Edited version of private advice

Authorisation Number: 1052257797787

Date of advice: 30 May 2024

Ruling

Subject: Income tax - general deductions

Question

In determining the net income of the Family Trust pursuant to subsection 95(1) of the Income Tax Assessment Act 1936 (ITAA 1936), are the amounts of the weekly payments paid to the Wife allowable deductions in accordance with section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commenced on:

Year ended 30 June 20XX

Relevant facts and circumstances

Family Trust

1.      The Family Trust is an Australian discretionary trust, established by deed executed on DDMMYY (the Trust Deed).

2.      The trustee of the Family Trust is the Trustee Company.

Trustee Company

3.      Trustee Company is an Australian Private Company.

4.      The sole director and secretary of Trustee Company is the Husband.

5.      Trustee Company as trustee for Family Trust trades as XX, the business operated by the Husband.

Timeline

6.      The Husband and Wife were married on DDMMYY.

7.      From YY the Wife was employed by Trustee Company T/F Family Trust T/AS XX.

8.      The Husband and Wife's marital relationship broke down and they separated in 20XX.

9.      The Wife's employment with XX was formally terminated on DDMMYY, a time following the separation of the Husband and Wife. Prior to her termination the Wife's gross pay was $X per week and her net pay was $Y per week.

10.   On DDMMYY the Wife filed a Form 1 Initiating Application (Initiating Application) in the Family Court. The Husband filed a Form 1A Response to Initiating Application on DDMMYY.

11.   The Wife's Initiating Application stated that the following types of orders were being sought:

•         Final Order(s) sought - Financial

•         Interim Order(s) sought - Interim Financial and Procedural/Other.

12.   In relation to the Interim Orders sought by the Wife, her Initiating Application requested an amount of $Y per week uncharacterised.

13.   On DDMMYY Interim Court Orders were made (Interim Orders).The Interim Orders held that without admission as to need, commencing on DDMMYY, the Wife receive the amount of $Y per week to be characterised at trial and the Husband take all necessary steps as may be required to effect this Order.

14.   The Husband complied with the Interim Orders and the Family Trust paid the Wife the weekly payments of $Y from the date specified in the Interim Orders.

15.   The Husband and Wife reached a settlement and the matter did not proceed to trial.

16.   The Final Orders following the mediation stated that, by consent, the Wife would receive a cash payment, part of which was attributable to spousal maintenance, and upon the Wife's receipt of the cash payment, the Husband's weekly payment of $Y be discharged.

Relevant legislative provisions

Income Tax Assessment Act 1936, subsection 95(1)

Income Tax Assessment Act 1997, section 8-1

Reasons for decision

Question 1

In determining the net income of the Family Trust pursuant to subsection 95(1) of the Income Tax Assessment Act 1936 (ITAA 1936), are the amounts of the weekly payments paid to the Wife allowable deductions in accordance with section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Summary

No. There is not the required connection or sufficient nexus between the payments made to the Wife and the assessable income or business of the Family Trust and the amounts of the weekly payments paid to the Wife are not allowable deductions in accordance with section 8-1. Therefore, in determining the net income of the Family Trust pursuant to subsection 95(1) of the ITAA 1936, the amounts of the weekly payments are not allowable deductions.

Detailed reasoning

17.   Subsection 95(1) of the ITAA 1936 defines "net income" as:

"net income", in relation to a trust estate, means the total assessable income of the trust estate calculated under this Act as if the trustee were a taxpayer in respect of that income and were a resident, less all allowable deductions...

18.   That is, for the purpose of determining the net income of a trust estate, the trustee is considered to be a resident taxpayer and its assessable income is therefore calculated as if the trustee is a resident taxpayer, less all allowable deductions.

19.   Section 8-1 sets out the rules about general deductions and provides that a deduction is allowed 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, relate to the earning of exempt income, or are prevented from being deducted by a specific provision.

Specifically, section 8-1 states:

(1)   You can deduct from your assessable income any loss or outgoing to the extent that:

(a)    it is incurred in gaining or producing your assessable income; or

(b)    it is necessarily incurred in carrying on a *business for the purposes of gaining or producing your assessable income.

(2)    However, you cannot deduct a loss or outgoing under this section to the extent that:

(a)             it is a loss or outgoing of capital, or of a capital nature; or

(b)    it is a loss or outgoing of a private or domestic nature; or

(c)    it is incurred in relation to gaining or producing your *exempt income or your *non-assessable non-exempt income; or

(d)    a provision of this Act prevents you from deducting it.

