Edited version of your written advice

Authorisation Number: 1051333118887

Date of advice: 16 March 2018

Ruling

Subject: Trust deductions

Issue 1 - Dispute regarding the removal of the Trustee Companies and replacement with an independent trustee

Question 1

Are legal and trustee fees incurred by the Trustee in relation to the removal and appointment of the trustee of the Trusts deductible under section 8-1 of the ITAA 1997?

Answer

No

Question 2

If the answer to question 1 is no, are legal and trustee fees incurred by the Trusts in relation to the removal and appointment of the trustee of the Trusts included in the cost base of the Trust’s assets under section 110-25 (6) of the ITAA 1997?

Answer

Yes

Question 3

If the answer to question 2 is no, are legal and trustee fees incurred by the Trusts in relation to the removal and appointment of the trustee of the Trusts deductible under section 40-880 of the ITAA 1997?

Answer

Not applicable as the answer to Question 2 is yes.

Issue 2 - Dispute regarding the validity and quantum of a loan provided by a beneficiary to the Trusts

Question 4

Are legal and trustee fees incurred by the Trusts in relation to the dispute arising in regards to the validity of a loan claimed to be owed to a beneficiary of the Trusts deductible under section 8-1 of the ITAA 1997?

Answer

No

Question 5

If the answer to Question 4 is no, are the legal and trustee fees incurred by the Trusts in relation to the dispute arising in regards to the validity of a loan claimed to be owed to a beneficiary of the Trusts included in the cost base of the Trust’s assets under section 110-25 of the ITAA 1997?

Answer

No

Question 6

If the answer to the Question 5 is no, are the legal and trustee fees incurred by the Trusts in relation to the dispute arising in regards to the validity of a loan claimed to be owed to a beneficiary of the Trusts deductible under section 40-880 of the ITAA 1997?

Answer

Yes

Issue 3 – Expenses incurred by the independent trustee in the day to day administration of the Trusts

Question 7

Are legal and trustee fees incurred by the Trusts in relation to the ongoing day to day administration of the Trusts deductible under section 8-1 of the ITAA 1997?

Answer

Yes

Question 8

If the answer to Question 7 is no, are legal and trustee fees incurred by the Trusts in relation to the ongoing day to day administration of the Trusts included in the cost base of the Trust’s assets under section 110-25 of the ITAA 1997?

Answer

Not applicable as the answer to Question 7 is yes.

Question 9

If the answer to Question 8 is no, are legal and trustee fees incurred by the Trusts in relation to the ongoing day to day administration of the Trusts deductible under section 40-880 of the ITAA 1997?

Answer

Not applicable as the answer to Question 7 is yes

This ruling applies for the following period(s)

Year ended 30 June 2013

Year ended 30 June 2014

Year ended 30 June 2015

Year ended 30 June 2016

Year ended 30 June 2017

The scheme commences on

1 July 2012

Relevant facts and circumstances

1. The X Family Trust No 1 and X Family Trust No 2 were established under deeds.

2. Prior to 2015, Company X was the trustee of the X Family Trust, and Company Y was the trustee of the X Family Trust No 2 (The Trustee Companies). The directors of the Trustee Companies are beneficiaries of the Trusts (in addition to other beneficiaries under the Deeds)

3. Each trust is a discretionary trust.

4. Each Trust operated a business, including the leasing and managing of rental properties.

5. Since its formation, both Trust’s assets have been used to operate the business/es including farming, bowling alleys in various regional locations, squash courts, and other commercial and residential operations.

6. Since the 1990’s The X Family Trust No 2’s assets have been used to operate the business/es including commercial and residential operations and the leasing of farming land.

7. In the 2013 and 2014 years, the relationship between the Directors of the Trustee Companies began to deteriorate, and the running of the businesses, including the day to day trust operations became increasingly difficult. This lead to a stalemate in the decision making process, including how the profits of the Trusts were to be distributed. The dispute escalated to court proceedings brought by a beneficiary for:

● The removal of the Trustee Companies and the appointment of an independent trustee. The Directors of the Trustee Companies engaged various legal firms to represent them in respect of the disputes. In accordance with a Deed of Settlement entered into by the Directors of the Trustee Companies, the Trusts paid a fixed amount for the legal fees in connection with the representation of the relevant directors, however afterwards the dispute continued to escalate.

