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Edited version of your written advice
Authorisation number: 1051316150981
Date of advice: 4 December 2017
Ruling
Subject: Deduction of legal expenses and settlement costs
Question
Are the legal expenses and settlement costs incurred in defending a legal action for breach of duty of care deductable?
Answer
Yes
This ruling applies for the following periods:
Year ending 2017
Year ending 2018
The scheme commences on:
1 July 2016
Relevant facts and circumstances
The taxpayer was engaged as a contractor by a company who had been contracted to a builder to build a residence.
The contract required putting in an installation.
The contract was completed in time.
Inspections and signoffs were given by both the contractor and the building company.
Some years latter a bad weather event caused damage to the installation.
An insurance claim was lodged by the property owners.
Much later after completion the insurer lodged a Writ of Summons and Statement of Claim for negligence as the plaintiff.
The plaintiffs claimed damages for breach of duty of care.
Legal costs for defending the Claim were incurred.
Consent orders were lodged with the Court and the Claim was dismissed subsequent to a settlement agreement.
In the settlement agreement it was agreed to pay the insurer a sum.
This sum consisted of legal costs and disbursements and was a full and final settlement.
The business ceased before the expenses were incurred.
There was no insurance policy to underwrite the expenses.
Assumptions
None
Relevant legislative provisions
Income Tax Assessment Act 1997 section 8-1
Reasons for decision
The legal expenses incurred are an allowable deduction under section 8-1 of the ITAA 1997. This is because the exposure to the risk of litigation was occasional and the legal action defended related to the business methods applied. In addition defending workmanship and not protecting the capital of profit-yielding business is distinguishing. Generally, the treatment of a settlement sum or damages payment will also follow the treatment of the other legal costs incurred in relation to a particular set of facts.
Detailed reasoning
Deduction of 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 except where the losses or outgoings are of a capital, private or domestic nature.
In determining whether a deduction for legal expenses is allowed under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered according to the decision in, 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.
ATO Interpretative Decision ATO ID 2001/549 Income Tax Legal Expenses Defamation Action: provides that legal expenses are deductible provided the legal action:
● arose out of, or concerns the day to day income producing activities of the taxpayer, The Herald and Weekly Times Ltd v. FC of T (1932) 48 CLR 113
● is not undertaken to protect the taxpayer's profit-yielding subject
● have more than a peripheral connection to the taxpayer's business, Magna Alloys and Research Pty Ltd v. FC of T (1980) 11 ATR 276; 80 ATC 4542; Putnin v. FC of T (1991) 21 ATR 1245; 91 ATC 4097
● may arise out of litigation concerning the taxpayer's professional conduct, Magna Alloys and Research Pty Ltd v. FC of T (1980) 11 ATR 276; 80 ATC 4542; Putnin v. FC of T (1991) 21 ATR 1245; 91 ATC 4097
When the principal reason for incurring the legal expenses is defending the actions of the taxpayer in carrying out their employment duties through which they gain or produce assessable income, such expenses are characterised as being of a revenue nature and are deductible, Inglis v. FC of T 87 ATC 2037; and Case V116 88 ATC 737; AAT Case 4502 (1988) 19 ATR 3703.
When the taxpayer is an employee who incurred legal expenses defending actions undertaken in carrying out employment duties through which assessable income is gained, the legal expenses are an allowable deduction under section 8-1 of the ITAA 1997.
Defence against prosecutions relating to professional conduct
Generally deductions will not be allowed for legal expenses incurred in defending a business or its employees from prosecutions for breaches committed in the course of carrying a business. However there may be marginal cases in which a deduction may be available to taxpayers who are necessarily exposed to the risk of occasional prosecution through the actions of an employee.
These occasional prosecutions include defending the taxpayer’s business methods where legal costs incurred are considered deductible. For example, an expenses incurred in defending criminal charges brought against directors and agents in relation to marketing practices when selling the businesses products were allowed to be deducted in the case of, Magna Alloys and Research Pty Ltd v. FC of T (1980) 11 ATR 276; 80 ATC 4542; Putnin v. FC of T (1991) 21 ATR 1245; 91 ATC 4097.
In this instance the installation activity was used to earn income. The legal expenses incurred directly relate to the installation undertaken to earn income. Therefore these legal expenses are an allowable deduction under section 8-1 of the ITAA 1997.
Expenses claimed after the income earning activities has ceased
Payments for losses or outgoings that arise after the business has ceased but relate to the businesses activities will be an allowable deduction under section 8-1 of the ITAA 1997.
The case of Evenden v. FC of T 99 ATC 2297, found that, the decision in AGC (Advances) Ltd v FC of T 75 ATC 4057; (1975) 132 CLR 175, established the following proposition;
that provided the occasion of a business outgoing is to be found in the business operations directed towards the gaining or production of assessable income generally, the fact that that outgoing was incurred in a year later than the year in which the income was incurred and the fact that in the meantime business in the ordinary sense may have ceased will not determine the issue of deductibility.
This allows a claim for legal expenses in the year they were incurred irrespective of the business having ceased.
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