Edited version of your written advice

Authorisation Number: 1051382139116

Date of advice: 13 June 2018

Ruling

Subject: Legal expenses

Question

Are you entitled to a deduction for legal expenses?

Answer

No.

Question

If you are entitled to claim a deduction for legal expenses, are the expenses claimed over four income years?

Answer

Not applicable, a deduction for legal expenses is not allowable.

This ruling applies for the following periods:

Year ended 30 June 20xx

Year ended 30 June 20xx

Year ended 30 June 20xx

Year ended 30 June 20xx

The scheme commenced on:

1 July 20xx

Relevant facts and circumstances

You had a large portfolio of shares.

You financed the purchase of the shares using a facility known as margin loan facility. This involves borrowing money to purchase the shares and using the shares as the security for the loan. The shares are held as security by the lender.

In 20XX you applied for and received a margin lending facility from Bank A. Bank A was subsequently taken over by the Bank B. (Hereafter, all reference to Bank B will include Bank A.)

For several years, you declared the dividends you earned on the shares in your income tax returns and claimed deductions for the interest paid on the loan to Bank B.

As you were negatively gearing the expenses of your loan (the interest payments) against the income earned from them (the dividends), you consider the legal expenses, like the interest, to be part of those expenses and therefore deductible.

In late 20XX, as a result of the Global Financial Crisis, the market value of your shares fell substantially. Bank B sold your shares to recover their loan. Part of your loan was replayed by the sale of the shares. However, the shares were sold for a loss, that is, the amount Bank B received for the shares upon sale fell short of the amount outstanding on your loan. Bank B held you held liable for the payment that portion of the loan which represented the loss on disposal of the shares.

In 20XX, when Bank B started court proceeding against you, they claimed the amount owed to them by you as of 20XX was $X. To this they would add claims for interest on the unpaid amount together with various fees relating to their legal action. Eventually, the amount awarded by the court to Bank B’s would total $X.

Your dispute with Bank B was about two things:

1. You were told before you signed the margin loan facility contract that the shares would be sold when their market fell below a stated level. But when Bank B actually sold the shares they did so at a much lower value, resulting in a loss of $X, for which they held you liable; plus ongoing interest accruing on this amount.

2. Bank B did not sell you the advertised product. They had described in their promotional brochure and contract how the margin loan facility was supposed to operate, whereas it actually functioned differently. Therefore the margin loan facility contract that you signed was invalid.

On advice from your lawyer, you did not pay the money demanded by Bank B, resulting in the bank taking you to court to recover the money they claim you owed them. You responded to this by filing a cross claim in which you claimed you were not indebted to them.

The case lasted from late 20XX until the middle of 20XX.

In your dispute with Bank B, you incurred legal expenses totalling hundreds of thousands of dollar. These expenses were incurred over several income years and involved payments to several lawyers.

The Judgment in the case issued on 20XX. In it, the Judge:

● Decided in Bank B’s favour, that is:

● Bank B had acted within the terms of the margin lending contract in selling the shares when they did.

● Bank B was not responsible for the losses incurred.

● Decided you were responsible for the losses.

● Ordered you to pay Bank B a total of $X; being the loss on the sale of the shares plus accumulate interest charges.

● Dismissed your cross-claim.

You have supplied copies of the following document in support of your ruling:

● Invoices/receipts from your lawyers detailing the actions they took on your behalf and the fees that they charged you.

● The margin lending terms and conditions and application forms.

● Court transcript of the case of Bank B v. the taxpayer.

Relevant legislative provisions

Income tax Assessment Act 1997 Section 8-1

Reasons for decision

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 outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income.

A number of significant court decisions have determined that for an expense to be an allowable deduction:

● 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),

● 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

● 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. 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 Weekly Times Pty ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 2 ATD 169) and the legal action has more than a peripheral connection to the taxpayer’s income producing activities (Manga Alloys and Research Pty Ltd v. FC of T (1980) 11 ATR 276; 80 ATC 4542).

However, where the expenditure is incurred for the purpose of securing an enduring benefit, rather than a revenue purpose, the expenditure is capital in nature and is not deductible (Sun Newspapers Ltd v. FC of T (1938) 61CLR 337; 5 ATD 87; (1938) 1 AITR 403).

In FC of T v. Rowe (1995) 60 FCR 99; (1995) 31 ATR 392; 95 ATC 4691 (Rowe’s case), the court accepted that legal expenses incurred in defending the manner in which a taxpayer performed his employment duties were allowable. The activities which produced the taxpayer's income were what exposed them to the liability against which they were defending themselves.

The expenditure must be related to the production of assessable income and not incurred at a point too soon to be deductible (FC of T v. Maddalena (1971) 45 ALJR 426; 2 ATR 541; 71 ATC 4161).

Application to your circumstances

You obtained a margin loan facility from Bank B to invest in shares. You purchased shares with this loan. The bank held the shares a security. The bank had the right, under the terms of the loan contract, to sell the shares if their market fell below a specified percentage of your loan.

For several years you earned assessable income in the form of dividends. You also incurred interest expenses on your loan for which you made payments to the bank and for which you claimed tax deductions.

As a result of the Global Financial Crisis, the value of your shares fell substantially and Bank B sold them off for considerably less than the amount you owed them. This resulted in a loss which you disputed but for which, after legal action initiated by Bank B, you were found liable.

For an expense to be an allowable deduction it must be a loss or outgoing incurred in gaining assessable income, that is, an income-producing expense. In your case, the relevant assessable income was the dividends you earned from the shares you had purchased with the loan and an example of a deductible income producing expense being the interest payments you made on the loan.

Your losses or outgoings were the payment of legal fees in disputing Bank B’s claim that your loan obligations included your liability to pay for the loss on disposal of the shares. Your legal expenses did not arise out of the day to day activities of your share trading but occurred after you had lost all of the shares you had been trading and hence had no connection to the your income producing activities. The loan was used to gain assessable income but the loan itself was not income but capital such that losses or outgoings incurred in relation to this capital are also considered capital in nature and, hence, not a deductible expense.

Conclusion

Your legal expenses were capital in nature not a loss or outgoing incurred in earning assessable income. Therefore, these expenses are not deductible under section 8-1 of the ITAA 1997.

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