● Payment of monies claimed to be owing to the beneficiary in loan accounts by each of the trusts

8. The dispute resulted in an independent trustee being appointed as a result of proceedings

9. Since the appointment of the independent trustee, the Trusts incurred additional legal fees, as well as trustee fees (based on the duties undertaken by the independent trustee in their capacity as independent trustee) in regards to various matters. As the trustee was appointed as an independent trustee, they have been renumerated for their professional services. The trustee was a senior advisor in an accounting firm and they engaged staff of that firm to assist them in their duties as Trustee. The trustee and their staff costs were charged at the accounting firm’s general charge rates less a discount of 10%.

10. The directors of the Trustee Companies were responsible for making the management decisions regarding the business. Since the independent trustee has been appointed, they have taken over the management decisions of the businesses’.

Beneficiaries Entitlement Dispute

11. The accounts of the Trusts disclose an amount owing to a beneficiary. The accounts show that this account balance accumulated over many years and comprised funds provided to the Trusts, the provision of other assets to the Trusts, distributions of income, less payments made to the beneficiary. These categories of funds have not been disclosed separately or described in the accounts as unpaid present entitlements (UPEs).

12. The funds are considered to be a loan. The loan funds were received by the former trustees of the Trusts. The former trustees would have a right of indemnity against the trust assets in respect of the repayment of those loans funds, and the present trustee is not aware of any evidence of disentitling conduct by the former trustees.

13. The funds have been put towards the working capital of the businesses contained in the Trusts.

14. In 2014, the beneficiary issued a statement of claim for repayment of this entitlement. Upon application, a dispute arose as to the validity and quantum of the amount owed to the beneficiary. Several of the Directors of the Trustee Companies disagreed with the claim on the basis of the quantum of the entitlement and the amount potentially being statute barred due to the lapsing of time, and also disputed the integrity of the accounting records. The beneficiary then filed an application for summary judgment which the court refused.

15. The Trustee engaged legal counsel (incurring both legal and trustee fees in relation to the matter) seeking advice on the legal validity of the claim and charged fees for their time and the time of their accounting firms, personnel in performing a detailed analysis of the entries in the relevant loan accounts in the Trusts general ledgers.

16. At mediation, the Trustee settled the loan account claim for an amount less that was initially disclosed in the account. The beneficiary wanted to settle the disputes regarding the quantum and validity of their entitlement therefore agreed to this figure which is much reduced from what the accounts of the trust initially disclosed.

Day to Day Administration of the Trusts

17. Consistent with the Trust Deeds, the Trustee has been renumerated for services provided in regards to the ongoing day to day administration of the Trusts including, but not limited to:

● Reviewing the trust deeds

● Consideration of the beneficiary entitlements

● Undertaking trustee duties consistent with the deeds

● Correspondence with parties to the deed, including beneficiaries (e.g. information requests) and guardians (e.g. seeking guardian approval for resolutions

18. The independent trustee makes the management decisions regarding the businesses contained in the Trusts.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 40-880(1)

Income Tax Assessment Act 1997 Section 40-880(2)

Income Tax Assessment Act 1997 Section 40-880(3)

Income Tax Assessment Act 1997 Section 40-880(5)

Income Tax Assessment Act 1997 Section 40-880(5) (f)

Income Tax Assessment Act 1997 Section 110-25

Reasons for decision

Issue 1 – Dispute regarding the removal of the Trustee and replacement with an independent trustee

Summary

The legal expenses incurred in defending the Trustee Companies right to control the Trusts are a capital expense and not deductible under section 8-1 ITAA 1997. It is included in the cost base of the Trust’s assets. Therefore it is unable to be deducted under section 40-880 ITAA 1997.

Question 1

Section 8-1 of the Income Tax Assessment Act 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 expenditure must be considered (Hallstroms Pty Ltd v. FC 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.

