Edited version of private advice

Authorisation Number: 1051609689033

Date of advice: 20 May 2020

Ruling

Subject: Deductions - legal expenses

Question

Are legal expenses relating to defending compensation claims against the allocation of land and improvements of that land deductible under section 8-1 of the Income Tax Assessment Act 1997?

Answer

No

This ruling applies for the following periods:

Year ending 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

You run a farm as tenants in common with your relative.

You have held equal share in the property with your relative since your parent's death.

This property has run as separate farms since that time.

In about X years ago your relative went to the Supreme Court requesting either subdivision or sale of the property.

As you refused to sell the property, the court ruled to subdivide.

Trustees were appointed in order to aid in reaching an agreement on the subdivision.

A valuation was acquired, and a line of partition was drawn.

The subdivision resulted in you gaining access to fertile paddocks that were previously farmed by your relative.

These paddocks contained better quality soil and therefore were more productive resulting in greater income.

In the time your relative farmed these paddocks, he made improvements to the land and requested compensation for these improvements.

You refused to pay compensation for these improvements as you were of the view that your relative was compensated by receiving additional income from these paddocks in the period between your parent's passing and the subdivision.

You engaged the Supreme Court following changes to the instructions to the valuer by the trustees. These changes compensated your relative for the upgrades via granting extra land that currently returns substantial income for you in produce sales.

You are now asking the Supreme Court to investigate the work of the trustees and valuer and have the land split returned to a 50:50 basis and compensation reduced to Nil.

You do not wish to claim any legal costs involved in subdivision.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1936 Section 51(1)

Reasons for decision

Legal Expenses and associated costs

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.

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. Expenditure is capital in nature where it is made with a view to bring into existence an asset or advantage that is of enduring benefit. Capital expenditure is characterised by the fact that it is usually a one-off payment and establishes, replaces or enlarges the income producing asset.

Taxation Ruling TR 95/33 Income tax: subsection 51(1) - relevance of subjective purpose, motive or intention in determining the deductibility of losses and outgoings considers the decision of the Full High Court of Australia in Fletcher & Ors v. FC of T 91 ATC 4950; (1991) 22 ATR 613 and situations relevant in determining the availability of an income tax deduction. There must be a sufficient connection between the legal expenses and the activities which produce assessable income. To determine whether the legal expenses are deductible, regard must be given to all the circumstances.

TR 95/33 considers the issue of whether a deduction would be an allowable deduction by considering the subjective purpose, motive or intention in making the outgoing. The essential character of an expense is a question of fact to be determined by reference to all the circumstances.

It may be necessary to examine the taxpayer's subjective purpose where there is no obvious commercial connection with the business activity or where the expense does not achieve its intended result. If an arrangement has an independent pursuit of some other objective, for example, to support a personal hobby, then the outgoing may not be deductible.

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). Where there is a voluntary payment or the objective purpose for expending an amount is unclear, the subjective purpose is relevant in drawing a conclusion on what the purpose of the expenditure was to effect.

In your case, you wish to claim legal expenses against your assessable income incurred due to:

·         a compensation claim relating to previous improvements to your newly acquired land, and

·         changes to the instructions to the valuer by the trustees which may result in you having to defend your right to land allocation.

You believe these legal expenses are deductable against your assessable income based on the principles discussed in Federal Commissioner of Taxation v. Snowden & Willson Pty Ltd 99 CLR 431 (the Snowden case).

You highlight that the requirement to pay unfair compensation to your relative would detrimentally affect the value of your overall land holding, the more significant impact of the compensation will be a direct impact on your future income from the farming business.

The Snowden case involved a business conducting the building of homes. A Royal Commission was conducted on the company's dealings due to increased complaints resulting from additional payments requested through the utilisation of their 'rise and fall clause' for providing 'extras'.

The company sought to both advertise to counter the effect produced by the reports and defend itself and its officers before the Royal Commission. The directors felt this was a necessary expense at the time as they believed the Commission would deter intending or likely customers from dealing with it and would destroy the faith of existing customers.

Dixon, CJ found that in the Snowden case, the Royal Commission did not imperil the existence of the business or the capital assets of the company but posed a threat to both the past revenue of the taxpayer, its goodwill and potential earning capacity. In short, the expenditure was for the purposes of trade.

In your case, the legal expenses incurred relate to property and improvements connected with that property. You have identified that an unfavourable outcome from your legal proceedings would impact your future income and that this drop of income would be due to a change in your land holding.

The principle here is identified in Broken Hill Theatres Pty Ltd v Federal Commissioner of Taxation where it was concluded that the expenditure was for the protection of the taxpayer's business as a whole, and was not directly incurred in gaining or producing the assessable income, or in carrying on a business for that purpose, and so was not an outgoing and deductible under section 51 (1) of the Income Tax Assessment Act 1936.[1]

It is important to determine if the expenditure adds to capital or merely protects or preserves capital. In your case, the possibility of paying compensation in the form of a loss of capital holdings would not relate to the gaining and producing of assessable income and would not be deductible under section 8-1.

Therefore no deduction is allowable for the legal expenses as these expenses were incurred in relation to capital assets and were not incurred in producing assessable income.

[1] As a result of the amendments to the Income Tax Assessment Act 1936, subsection 51(1) does not apply to the 1997-98 year of income or a later year of income. Section 8-1 of the Income Tax Assessment Act 1997 sets out rules for working out what losses or outgoings an entity can deduct for the 1997-98 year of income and later years of income.

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).