Edited version of private advice

Authorisation Number: 1052085676768

Date of advice: 9 February 2023

Ruling

Subject: Deductibility of legal expenses

Question 1

Is the Taxpayer entitled to a deduction in the 20XX year for the legal expenses incurred in relation to the dispute with their tenant?

Answer

Yes

Question 2

Is the Taxpayer entitled to a deduction in the 20XX year for the damages and costs paid in respect of the dispute with their tenant?

Answer

Yes

This ruling applies for the following period:

Income year ended 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

The Taxpayer owns a commercial warehouse (the Property).

The Property has solely been used to generate rental income since the time of acquisition.

The Taxpayer entered into a commercial lease with the Tenant. The lease was for one year with rent payable on the first day of each month.

The Tenant defaulted on their rent payment for several months.

Consistent with the terms of the lease agreement, the Taxpayer exercised their right to terminate the lease with the Tenant.

The Taxpayer proceeded to have the locks on the Property changed, and took actions to have the Tenant vacate the premises so it could lease the property to a new tenant.

The Taxpayer was unsuccessful in recovering the unpaid rent and commenced legal proceedings against the Tenant. The Taxpayer sought to recover the unpaid rent and interest.

The Tenant filed a cross-claim for the Taxpayer failure to comply with the procedures set out in the lease agreement in respect of termination of the lease.

The cross-claim sought to recover compensation, and damages.

The legal proceedings and cross-claim proceeded through several courts.

The Court made the following orders:

•         legal proceedings - judgement for the Taxpayer as against the Tenant for a specified sum being unpaid rent and interest.

•         cross-claim - judgement for the Tenant as against the Taxpayer for a specified sum being damages, and interest.

•         the Taxpayer pay the costs of the Tenant for the whole proceedings.

The Taxpayer paid the Tenant a specified amount in full and final settlement of the matter.

The Taxpayer also incurred legal expenses in pursuing the legal proceedings and defending the cross-claim.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Subsection 8-1(1) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that 'you can deduct from your assessable income any loss and outgoing to the extent that it is incurred in gaining or producing your assessable income, or it is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income'. However, no deduction is allowed under subsection 8-1(2) of the ITAA 1997 if the loss or outgoing is of a capital nature, a private or domestic nature, or relates to gaining or producing exempt income or non-assessable non-exempt income.

The characterisation of legal expenses as an outgoing on revenue account or an outgoing of capital nature will depend on the cause or purpose for which the legal expenses were incurred (Hallstroms Pty Ltd v Federal Commissioner of Taxation (1946) 72 CLR 634; [1946] HCA 34; 8 ATD 190; (1946) 3 AITR 436).

The question of whether expenditure is of a capital nature revolves around the character of the advantage sought by the expenditure; whether an enduring benefit is obtained as a result of the outgoing (Sun Newspapers v FCT (1938) 61 CLR 337 and BP Australia Limited v FCT (1965)112 CLR 386 (Sun Newspapers)). Where expenditure is devoted towards a structural rather than an operational purpose, the expenditure is of a capital nature and the expenses are not deductible (Sun Newspapers).

For legal expenses to constitute an allowable deduction, it must be shown that they were incidental or relevant to the production of the taxpayer's assessable income, (Ronpibon Tin NL & Tong Kah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 4 AITR 236; (1949) 8 ATD 431).

Generally, legal expenses are deductible under section 8-1 of the ITAA 1997 if the:

•         expenditure arose out of, or concerned the day-to-day activities of the taxpayer's business (Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113 (Herald and Weekly Times))

•         expenditure is not undertaken to alter the organisation or structure of the taxpayer's profit yielding subject (Foley Brothers Pty Ltd v. FC of T (1965) 13 ATD 562)

•         legal action has more than a peripheral connection to the taxpayer's income producing activities (Magna Alloys and Research Pty Ltd v. Commissioner of Taxation (1980) 49 FLR 183; (1980) 11 ATR 276; 80 ATC 4542; (1980) 33 ALR 213; Putnin v. Commissioner of Taxation (1991) 27 FCR 508; 91 ATC 4097; (1991) 21 ATR 1245)

In Herald and Weekly Times, a newspaper publisher was entitled to deduct both legal costs incurred in defending defamation proceedings and the damages payments it made to successful claims because the nature of the taxpayer's business exposed it to risk of such action.

In Case No Q49 15 TBRD 232, one of the issues considered by the Board of Review was whether legal costs incurred in obtaining an order for ejectment of a tenant was deductible. Chairman Burke, in finding that the legal costs were deductible, stated:

In my opinion, the legal expenses incurred in obtaining the order for ejectment were incidental and relevant to the gaining or production of the company's assessable income in the form of rents. In the course of letting premises the non-paying is always likely to be encountered and the removal of such a tenant is not only desirable but essential if income production is going to continue. (237)

In Case No. C12 3 TBRD 100, the Board of Review considered whether a landlord which was liable to make payments for damages relating to an accident on their property involving an employee of a tenant, was entitled to a deduction for the amounts paid. In finding that the payments were deductible, Chairman Trebilco stated:

... it seems to me that the risk of such a happening is always present in the letting to tenants of rooms in a city building... My view of the matter is that the expense claimed as a deduction was one which arose out of the letting of the building to tenants for the purpose of producing assessable income, and that it can properly be regarded as having been incurred "in the course of" gaining or producing that assessable income. (102)

ATO publication Rental properties 2020 provides that the cost of incurring the following legal expenses in producing rental income are deductible:

•         evicting a non-paying tenant

•         taking court action for loss of rental income

•         defending damages claims for injuries suffered by a third party on your rental property.

Generally, the treatment of a settlement sum or damages payment will follow the treatment of the other legal costs incurred in relation to a particular matter (see ATO ID 2002/663 Income Tax: Deductions & Expenses: Sum paid in settlement of a harassment and victimisation claim).

The Taxpayer derived income by leasing the Property for rent. The Taxpayer leased the Property to the Tenant which defaulted on its obligation under the lease agreement to pay rent. As a consequence, the Taxpayer terminated the lease and took actions for the Tenant to vacate the Property so it could be leased to a new tenant. Ultimately the Taxpayer commenced legal proceedings against the Tenant to recover the unpaid rent and incurred legal costs.

The legal proceedings of the Taxpayer gave rise to a cross-claim by the Tenant which contended that the Taxpayer failed to comply with the terms of the lease agreement in respect of terminating the lease. The Tenant was successful in their cross-claim and the Court awarded it damages plus costs.

It is a risk in letting a premises for rent that a tenant might default on the payment of rent and that action will need to be taken to recover the unpaid rent, including terminating the lease. In this case the actions taken to terminate the lease did not comply with the terms of the lease agreement, and left the Taxpayer open to a claim for damages.

The legal expenses, liability to damages and costs arising from the legal proceedings and cross-claim relate to the Taxpayer's income producing activity of letting the Property for rent. The legal expenses, damages and costs are not of a capital nature. The character of the advantage sought by the expenditure did not relate to the establishment, replacement or enlargement of the Taxpayers profit yielding structure. The expenditure was incurred for an income producing purpose of the Taxpayer.

As such, the legal fees, damages and costs arising from the legal proceedings and cross-claim are deductible to the Taxpayer under section 8-1 of the ITAA 1997.

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