The courts, on a number of occasions, have determined legal expenses to be an allowable deduction if the expenses arise out of the day to day income producing activities of the taxpayer (The Herald and Weekly Times Ltd v. FC of T (1932) 48 CLR 113). The action out of which the legal expense arises has to have more than a peripheral connection to the taxpayer's business or income earning activities. The expense 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).

In the circumstances of the trust, the expenses were incurred to defend the right of the trustees to remain in their capacity as trustee. This would be considered to be a capital expense. It has not arisen out of the ordinary day to day activities of the businesses of the trusts. It arises to secure an enduring benefit to the Trusts.

Therefore they will be considered a capital expense and will not be deductible under section 8-1 ITAA 1997.

Question 2

Section 110-25 of the ITAA 1997 provides the general rules regarding cost base. The cost base consists of five elements:

● Acquisition costs

● Incidental costs

● Non-capital ownership costs which are not deductible elsewhere

● Amounts which increase or preserve the value of the asset

● Amounts incurred in establishing, preserving or defending your title to the asset, or right over the asset

The first four elements are not relevant to this situation. Therefore consideration will be limited to the fifth element which concerns amounts incurred defending title to the asset.

ATO ID 2001/730 (Withdrawn) Income Tax; CGT – deceased estate – cost base of CGT asset – legal costs to determine control of the estate considers whether costs incurred by an executor of a deceased estate to defend a claim for control of the estate, form part of the cost bases of the estate’s assets pursuant to subsection 110-25(6) of the ITAA 1997.

It states that:

“As the executor of the deceased estate, the taxpayer incurred this expenditure to preserve and defend the rights over the assets of the estate in defending the claim for control of the estate. Consequently, it forms part of the cost bases of the estate’s assets pursuant to subsection 110-25(6) of the ITAA 1997”

The ATO ID has been withdrawn however this was not because of a change of ATO view. This information has now been incorporated into the content on the ATO’s website.

The current scenario does not relate to a deceased estate as per the ATO ID above. However the principles can be used in the arrangement in question.

In your situation, the Trusts incurred expenses defending their right to remain trustees and have control over the estate. Based on the principles in the ATO ID mentioned above, the expenditure will form part of the fifth element of the cost base.

Question 3

Due to the conclusion that the expenditure forms part of the cost base of both the Trust’s assets, the expenditure cannot be deducted under section 40-880 of the ITAA 1997. This is due to the operation of section 40-880(5)(f) as the expenditure can be taken into account in working out the amount of a capital gain or capital loss from a CGT event and is therefore specifically excluded from being able to be deducted under section 40-880. Alternatively, section 40-880(5)(d) would also operate to deny the deduction as it relates to a legal or equitable right, being the right of the Trustee over the assets.

Issue 2 – Dispute regarding the validity and quantum of a loan provided by a beneficiary to the Trusts

Summary

The expenditure incurred in the dispute regarding the validity and quantum of a loan provided to the Trusts by the beneficiary is capital expense and is not deductible under section 8-1. It also does not fall within the cost base of the Trust’s assets as there is an insufficient nexus between the expenditure and the Trust’s assets. It is able to be deducted under section 40-880.

Question 4

The expenses incurred by the Trusts did not come from the day to day activities of the income producing businesses contained in the Trusts. The expenditure is more accurately characterised as being towards the profit-yielding structure of the business and providing an enduring benefit. The benefit being the ability to preserve or maintain the assets of the trust as a whole by the utilisation of the funds from the loan.

Therefore the expenditure will be considered a capital expense and cannot be deducted under section 8-1.

Question 5

The expenditure itself is most directed towards the loan provided to the Trusts. The loan itself is not a CGT asset. It is a liability to the Trusts. The question turns to whether there was a sufficient nexus between the assets of the trust and the relevant expenditure in order for the expenditure to potentially be included in the cost base.

The expenditure cannot be considered to be put towards the assets of the Trusts, more correctly being expended towards determining the correct amount of the loan liability. While the money from the loan was used in the Trusts as working capital, the expenditure is more specifically related to the loan itself. Therefore it cannot be considered to relate to both the Trust’s assets and cannot form part of the CGT assets. The expenditure would not fall into any of the elements of the cost base.

