Will the legal expenses be included in the cost base under Section 110-25 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

This ruling applies for the following period:

Year ended 30 June 20YY

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

You had a property in Country X.

You sold the property in the 20YY financial year.

Your real estate agent kept the proceeds of the sales.

You incurred legal expenses for the debt recovery from the agent.

You received your capital proceeds back in full after you took the legal action.

You received the capital proceeds in the 20YY financial year.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 25-5

Income Tax Assessment Act 1997 Section 102-20

Income Tax Assessment Act 1997 Section 103-10

Income Tax Assessment Act 1997 Section 104-10

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Section 110-25

Income Tax Assessment Act 1997 Section 995-1

Reasons for decision

Section 25-5 of the ITAA 1997 provides that certain tax-related expenses are deductible. Paragraph 25-5(1) (a) of the ITAA 1997provides that a taxpayer can deduct expenditures they incur to the extent that the expenditure is for managing tax affairs.

The expression 'tax affairs' is defined in Section 995-1 of the ITAA 1997 as 'affairs relating to tax'; however, the ITAA 1997 does not define the meaning of 'managing tax affairs'. ATO Interpretative Decision ATO ID 2003/955 states it is considered that, for the purposes of section 25-5, managing tax affairs includes activities required to prepare income tax returns.

D10 cost of managing tax affairs of individual income tax return includes:

• Preparing and lodging tax return and activity statements

• Fees paid to a recognised tax adviser for preparing and lodging tax return

• Travel to obtain tax advice from a recognised tax adviser

• Buying tax reference material

• Dealing with ATO about your tax affairs

• Appealing made to the administrative Appeals Tribunal or courts in relation to your tax affairs

• An interest charge ATO imposed on you.

• Any costs you incurred in complying with your legal obligation relating to another person's tax affairs

In your case, you incurred legal expenses for the debt recovery from your real estate agent. The expenses were not related to tax affairs; therefore, it cannot be included under D10 cost of managing tax affairs.

General deduction

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 to be gained is of a revenue nature, then the expenses incurred in gaining the advantage will also be of a revenue nature. In the same way, 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. It follows also that the character of legal expenses is not determined by the success or failure of the legal action.

In addition, ATO Interpretative Decision ATO ID 2001/42 Income tax - deductions and expenses: Legal expenses in recovery of misappropriated funds states that legal expenses are not deductible under section 8-1 of the ITAA 1997 if they are incurred to recover misappropriated capital receipt.

In your case, you incurred legal expenses to recover money misappropriated by your real estate agent. The legal expenses were incurred by you with the purpose of recovering your capital proceeds, which is capital in nature. Therefore, the legal expenses are of a capital nature and not deductible under section 8-1 of the ITAA 1997.

Capital Gains Tax

Generally speaking, a capital gain or loss can only occur when a CGT event happens. A capital loss occurs when the taxpayer's costs associated with a CGT event exceed the amounts received from it.

Section 102-20 of the ITAA 1997 provides that you make a capital gain or capital loss as a result of a CGT event happening to an asset in which you have an ownership interest. Section 108-5 of the ITAA 1997 provides that a CGT asset is any kind of property, or a legal or equitable right that is not property.

CGT event A1 occurs if you dispose of a CGT asset (section 104-10 of the ITAA 1997). The disposal of property triggers CGT event A1.

If more than one CGT event (except CGT events D1 and H2) happens to your situation, then in accordance with subsection 102-25(1) of the ITAA 1997 you use the one that is the most specific to your situation.

In your case, you disposed your investment property in Country X in 20YY financial year. However, your real estate agent kept the proceeds of sales. You took legal action against your real estate agent. You received the capital proceeds in full after taking legal action. Therefore, only CGT event A1 will be considered in your case.

Subsection 116-20(1) of the ITAA 1997 states that capital proceeds of a CGT event are the total of the money you are entitled to receive. Subsection 103-10(2) of the ITAA 1997 provides an extended meaning where capital proceeds include money and other property you will not receive until a later time.

Modifications to the general rules of the calculation of capital proceeds are explained in section 116-10 of the ITAA 1997. Section 116-60 of the ITAA 1997 explained the sixth rule, which is the misappropriate rule and it states that the capital proceeds from a CGT event are reduced if you employee or agent misappropriates (whether by theft, embezzlement, larceny or otherwise) all or part of those proceeds.

Therefore, in your case, the debt recovered after taking legal action should be included in the capital proceeds of the CGT event A1. If you had not received the capital proceeds in full, you would be able to reduce all or part of those proceeds under section 116-60 of the ITAA 1997.

The cost base of a CGT asset is generally the cost of the asset when a taxpayer bought it. However, it also includes certain other costs associated with acquiring, holding and disposing of the asset.

In order to work out how much a taxpayer's capital gain or capital loss is, a taxpayer must first establish the cost base or reduced cost base of a taxpayer's ownership interest in the property.

Section 110-25 of the ITAA 1997 states that the cost base of a CGT asset is made up of five elements. The second element is the incidental costs you incurred. Incidental costs are costs you may have incurred to acquire a CGT asset or relate to a CGT event.

CGT Determination Number 23 Capital gains: can incidental costs incurred after an asset disposed of form part of the cost base of the asset provides that there is no requirement that the calculation of the cost base be limited to expenditure incurred before the time the disposal.

In your case, the legal expenses you incurred to recover the capital proceeds misappropriated by your agent related to the CGT event A1, therefore, it should be included in the second element of cost base.

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