(3)    A loss or outgoing that you can deduct under this section is called a general deduction.

20.   Subsection 8-1(1) contains the two positive limbs of the general deduction rules and subsection 8-1(2) contains the four negative limbs of the general deduction rules. The negative limbs qualify the application of the positive limbs.

21.   The two positive limbs of subsection 8-1(1) are not mutually exclusive and taxpayers that are carrying on a business can rely on either, one or both, of the positive limbs (FC of T v Snowden & Wilson Pty Ltd (1958) 99 CLR 431).

22.   Subsections 8-1(1) and 8-1(2) together have the effect that, if neither of the positive limbs are satisfied, the expense is not deductible, and the negative limbs do not need to be considered. Where at least one of the positive limbs is satisfied, the exceptions contained in subsection 8-1(2) should then be considered to see if the deduction is excluded (Steele v DFC of T 99 ATC 4242; [1999] HCA 7).

23.   As stated above, a taxpayer can deduct a loss of outgoing from their assessable income to the extent that it is incurred in gaining or producing their assessable income or it is necessarily incurred in carrying on a business for the purposes of gaining or producing their assessable income. That is, in order for a loss or outgoing to be deductible, there must be a link or nexus between the loss or outgoing and the activities which produce the income.

24.   Numerous Court decisions have considered the concept of the required connection or sufficient nexus and have determined that in order to be deductible:

•      there must be a nexus between the outgoing and the assessable income so that the outgoing is 'incidental and relevant' to the gaining of the taxpayer's income producing/business operations (Ronpibon Tin NL v. FC of T, (1949) 78 CLR 47 (Ronpibon)), or

•      the loss or outgoing must have the 'essential character' of an income producing/business expense (Lunney v. FC of T; (1958) 100 CLR 478 (Lunney)), or

•      the loss or outgoing must have a 'perceived connection' with the gaining or producing of income (FC of T v Hatchett 71 ATC 4184 (Hatchett)).

25.   These concepts were discussed in the case of FC of T v Firth 2002 ATC 4346, where Hill J stated at 4348:

The positive tests require that there be a connection between the loss or outgoing on the one hand and the assessable income or business on the other. The nature of that connection has been expressed in different ways in the cases. It is sometimes said that there must be a 'perceived connection' between the loss or outgoing and the assessable income or business: FC of T v Hatchett 71 ATC 4184 at 4187...In other cases it has been said that the expenditure must be ' incidental and relevant ' to the operations or activities regularly carried on by the taxpayer for the production of income: Ronpibon Tin NL & Tongkah Compound NL v FC of T (1949) 8 ATD 431 at 435; (1949) 78 CLR 47 at 56, FC of T v Smith 81 ATC 4114 at 4117. These ways of describing the connection that is a necessary prerequisite to deductibility are but part of the process of identifying the essential character of the expenditure in order to determine whether a particular loss or outgoing is in fact incurred in gaining or producing the assessable income or in carrying on a business which more directly contributes to the gaining or production of the assessable income: Lunney v FC of T (1958)11 ATD 404; (1957-1958) 100 CLR 478 at 413 and 499 respectively.

26.   Furthermore, the required connection between the loss or outgoing and the assessable income or business was also considered in the case of Federal Commissioner of Taxation v Wood [2023] FCA 574 (Wood). The case concerned whether a settlement sum paid by the taxpayer to bring an end to litigation after his relevant employment ended, was incurred in gaining or producing the taxpayer's assessable income and deductible under paragraph 8-1(1)(a).

27.   In Wood, the taxpayer was employed by a company (Carina) owned by the taxpayer and his wife. Carina provided consultancy services to another company (Alleasing) and Alleasing paid fees to Carina, which in turn paid a salary to the taxpayer. The consultancy arrangement between the taxpayer, Carina and Alleasing was governed by a consultancy agreement which provided that the consultancy services to be provided by Carina would be performed 'through' the taxpayer.

28.   The consultancy arrangement came to an end and the parties entered a Separation Deed. Alleasing and its parent company commenced proceedings against the taxpayer (and Carina), seeking damages claiming the taxpayer had engaged in misleading or deceptive conduct that breached the consultancy agreement. Carina went into liquidation and the proceedings were stayed. The remaining parties settled the proceedings with a settlement deed on the basis that the taxpayer pay Alleasing $200,000 'without admission of liability'. In their relevant income tax return the taxpayer claimed a deduction under section 8-1 for the settlement sum. The Commissioner disallowed the deduction and issued a notice of assessment. The decision was subsequently objected to, which the Commissioner disallowed. The taxpayer then escalated the issue to the AAT for review.