Therefore the expenditure will not form part of the cost base of both the Trust’s assets.

Question 6

Section 40-880 of the ITAA 1997 provides a deduction for business capital expenditure. It is a provision of last resort such that a deduction is not available under section 40-880 of the ITAA 1997 if the expenditure is otherwise available under some other provision (paragraph 40-880(1)(a) of the ITAA 1997).

Deductibility under 40-880

The object of section 40-880 of the ITAA 1997 is to make certain business capital expenditure deductible over 5 years if:

(a) the expenditure is not otherwise taken into account; and

(b) the deduction is not denied by some other provision; and

(c) the business is, was or is proposed to be carried on for a taxable purpose.

Subsection 40-880(2) of the ITAA 1997 allows you to deduct, in equal proportions over a period of 5 income years starting in the year in which you incur it, capital expenditure you incur:

(a) in relation to your business; or

(b) in relation to a business that used to be carried on; or

(c) in relation to a business proposed to be carried on; or

(d) to liquidate or deregister a company of which you were a member, to wind up a partnership of which you were a partner or to wind up a trust of which you were a beneficiary, that carried on a business.

Section 40-880 of the ITAA 1997 also contains limitations and exceptions to the claiming of the deduction.

‘In relation to’

Under subsection 40-880(2) of the ITAA 1997 you are able to deduct if the capital expenditure you incur is “in relation” to your business.

TR 2010/D7 states at paragraph 15 that ‘for capital expenditure to be “in relation to” a business there must be a sufficient and relevant connection between the expenditure and the business’. Additionally, at paragraph 16, it is recognised that the connection between the expense and the business must ‘objectively support the conclusion that the capital expenditure is a business expense of the particular business’, which is a business carried on by the taxpayer, formerly carried on by the taxpayer or another entity or proposed to be carried on by them or another entity.

As 'in relation to' is not defined, it takes on its ordinary meaning.

In TR 2010/D7 the Commissioner considers that the legislative context of section 40-880 of the ITAA 1997 indicates that the closeness of the association or connection must objectively support the conclusion that the expenditure is a business expense of the particular business, and must be a genuine business expense of a particular business.

In considering the phrase 'in relation to' contained within subsection 40-880(2) of the ITAA 1997, paragraph 2.25 of the Explanatory Memorandum to Tax Laws Amendment (2006 Measures No. 1) Bill 2006 states:

The provision is concerned with expenditure that has the character of a business expense because it is relevantly related to the business. The concept used to establish this character or requisite relationship between the expenditure incurred by the taxpayer and the business carried on (current, past or prospective) is 'in relation to'. The connector 'in relation to' allows the appropriate latitude to enable the deductibility of qualifying capital expenditure incurred before the business commences or after it has ceased.

The phrase 'in relation to' was considered by the High Court in PMT Partners Pty Ltd (In Liquidation) v. Australian National Parks & Wildlife Service (1995) 184 CLR 301. Brennan CJ, Gaudron and McHugh JJ observed, in considering the application of the Commercial Arbitration Act 1985 (NT), at 313:

Inevitably, the closeness of the relation required by the expression 'in or in relation to' in s 48 of the Act, indeed, in any instrument - must be ascertained by reference to the nature and purpose of the provision in question and the context in which it appears.

In that case, Toohey and Gummow JJ also observed:

It is apparent that the words 'in or in relation to' are particularly wide.... Cases concerning the interpretation of this phrase in other statutory contexts are of limited assistance. However, the cases do show that the words are prima facie broad and designed to catch things which have sufficient nexus to the subject. The question of sufficiency of nexus is, of course, dependent on the statutory context....

The connection which is required by the phrase 'in relation to' is a question of degree. There must be some 'association' which is 'relevant' or 'appropriate'. The question of the relevance or appropriateness of the connection is a question which cannot be divorced from the particular statutory context.

In First Provincial Building Society Limited v. Federal Commissioner of Taxation (1995) 56 FCR 320; 95 ATC 4145; (1995) 30 ATR 207, Hill J considered the phrase 'in relation to' within the context of paragraph 26(g) of the ITAA 1936. He considered the words 'in relation to' in that context included a relationship that may either be direct or indirect, provided that the relationship consisted of a real connection, but that a merely remote relationship is insufficient.

