Edited version of your written advice

Authorisation Number: 1051430743266

Date of advice: 25 September 2018

Ruling

Subject: Court orders and legal expenses

Question 1

Is the amount awarded assessable under the capital gains tax (CGT) provisions?

Answer 1

Yes

Question 2

Are you entitled to claim a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for legal expenses incurred in seeking possession of the properties and mesne profits?

Answer 2

No

Question 3

Are you entitled to claim an input tax credit for the GST paid on legal fees and disbursements?

Answer 3

Yes

Question 4

Is the Costs Order settlement amount assessable under the CGT provisions?

Answer 4

Yes

This ruling applies for the following periods:

Year ended 30 June 2015

Year ended 30 June 2016

Year ended 30 June 2017, and

Year ended 30 June 2018

The scheme commences on:

01 July 2014

Relevant facts and circumstances

You are The Trustee of X Trust.

X Trust owns a rural property and designated livestock.

You operated a primary production business and you are registered for GST.

You leased the property to persons A & B with options to renew. The last lease was extended up to a specified date.

You demanded vacant possession and return of the livestock by the end of the lease. Persons A & B refused to comply with that request and have not paid rent.

You commenced proceedings against persons A & B. In response, they filed a cross claim against you.

The Courts found in your favour and it ordered persons A & B to:

● give you exclusive possession of the land

● pay you mesne profits and interest

● pay your costs of the proceedings as agreed or assessed

The parties to the proceedings executed a deed of settlement in relation to the Costs Order and they have agreed to a settlement sum for the costs of the proceedings and the cross-claim.

You incurred legal costs for the proceedings. This comprises professional costs, disbursements, and GST.

Relevant legislative provisions

Income Tax Assessment Act 1997 Part 3-1

Income Tax Assessment Act 1997 Part 3-3

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 108-5

A New Tax System (Goods and Services Tax) Act 1999 (GST Act) Section 11-5

A New Tax System (Goods and Services Tax) Act 1999 (GST Act) Section 11-20

Reasons for decision

Question 1

Ordinary Income

Section 6-5 and section 6-10 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of a taxpayer includes ordinary and statutory income derived directly and indirectly from all sources during the income year.

Ordinary income has generally been held to include three categories, namely income from rendering personal services, income from property and income from carrying on a business.

Other characteristics of income that have evolved from case law include receipts that:

● are earned

● are expected

● are relied upon

● have an element of periodicity, recurrence or regularity.

Capital

Taxation Ruling TR 95/35 Income Tax: capital gains: treatment of compensation receipts (TR 95/35) takes a look-through approach where it seeks to connect the relevant compensation to the most relevant impacted asset or head of claim which generated the compensation.

Whether a lump sum or other compensation payment constitutes assessable income in the hands of the recipient depends on whether it is a receipt of a capital or income nature (based on the circumstances surrounding the payment). It is the character of the receipt in the hands of the recipient that must be determined. For income tax purposes, a compensation amount generally bears the character of that which it intends to replace.

In Progressive Mailing House Pty Ltd v Tabali Pty Ltd 57 ALR 609, it was said that “mesne profits are damages for trespass; mesne profits are not rent, nor are they damages for breach of a covenant to pay rent”.

In your case, the amount awarded relates to a right to seek compensation. The tenants had no current lease and remained in occupation while trying to enforce their claim in estoppel. Their claim was rejected by the Court and was decided in your favour. The calculation for mesne profit was based on the real value of the premises from the time of the forfeiture until recovery of possession. The amount received is considered a capital receipt, not as an ordinary income.

Question 2

Section 8-1 of the ITAA 1997 allows a deduction for all losses or outgoings to the extent to which they are incurred in gaining or producing assessable income. However, where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income they will not be deductible.

Paragraphs 66-68 of Taxation Ruling TR 2011/6 Income tax: business related capital expenditure - section 40-880 of the Income Tax Assessment Act 1997 core issues provides:

The classic test for determining whether expenditure is of a capital or revenue nature which is explained in the judgment of Dixon J in Sun Newspapers Ltd and Associated Newspapers Ltd v Federal Commissioner of Taxation (1938) 61 CRL 337; (1938) 5 ATD 23; (1938) 1 AITR 403 (Sun Newspapers):

His Honour said at 363:

There are, I think, three matters to be considered,(a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment.

The character of the advantage sought provides important direction. It provides the best guidance as to the nature of the expenditure as it says the most about the essential character of the expenditure itself. This was emphasised in the decision of the High Court in G.P. International Pipecoaters v Federal Commissioner of Taxation (1990) 170 CLR 124; 90 ATC 4413; (1990) 21 ATR1.

If expenditure produces some asset or advantage of a lasting character for the benefit of the business it will be considered to be capital expenditure. As stated in Sun Newspapers at 355 per Latham J, an enduring benefit does not require that the taxpayer obtain an actual asset, it may be a benefit which endures, in the way that fixed capital endures.

In your case, you sought to defend your right to the land, which is capital in nature Therefore, the legal expenses incurred are capital expenditures and are not deductible under section 8-1.

Question 3

Section 11-20 of the A New Tax System (Goods and Services Tax) Act 1999 (GST Act) (all further references are to this act unless stated otherwise) provides that:

You are entitled to the input tax credit for any creditable acquisition that you make.

The requirements for a creditable acquisition are set out in section 11-5 of the GST Act and provide that you make a creditable acquisition if:

(a) you acquire anything solely or partly for a creditable purpose; and

(b) the supply of the thing to you is a taxable supply; and

(c) you provide, or are liable to provide, consideration for the supply; and

(d) you are registered, or required to be registered.

It is necessary to determine whether you made a creditable acquisition of legal services from your legal representatives in participating in the class action. In this respect, paragraph 146 of GSTR 2001/4 states:

146. In any legal action the parties concerned are required to pay their legal advisers the solicitor client costs incurred and the supply of these legal services will attract GST and be GST inclusive sums to the extent that they are not GST-free. Both parties to a dispute, as recipients of a supply of legal representation respectively, may be entitled to an input tax credit for a creditable or partly creditable acquisition of these services.

You are entitled input to the input tax credit on the acquisition of legal services in pursuing your legal claim. The legal costs were incurred in relation to your primary production business involving a lease of the land and the herd. The supply by the lawyers is a taxable supply. You paid an amount as consideration for the supply. Lastly, you are registered for GST purposes.

Question 4

For income tax purposes, an amount paid to compensate for a loss generally acquires the character of that for which it is substituted (Federal Commissioner of Taxation v. Dixon (1952) 86 CLR 540; (1952) 5 AITR 443; 10 ATD 82). Compensation payments which substitute income have been held by the courts to be income under ordinary concepts (Federal Commissioner of Taxation v. Inkster (1989) 24 FCR 53; (1989) 20 ATR 1516; 89 ATC 5142, Tinkler v. FC of T (1979) 10 ATR 411; 79 ATC 4641, and Case Y47 (1991) 22 ATR 3422; 91 ATC 433).

The agreed settlement sum for the costs incurred in relation to your successful litigation takes the character of the advantage sought in commencing the proceedings. You sought to defend your interest in the land, which is a CGT asset. Regaining the exclusive right to possession of the properties and being compensated by way of receiving mesne profits have the nature of capital receipts as discussed earlier. Accordingly, the cost order settlement amount is assessable as a capital payment.

Copyright notice

© Australian Taxation Office for the Commonwealth of Australia

You are free to copy, adapt, modify, transmit and distribute material on this website as you wish (but not in any way that suggests the ATO or the Commonwealth endorses you or any of your services or products).