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This edited version has been archived due to the length of time since original publication.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: 1051236421556

Date of advice: 9 June 2017

Ruling

Subject: Legal fees

Question 1

Can you claim a deduction for your share of the legal expenses you incurred in having another person meet your capital gains tax liability associated with your rental properties?

Answer:

No

Question 2

Will your share of the legal expenses you incurred in having another person meet your tax liability associated with your rental property form part of the cost base of your rental properties for capital gains tax purposes?

Answer:

No

Question 3

Will your share of the legal expenses you incurred in having another person meet your tax liability associated with your rental property form part of the cost base of your right to seek compensation?

Answer:

Yes

Question 4

Will your share of the expenses for property valuation form part of the cost base for your properties for capital gains tax purposes?

Answer:

Yes

Question 5

Does the payment of your tax liability by a third party form part of the capital proceeds for your CGT C2 event?

Answer:

Yes

This ruling applies for the following periods:

Year ending 30 June 2015

Year ending 30 June 2016

This scheme commenced on:

1 July 2014

Relevant facts:

You own a portion of a number of rental properties as a tenant in common.

As a result of advice from your former accountant, you and your co-owner changed the ownership proportion of the properties, which resulted in a large capital gains tax payable. The transfer of property ownership proportion occurred over twelve months ago.

In order to establish market value, you had to pay for a property valuation.

You took legal action against the other person, which resulted in the agreed terms including:

The other person would pay to the ATO on your behalf the estimated CGT liability as assessed by the ATO.

This has now been done.

In the last income year you incurred legal costs in order to have this agreement carried out.

You have no other way of recovering the CGT, you held no insurance to cover the cost of the legal fees, and are unable to recover the cost.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1.

Income Tax Assessment Act 1997 section 25-5.

Income Tax Assessment Act 1997 paragraph 25-5(1)(a)

Income Tax Assessment Act 1997 paragraph 25-5(2)

Income Tax Assessment Act 1997 subsection 104-25(1)

Income Tax Assessment Act 1997 subsection 110-25(6).

Reasons for Decision

Section 8-1 of the ITAA 1997 allows a deduction for a loss or an outgoing to the extent to which it is incurred in gaining or producing assessable income, except where the loss or outgoing is of a capital, private or domestic nature.

For legal expenses to constitute an allowable deduction, it must be shown that they were incidental or relevant to the production of your assessable income.

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.

The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses.

In your case, you incurred legal expenses to obtain compensation for the tax liability which had arisen from the actions you took because of advice from another person.

The tax liability you incurred was paid by another person. This is not regarded as assessable income.

As you did not incur legal expenses to obtain assessable income, and there is no direct relationship between the incurring of the expense and the derivation of assessable income, the legal expenses will not be deductible under section 8-1 of the ITAA 1997.

Section 25-5 of the ITAA 1997 provides that certain tax related expenses are deductible.

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

Paragraph 25-5(2)(a) of the ITAA 1997 states that you cannot deduct tax.

Expenses for managing tax affairs include expenses relating to preparing and lodging your tax return and the costs associated with lodging your tax return through a registered tax agent.

Your legal expense incurred in order to have your capital gains tax paid are not related to preparing and lodging your tax return, and so is not a deductible expense under Section 25-5 of the ITAA 1997.

In your case, you incurred legal expenses to recover the cost of the capital gains tax (CGT) which resulted from the transfer of a proportion of title of the rental property.

The CGT payment was paid on your behalf.

Why the payment was made is an important factor in determining whether an asset has been disposed of for capital gains tax purposes.

Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts discusses the capital gains tax implications for compensation receipts.

Your right to seek compensation is an intangible CGT asset (acquired at the time of the compensable wrong) and your ownership of that asset ended when you accepted the payment of your CGT liability. At that time CGT event C2 happened.

CGT event C2 happens if your ownership of an intangible CGT asset ends in certain ways, including being released or cancelled (subsection 104-25(1) of the ITAA 1997). The time of the event is when you enter into the contract that results in the asset ending, or if there is no contract, when the asset ends (subsection 104-25(2) of the ITAA 1997).

In your case, the compensation payment represents capital proceeds for your CGT C2 event.

The legal expense incurred forms part of the cost base. As you acquired the right to seek compensation more than 12 months before the CGT event, you are able to apply the 50% general discount to the capital gain.

Valuation costs

The costs of obtaining the market value of a property relates to the property itself and not to the earning of the rental income. Such valuation costs are capital in nature. Therefore no deduction is allowed for the costs incurred in obtaining the market value of the properties, as they are capital in nature and not sufficiently connected to the assessable rental income derived. However, these costs are relevant in calculating the cost base of the properties for CGT purposes – please see below.

Capital Gains

The cost base of a CGT asset consists of five elements. The second element includes incidental costs. Section 110-35 of the ITAA 1997 lists incidental costs that may be incurred to either acquire a CGT asset or that relate to a CGT event. Some of these are:

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