It is therefore necessary to consider the legislative context of subsection 40-880(2) of the ITAA 1997 in order to determine whether there is a sufficient and relevant connection between the expenditure incurred and the taxpayer's business. In discussing the types of business capital expenditure to which subsection 40-880(2) of the ITAA 1997 applies, the Explanatory Memorandum to Tax Laws Amendment (2006 Measures No. 1) Bill 2006 states:

2.19 Expenditure on the structure by which an entity carries on (or used to or proposes to carry on) their business and on the profit yielding structure of the business would ordinarily be expected to be of a capital nature. Capital expenditure can also relate to a business's trading operations or the entity that will carry on the business.

2.20 The structure covers the legal entity (such as a company) or the legal relationship (such as a partnership or trust) that is the entity that carries on the business for a taxable purpose and that holds the business assets.

This indicates that capital expenditure that is incurred on the structure by which an entity carries on their business is capable of being described as capital expenditure incurred 'in relation to' that business for the purposes of subsection 40-880(2) of the ITAA 1997. Whether such capital expenditure is incurred 'in relation to' the particular business will depend on whether there is a sufficient and relevant connection between the incurring of the expenditure and that business on the facts of the particular case.

Taxation ruling TR 2005/12 Income tax: deductibility of interest expenses incurred by trustees on funds borrowed in connection with the payment of distributions to beneficiaries primarily discusses the deductibility of interest expenses incurred on funds borrowed in connection with the payment of distributions to beneficiaries. However it does broadly establish that there can be a sufficient nexus between income producing activities and a beneficiary loan.

Application to your circumstances

The expenditure incurred from the dispute as to the validity and quantum of the loan given by the beneficiary to the Trusts are incurred in relation to the business of the Trusts. The financial accommodation provided by the beneficiary loan, along with the liabilities owed to other beneficiaries and external parties has been used as working capital to fund the business asset acquisition, maintenance and ongoing business transactions.

None of the exceptions in section 40-880 apply to deny the deductibility of this expenditure as they do not form part of any cost base (as discussed in Question 5 above) and have therefore not been included in any capital gain calculation.

Therefore the expenditure is able to be deducted over the 5 year period as per section 40-880.

Issue 3 – Expenses incurred by the independent trustee in the day to day administration of the Trusts

Summary

The specific administration expenses incurred by the independent trustee are deductible under section 8-1.

Question 7

Expenses incurred in the administration of the Trusts need to be analysed to determine their deductibility under section 8-1 ITAA 1997.

The following expenses have been incurred by the trustee in the administration of the Trusts:

● Reviewing and seeking legal advice on the trust deeds

● Calculation of beneficiary entitlements

● Undertaking trustee duties consistent with the trust deeds

● Correspondence with the parties to the deeds including beneficiaries and guardians

The expenses can be deducted 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.

The Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No.1) Bill 2006 states:

2.19 Expenditure on the structure by which an entity carries on (or used to or proposes to carry on) their business and on the profit yielding structure of the business would ordinarily be expected to be of a capital nature. Capital expenditure can also relate to a business’s trading operations or the entity that will carry on the business.

While the expenses are related to the structure in which the businesses are carried on, being the Trusts, they are not specifically going towards the structure. The tasks detailed above are incidental to running a business. These exhibit a revenue character as opposed to being capital in nature. They do not provide an enduring benefit but are associated to running the day to day administration of the structure in which the businesses are contained. Therefore the trustee’s fees incurred by the Trust’s for the activities described above are deductible under section 8-1.

The legal expenses incurred by the Trusts in order to determine the legal position of the independent trustee incurring these expenses would exhibit the same character as the expenses detailed above. Therefore they are also deductible under section 8-1.

Therefore the legal and trustee expenses incurred by the trustee in relation to the ongoing administration of the Trusts are deductible under section 8-1.

Question 8

The expenditure is considered deductible under section 8-1 therefore will not form part of the cost base of the Trust’s assets.

Question 9

The expenditure is deductible under 8-1 therefore section 40-880 does not need to be considered.

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