29.   The AAT held that section 8-1 operated to allow the taxpayer a deduction in respect of the settlement sum. The AAT's reasoning was summarised by the Federal Court as follows:

18...

(2) From a "practical business point of view" the Settlement Sum bore the essential character of a payment related directly to the activities that the [taxpayer] performed in the work that he did for Alleasing, which work produced assessable income for him by reason of his position with Carina.

30.   The Commissioner appealed to the Federal Court where Stewart J held that the sum was properly characterised as having been incurred in gaining or producing the taxpayer's assessable income in accordance with paragraph 8-1(1)(a).

31.   Stewart J stated at 42:

In my view the Settlement Sum is properly characterised as having been incurred in the course of gaining or producing the respondent's assessable income. The occasion of the liability that was discharged was the work done by the respondent as employee of Carina under the relevant consultancy agreement with Alleasing. As in Herald & Weekly Times, it does not matter that the liability itself was created by the Settlement Deed because the claim that was compromised by that deed arose directly out of the respondent's employment; the respondent's conduct in his employment was at once the source of income and the cause of the risk of liability. In much the same way as legal expenses incurred in contesting allegations (ie, claims) about the conduct of the taxpayer in their employment are regarded as being incurred in gaining income (Putnin, Rowe and Day), the respondent's agreement to pay, and then payment, to bring allegations about his conduct in his employment to an end is similarly characterised - it is a loss or outgoing that reduces his income from his employment. As held in Day, it is not to the point that the allegations, if established, would show that the relevant conduct was outside the scope of his employment. The conduct in question was conduct he engaged in as employee in gaining his assessable income - indeed, the claims included that he was engaged in trade and commerce and that he breached the consultancy agreement under which he was employed. The claims therefore arose directly from his employment.

32.   The Commissioner has issued a Decision Impact Statement on the Wood case which summarised Stewart J's decision about this issue as follows:

Justice Stewart found that the Settlement Sum was properly characterised as having been incurred in gaining or producing the taxpayer's assessable income under paragraph 8-1(1)(a).

His Honour observed that the Settlement Sum and releases under the Settlement Deed were to bring to an end the litigation in which some $2.4 million was claimed - avoiding the risk of a judgement, which would have amounted to a very considerable reduction in income gained in the 2006 and 2007 tax years. It is also not to the point that at the time of the Settlement Sum the taxpayer was no longer employed by Carina or through Carina by Alleasing. The outgoing was calculated to bring to an end a litigation risk which had as its source the taxpayer's employment with Carina and the Consultancy Agreement with Alleasing - this is a closer and more immediate connection than mere factual causation on a 'but for' basis.

33.   The Decision Impact Statement states that the ATO view of the decision is that Commissioner accepts on the facts found by the AAT that the conclusion was available to the Court, the decision has limited application beyond its own factual circumstances and does not represent a departure from established principles concerning 8-1.

Taxpayer's circumstances

34.   On DDMMYY the Wife initiated Court proceedings against the Husband, seeking interim financial and procedural orders, as well as final financial orders. In her Initiating Application in relation to the interim orders the Wife made a submission that she receive $Y per week uncharacterised.

35.   On DDMMYY Interim Orders were made which held that without admission as to need, commencing on DDMMYY, the Wife receive the amount of $Y per week to be characterised at trial and the Husband take all necessary steps as may be required to effect this Order.

36.   The Husband complied with the terms of the Interim Orders and the Family Trust paid the Wife a weekly payment of $Y commencing on DDMMYY.

37.   The Husband and Wife reached a settlement at a Mediation conducted and the matter did not proceed to trial.

38.   The Final Orders following the mediation stated that, by consent, the Wife would receive a cash payment, part of which was attributable to spousal maintenance, and upon the Wife's receipt of the cash payment, the Husband's weekly payment of $Y be discharged.

39.   In complying with the Interim Orders and Final Orders, the Husband caused X weekly payments of $Y to be paid to the Wife via payment from the Family Trust.

40.   As discussed above, subsection 8-1 provides that a taxpayer can deduct from their assessable income any loss or outgoing to the extent that it is incurred in gaining or producing their assessable income or is necessarily incurred in carrying on a business for the purposes of gaining or producing assessable income.

41.   That is, and as considered in the Court decisions discussed above, there must be a sufficient nexus or connection between the loss or outgoing and the assessable income or business.

42.   The Court Orders held that the Husband, as an individual party to the legal proceedings, pay (or cause to be paid), the amounts to the Wife. The orders do not instruct the Family Trust to make the payments or refer to the Family Trust in relation to the order for the Wife to be paid. The Court orders also do not refer to the Wife's past employment or the amount that she was previously paid in her employment in relation to the order for her to be paid.

43.   That the weekly amount was the same as the Wife's previous net pay from her employment or that the amounts were paid to her by the Family Trust does not demonstrate a link between the expenditure by the Family Trust and the gaining or producing of it's assessable income.

44.   The payments to the Wife by the Family Trust were not incidental and relevant to the gaining of the Family Trust's income production or business operations (Ronpibon), the payments do not have the essential character of an income producing or business expense (Lunney) and there is not a perceived connection between the payments and the gaining or producing of income (Hatchett).

45.   In the Federal Court case of Wood, discussed above, it was held that a payment made by a taxpayer to settle litigation in relation to a breach of a consultancy agreement after his relevant employment ended, was deductible in accordance with subsection 8-1(1). In Wood, the parties were involved in a consultancy arrangement. Two of the parties (related entities) commenced legal proceedings against the taxpayer and a company owned by the taxpayer (the other two parties involved in the consultancy agreement), seeking damages from the taxpayer claiming that the taxpayer had engaged in misleading or deceptive conduct that breached the consultancy agreement. That is, the legal proceedings were between entities that had been involved in a business arrangement together and the legal proceedings related to their business dealings.

46.   In comparison to the Wood case,in the matter considered in this private ruling the legal proceedings were a private (non-business) dispute between the husband and the wife in their capacities as individual taxpayers. It is important to note when comparing this matter to the Wood case, that the Family Trust, the entity that made the weekly payments and is seeking the deduction, was not a party to the legal proceedings.

47.   In Wood the company owned by the taxpayer went into liquidation and the remaining parties settled the proceedings with a settlement deed on the basis that the taxpayer pay a settlement sum to one of the other parties, without admission of liability. The issue for the Court was whether the taxpayer could claim a deduction under section 8-1 for the settlement sum. In the matter of this private ruling the 122 weekly payments paid by the Family Trust were not paid to settle litigation and as discussed above, the litigation did not relate to the relevant taxpayer's income earning activities or business (the relevant taxpayer being the entity that made the payments and is seeking the deduction, the Family Trust). In the present circumstances the wife initiated court proceedings against the husband seeking interim financial and procedural orders, as well as final financial orders, and an Interim Order was made which required the weekly amount to be paid to the wife by, or effectively on behalf of, the husband. As discussed, the Family Trust was not a party to the litigation and was not required as a result of the litigation or Interim Order, to pay the amount to the wife.

48.   In determining that the settlement sum in Wood had been incurred in gaining or producing the taxpayer's assessable income and was thus deductible, Stewart J discussed that the settlement sum and releases under the settlement deed were to bring an end to litigation in which a large amount was claimed, avoiding the risk of judgement. The outgoing was calculated to bring to an end a litigation risk which had as its source the taxpayer's employment with the taxpayer's company and the Consultancy Agreement with the other two parties. The occasion of the liability that was discharged by the settlement deed and settlement sum being paid, was the work done by the taxpayer as an employee under the relevant consultancy agreement with the other parties to the litigation. Comparatively, in the matter of this private ruling, the weekly payments were not a settlement amount paid to discharge any liability or to bring an end to a litigation risk but, as discussed above, the payments were Interim Order in a private property dispute between two taxpayers in their individual capacities. Again, it is noted that the relevant litigation was unrelated to the production of the Family Trust's assessable income, the entity that made the payments and is seeking the deduction.

49.   Considering the comparisons made above, the matter of Wood cannot be used as a precedent to establish that the connection required by subsection 8-1(1) exists in the circumstances of this ruling.

Summary

50.   The required connection or sufficient nexus between the weekly payments as a loss or outgoing, and the assessable income or business of the Family Trust does not exist, and neither of the positive limbs of subsection 8-1(1) are satisfied. Therefore, the amounts of the weekly payments paid to the Wife are not allowable deductions in accordance with section 8-1 and, in determining the net income of the Family Trust pursuant to subsection 95(1) of the ITAA 1936, the amounts of the weekly payments are not allowable deductions.

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